The Reserve Bank of India (RBI) is celebrating its 90th anniversary today. It is India’s oldest Indian institution, older than even Parliament. It used to have private shareholders between 1935 and 1949, when, following the British nationalisation of 1946 of the Bank of England, it was nationalised.

Things worked well enough after that but for the last 15 years there has been an ongoing debate about the ‘challenges before central banks’. Every participant agrees that there are ‘challenges’ but, quite frankly, no one is willing to talk about the two gorillas in the room, namely, governments and politics.

Economists have been arguing incessantly about the technical aspects of monetary policy and their impact on the financial markets. That’s necessary but not sufficient because the two gorillas can no longer be ignored. It’s time to acknowledge openly that they have brought about a massive transformation in the relationship between governments and central banks.

Me Tarzan, you Jane

Governments have always spent more than they receive as tax revenues. The difference now is that they want to spend on the economy whereas earlier they wanted to spend on wars. Indeed, it was to enable the King of England to keep fighting that the Bank of England was set up in 1694. It would oversee the loans he took to fight his wars.

The huge difference between then and now is that whereas it was the central banks that controlled governments till 1971, it’s the governments that control central banks now. This reversal of the power equation is the biggest challenge before central banks today.

So the central banks can bleat on and on about ‘independence’ but that era ended when the US did two things between 1968 and 1972. One, it fully legitimised the politics of huge budget deficits, and and two, it snapped the link between metal (gold) and money.

Basically, it said governments could now borrow without limit because as the world’s signature currency provider it would print dollars without restraint. And that’s exactly what it has been doing since then. The rest of the world has had to adjust accordingly.

All this eventually culminated in the western Atlantic financial crisis of 2008 which, far from giving central banks more control, as it ought to have, has nearly eliminated them from the stage. Or, as an Indian finance minister told the Reserve Bank of India’s governor about 70 years ago, you are a ‘subordinate department of the finance ministry’. Even the US Fed’s freedom of action is constrained.

In other words, what India did at the end of the 1950s, the world has done after 2008. To misquote the novelist James Hadley Chase, when governments say “jump, the central banks now ask how high — on the way up”.

Private shareholding?

Here’s the point: the biggest challenge before central banks are governments. Their objectives are totally misaligned. Central banks have to worry about long-term financial stability. Governments have to ensure short-term political gains. The two are mutually contradictory.

Thus, the RBI, until nationalisation, had quite a record of independence not just because of its first governor — who was sacked for his independence — but also because of its private shareholders, some of whom were on the board. They opposed British policies on interest rates and exchange rates depending on what they thought was good for India.

Now it’s not the shareholding that determines who will sit on the board. It’s the government’s ‘inayete nazar’ or benevolent eye. The RBI board is such a toothless body that, hold your breath, when it met two days after the government nationalised 14 private banks in 1969, it didn’t discuss the matter. Things have improved since then but we don’t know by how much.

So here’s what I think should happen if the RBI has to do its duty better: private shareholding must be allowed and the board must have private directors. There is absolutely no reason to believe that a fully government-controlled RBI and fully government appointed board will reach better decisions than one that has private shareholders and directors.

There are two major things that a central bank does: it controls money supply and thus does the second thing, it controls interest rates. But if you have the government owning the central bank and also being the biggest borrower, what you get is a persistent tussle over interest rates which are often too high or too low.

A very senior RBI officer, now retired, once asked this question: “Thakrasyaadhaaram Ghatam vaa Ghatasyaadhaaram Thakram?” That is, is the curd dependent on the pot for its existence or does the pot get value addition because it contains the curd?

One could, likewise, ask if a central bank functions better because the government owns it or is it the government that benefits because it owns the bank. I think we know the answer to that one.