People's Democracy

(Weekly Organ of the Communist Party of India (Marxist)


No. 51

December 29,2002

What’s Wrong With Independent Central Banks?  

Jayati Ghosh

 ECONOMIC policy making – especially macroeconomic policy – is not really only about the total aggregates in the economy. It is much more about income distribution, and the different gains and losses made by different classes and groups in society. Therefore, it reflects the interests of those groups, and the extent of their ability to influence government decisions.  

Consider the currently fashionable aim of “central bank independence”. This is the latest mantra that is common across the world, and of course has been picked up by our own market-oriented reformers.

This is usually referred to as independence from the political process, and therefore from the state. At one level, the very aim is manifestly absurd, since the basic wherewithal of the central bank, the management of the country’s currency cannot occur without the explicit backing of the state and its power. Since money is ultimately a creation of human minds depending upon trust and reflecting economic and other power, it necessarily requires state support simply in order to exist. Therefore, no central bank can ever be “independent” of the government.


But if this is the case, then what is the point of insisting that the very government that sets up and provides the backing for the activities of the central bank, should provide it with independence in terms of its actions? The point, it turns out, is not a “technocratic” and “apolitical” goal, as is usually argued. Instead, the aim is to make central banks focus on only one aspect of economic policy – the control of inflation – and ignore all the other crucial issues such as growth and employment generation.

So the notion of central bank independence usually implies a focus on price stability as the basic aim of central bank policy, rather than any other objective such as increasing employment. It is possible that this will not just ignore, but actually come into conflict with, other more “popular” objectives, since the central bank will then always have a deflationary bias. Central bankers would be free to ignore any sort of political pressure for relaxing monetary policy even when it means sacrificing economic activity and employment. In effect, it means removing monetary policy from any political or democratic accountability.

It is important to note that this does not mean that the central bank therefore becomes “apolitical”; rather, it implies a certain political choice on the part of the policy makers who grant the central bank such autonomy. The interests of rentiers and other groups, who are more interested than others in keeping inflation low, are therefore privileged over the interests of those – say workers without jobs – who would be in favour of increasing employment, or those – such as small scale industrialists and agriculturalists – interested in higher level of economic activity in general.


Across the world, therefore, the shift in policy discussion that has made this option of central bank independence so popular, reflects shifts in the balance of political and economic power, between rentiers and other groups in particular societies. This political economy shift has been accentuated by the growing integration of many householders into what used to be a much more exclusive segment of society.

More and more people in the developed world, including workers in employment, now have their interests closely tied with those of the fortunes of the capital markets. This actually reflects the withdrawal of the state from its earlier social security functions to a large extent, and the consequent need for people to ensure for their futures through private savings. Such small investors in turn are as anti-inflationary as large rentiers, and contribute to the political constituency that argues for central bank independence.

In many developing countries there is a further consideration. Most of the policies of financial liberalisation in developing countries, which have subsequently therefore become “emerging markets”, have been driven by one of two visions. The first, which is by far the most widely prevalent, is the hope that financial liberalisation and other measures to attract investors will attract significantly more foreign capital inflows into developing economies. The second, which has tended to be confined to the more ambitious of the newly industrialising economies, is the hope of becoming an international financial centre, and reaping all the benefits of increased activity, employment and profits through the consequent expansion in high value services generally.

In aiming for these goals, governments of developing countries have generally been willing to accede to almost all requests or conditions laid down by private international capital with respect to financial liberalisation. The granting of formal autonomy of actions to central banks, and thereby declaring that price stability will take precedence over other macroeconomic goals, is also one other attempt to attract international investors.


However, the experience since 1991 suggests that both of these hopes have been over-optimistic at best, and even misplaced. Despite all the much-hyped liberalisation and integration of world markets, developing countries as a group have actually received less net capital inflow as a share of GDP in the 1990s than they did in the 1970s, during the petrodollar recycling phase. Even if only “emerging markets” are considered, the picture is still unexpectedly bleak. All emerging markets together accounted for only 5 – 7 per cent of global bond and equity market values by the end of 2001.

The main recipient of international capital resources has in fact been the United States economy, which has absorbed 70 per cent of the world’s savings in recent years, which amounted to more than $400 billion in 2001. In that year, gross emerging market financing was less than half of net US inflows.

Evidently, all the financial liberalisation and inflation control measures that swept emerging markets from the early 1990s, have not really helped them to attract more net capital inflows. Indeed, it could be argued that the waves of crises in emerging markets, which were themselves largely the results of such blanket financial liberalisation, operated to scare away investors and reduce net inflows.

            The point, therefore, is that financial liberalisation has not really helped developing countries to increase their access to international capital markets to any substantive extent. Nevertheless, the very process of trying to attract such capital inflow carries very high costs for the domestic economy. The first cost is that financial liberalisation drastically undermines the capability of the monetary authorities to address basic macro policy issues or undertake effective regulation of the financial sector. In addition, this strategy usually means higher real interest rates, whatever be the requirements of the domestic economy. This further depresses domestic economic activity. In this context, central bank “independence” implies further constraints on fiscal policy as well, since it would put limits on government’s recourse to deficit financing, raise the cost of government borrowing, and put the economy on a deflationary course even if that is not desired. 

So the trade-off between giving up control of monetary policy and attracting capital inflow does not really appear to exist, except unfortunately in the minds of policy makers across the developing world. We need to fight this in the Indian case if the Indian economy is at all to achieve a revival of growth and increase in employment.