Relationship between the central bank and the treasury

The earliest central banks were set up to finance commerce in the era of gold standard, foster growth of the financial
system and as an authority for uniform issuance of notes. Trade and commerce increased the circulation of currency,
and aided the growth of the banking system- played a prominent role in lending money and financing domestic and
foreign trade with currency. Given the inherent adverse selection and moral hazard associated with lending, there were
repeated bank failures. This led to the need for an independent authority to act as a lender- of-last- resort.

Even after the emergence of central banks, the concerned governments continued to decide asset backing for issue of
coins and notes. The asset backing took various forms including gold coins, bullion, foreign exchange reserves and
foreign securities. With the emergence of a fractional reserve system, this reserve backing (gold, currency assets, etc.)
came down to a fraction of total currency put in circulation.

Role in managing economic growth and inflation

Under the gold standard, the price specie flow mechanism led to automatic maintenance of internal value (purchasing
power) and external value (exchange rate) of currency prior to the Great Depression. Hence, maintaining price stability
was not a role under monetary management.

However, the abandonment of the gold standard with pure fiat standards in the twentieth century recast the objective
of central bank policy and required separate efforts to maintain price stability. Abandoning the gold standard led to
losing the mechanism of automatic maintenance of the internal value. The high inflation of the 1970s and early 1980s
was one of the primary motivations for the broadening and deepening of monetary policy independence worldwide.,
establishing monetary policy to ensure price stability.

The political business cycle was one of the primary motivations for central bank independence. The temptation to run
the economy too hot in the lead-up to an election argued for the allocation of monetary policy management of the
economic cycle to an agency insulated from the political cycle. This led to a political consensus: central banks should be
run by technocrats, free of interference by government, pursuing one goal, price stability, with one tool, short-term
interest rates.

Guy Debelle argues that the economic outcomes of the 1990s and 2000s in terms of low inflation, low unemployment
and lower economic volatility were at least partly attributable to central bank independence.

By 1994, both theory and evidence suggested that more independent central banks deliver better outcomes, particularly
lower and more stable inflation. The theoretical case for monetary policy independence focused on countering
inflationary biases that were likely to exert themselves in the absence of an independent central bank. Such a bias could
result from political pressure to boost output in the short run – for example, before an election – or to use a central
bank’s power to issue money as a means to finance government spending (Nixon-Burns saga). Even in the absence of
political interference, inflationary bias can result from the problem of dynamic inconsistency if central banks cannot
credibly commit to keeping inflation low.

Financial Crisis, 2007

The research on monetary policy independence at the end of the 20th century was conducted on the assumption that
the central bank was focused on its direct macroeconomic mandates such as inflation and employment. In the pre-global
financial crisis period, mainstream economic literature agree that financial stability concerns should not influence
monetary policy decisions and that macroprudential policies were best devices to tackle such considerations.

Post the Global Financial Crisis, while price stability still remained a goal to be targeted by the Central Banks, they had to
take up additional roles:

 Preserving and contributing to financial stability: The financial crisis had shown that the central banks were the
first responders to systemic financial crisis. A crisis of such a nature has the potential to threaten the
transmission mechanism of the monetary policy, creating road blocks in achievement of price stability. Since
 2004, RBI has added financial stability as an additional objective in view of the fast-growing size and importance
of the Indian financial sector.
1. Identification of Domestic Systematically Important Banks (D-SIBs): Banks having size (Basel III leverage ratio
exposure measure) as a percentage of GDP equal to or more than 2%. Additionally five largest foreign banks,
based on their size, will also be added in the sample. These are banks of systemic importance
2. Regulatory role of the Central Bank was expanded: In many countries, central banks have a had clear- cut role
with regards to regulation and supervision of financial institutions in the past. For instance, RBI has had
regulatory and supervisory powers over NBFCs since 1964. The Reserve Bank introduced a comprehensive
regulatory framework for the systemically important NBFCs to keep pace with the changing financial dynamics.
3. Macroprudential Policy: These policies are meant to target systemic risks (in the financial sector) as against
individual components of the financial sector. The aim of the policy is to prevent widespread disruption in the
financial services, and the contagion to the economy as a whole. (Reserve Bank was among the first to adopt an
entire gamut of macroprudential tools.

The macroprudential tools are used to mitigate risks arising out of:

i. Cyclical fluctuations in credit growth and credit-driven asset price inflation

ii. Risks arising from excessive leverage and the consequent deleveraging
iii. Systemic liquidity risk (occurs when multiple financial institutions experience financial difficulties at the same
time)
iv. Risks related to large and volatile capital flows, including foreign currency lending.

There are three types of measures: (Macroprudential policies are typically aimed at a specific sector. Often the housing
sector is disproportionately involved in financial crises)

 Credit-related, i.e., caps on the loan-to-value (LTV) ratio, caps on the debt-to-income (DTI) ratio, caps on foreign
currency lending and ceilings on credit or credit growth;

 Liquidity-related, i.e., limits on net open currency positions/currency mismatch (NOP), limits on maturity mismatch
and reserve requirements;

 Capital-related, i.e., countercyclical/time-varying capital requirements, time varying/dynamic provisioning, and

restrictions on profit distribution.

The instruments of macroprudential policy in India:

 Credit related: Introduction of 80% of LTVs for residential real estate (2010)
 Liquidity related: Reserve requirements- increase in cash reserve requirements from 5.5% (2006) to 6% (2007)
 Risk weight: increase in risk weight on housing loans from 50% to 75% (2005) and for commercial real estate
exposure from 100% to 125% (2005), 150% (2006), and then to 100% (2008)
 Provisions: an increase in general provisions from 0.25% to 0.4% (2005), 1% (2006), and then to 2% (2007)

Why are short term rates not suitable for managing the financial crisis?

 Ben Bernanke said that monetary policy is a blunt tool to deal with financial imbalances.
 There is significant response lag in using interest rate.
 Cost of policy intervention: A rise in interest rate will affect the whole economy, leading to a generalised
reduction in economic activity. However, macroprudential policies can be tailored to risks of specific sectors and
can be implemented with smaller implementation lags.
 These instruments are especially useful when a tightening of monetary policy is not desirable (e.g., when
inflation is below target).

(Financial stability- implicit policy, price stability- explicit policy)

CENTRAL BANK INDEPENDENCE AND TREASURY

The monetary policymaker (the Central Bank) controls the money supply and can adjust it in pursuit of various
macroeconomic goals. The fiscal policymaker (Treasury) controls government spending and tax collections and can
adjust them as it pursues its macroeconomic goals.

fiscal dominance refers to relatively large fiscal deficit (especially revenue deficit)-to-GDP ratios impacting monetary
policy.

Monetary policy autonomy may be at risk if the central bank can be obliged to manage government debt through
seignorage (the revenue raised by printing money). The central bank printing more money leads to an increase money
supply, causing inflation. (Inflation Tax) This would undermine the price stability objective of the central bank. The need
for a clear dialogue between the fiscal and monetary policy makers as regards the mutual consistency of their policies
was recognised in developed countries. On the other hand, in developing countries there was less of such dialogue and
the central bankers as debt managers often tried to keep interest rates artificially depressed as it lowered the cost of
rolling over government debt. Inflation was then contained by other more stringent tools involving the use of direct
instruments like reserve requirements or selective credit controls that led to financial repression. After some initial level
of development, these central banks may take steps to ensure that this dependence of the government borrowing
programme on the banking sector is reduced. In this direction, several steps need to be taken such as free market
determination of interest rates on government securities and market based procedures for monetary policy.

The second aspect of financial autonomy concerns an adequate level of central bank capital in relation to the risks the
central bank is expected to absorb, as well as clear and consistent provisions on accounting for valuation changes, on the
creation of reserves, and on the transfer of a central bank surplus (or loss) to the government. This aspect is of particular
significance for India where demands of excess reserves of the central bank to the government have been made for
some time now. These demands are driven by fiscal imperatives. However, given the external sector vulnerabilities of
the country (NIIF – Net Internal Investment Position is negative), it is important that these reserves remain untouched.

Concerning the third aspect of financial autonomy, the challenge is to devise an approach for funding the expenditure
budget of the central bank that encourages the careful stewardship of resources but does not allow the government to
control the central bank via the purse strings. The Minister of Finance has a substantial say on the central bank’s
operating budget in only about 20% of the countries surveyed, and parliaments generally only have the right to be
informed of the central bank’s budget but need not approve it.

According to the RBI Act, there is no security of tenure for the Governor. He can be removed
without any reason, if the government wishes to. In addition, out of the 6-member Monetary
Policy Committee, 3 are appointed by the Central Government.
https://www.thehindubusinessline.com/opinion/books/a-theory-of-fiscal-dominance-in-india/article32254323.ece

For goals such as financial stability, there is a need to act in synergy with the government. Greater interaction with the
government need not compromise central bank autonomy, but it does require well specified mechanisms for
coordination. Indeed, the arguments in the area of monetary policy in favour of making the central bank independent
from the political cycle apply with equal force in the area of financial stability. In addition, there is a need to shield day-
to-day decision-making from the commercial interests of the financial industry.

Central Bank independence does not imply lack of accountability. The central bank is accountable to the political process
in achieving the goals given to it. For instance, if the RBI fails to meet the inflation target, wherein the average inflation
remains more (less) than the upper(lower) tolerance level for three consecutive quarters, it has to explain in a report to
the Central government settting out the reasons for the failure to achieve the inflation target; remedial measures
proposed and an estimated time priod within which the inflation target would be achieved.
While it is a commonly accepted fact that the independence of the treasury and the central bank is desriable, academic
literature does not decisively establish that more independence is better than less.

The key argument favoured by the proponents of central bank independence is that discretionary policy, led by the
treasury/ government, will have an inflationary bias (think of Phillips curve- to boost employment and output,
incumbent government will end up increasing inflation). However, central banks might have a tendancy to swing to the
other extreme- sacrificing potential output for an extended period of time simply to ensure price stability. Thus, a
central bank can be ‘too independent’ to be socially optimal.

Independent central banks also suffer from the problem of dynamic inconsistency- game thoeretic models can show
that it is optimal ex-ante for the central bank governors to act in a manner that suggests that inflation is going to be low.
If this is credible, and if inflationary expectations in the economy are thus ‘anchored’ at a low level, the central banker
will have an incentive to loosen monetary policy to boost growth (think of Keynesian labour supply and demand curves-
in this case, only the Ld curve will expand out!). The solution to the problem of dynamic inconsistency comes not from
central bank independence, but by steadfast adherence to a monetary policy rule/ contracts for central bankers.

The empirical literature on central bank independence shows a significant negative correlation between average
inflation over 10-year periods and a measure of independence among developed countries. However, the coefficient on
this measure is positive, although not significant, in a regression that also includes less developed countries.

In discussing central bank independence, it is useful to draw a distinction between goal independence and instrument
independence. A central bank has goal independence when it is free to set the final goals of monetary policy. Thus, a
central bank with goal independence could, for instance, decide that price stability was less important than output
stability and act accordingly. Goal independence is related to the concept of political independence; however, by
political independence they mean the central bank’s ability to pursue the goal of low inflation free of political
interference. A bank that has instrument independence is free to choose the means by which it seeks to achieve its
goals. The Reserve Bank of New Zealand, whose goals are precisely described in a contract with the government, has no
goal independence; however, it has instrument independence since it chooses the method by which it tries to achieve
the pre-assigned goals. A central bank whose task was specified as attaining a given growth rate of the money stock
would have neither goal nor instrument independence.

“It’s not as if central banks have covered themselves in glory since breaking loose of their political masters. Inflation
targets are habitually missed or undershot. Central banks not only failed to spot the sub-prime crisis, they arguably made
matters worse by keeping interest rates too low for too long and thus stoking the credit bubble. And yet, governments
have rewarded central banks for these failings by handing them even more responsibility for prudential and financial
regulation.”

Guy Debelle argues that the economic outcomes of the 1990s and 2000s in terms of low inflation, low unemployment
and lower economic volatility were at least partly attributable to central bank independence.

https://economictimes.indiatimes.com/news/economy/finance/financial-stability-taken-care-of-under-flexible-inflation-
targeting-regime-rbi-research/articleshow/87135327.cms?from=mdr