Thread by @shrikanth_krish

Urijit Patel's resignation is news.

Not surprisingly there is consternation at the undermining of RBI's autonomy

There is alarm that this means the subordination of RBI, and the use of the bank's reserves to fund "vote buying expenditure"

But how valid are these concerns?

Given the brouhaha over this topic, it is worthwhile to stop using buzzwords, but instead understand what exactly is "Central bank independence", what is its track record, and how bothered we must be about it

It is also worthwhile to reflect on the views of past economists on "Central bank independence".

What about the great monetary economist Milton Friedman for instance?

What did he think about "CBI"? Did he really believe it is such a big deal?

First of all we must remind ourselves that "central banking" is not a new fangled thing. It is as old as civilization

Money has played a role in economies for the past 2500-3000 years. And the creation of money was always entrusted to the state in most cultures

Let's go back to the Mauryan state in India (circa 300 BCE). The treatise Arthasastra tells us that the mint was managed by a superintendant named "lakshanadhyakshah" who was in charge of the issue of coins

And at no point is it hinted that this body was independent of the govt

So in much of the pre-modern world, central banking was hardly ever thought of as something totally distinct from the state, which requires insulation

As many may find the citing of ancient history odd, let's discuss more recent history

In the US, the Federal Reserve was instituted in 1913.

So prior to 1913, the US, for a major part of its existence (1776 to 1913), did not have a central bank

But the absence of an independent central bank did not mean the US did not undertake central banking. Much of the functions we now think of as those of the Fed was undertaken by the Treasury (equivalent of the Indian Finance ministry)

So central banking was very much part of politics. Not insulated from it.

This did not prevent the US from being easily the fastest growing country on earth during this period (1776 to 1913)

During the American Civil war in the 1860s, the Union was in fact financed by the printing of bank notes, and the issuance of large volumes of govt bonds - acts undertaken by the Congress and the Federal govt. And not by technocrat monetary economists

In 1861, Treasury secretary in the Lincoln Administration, Portland Chase, suggested that the federal govt issue $150 million worth of new paper currency (not backed by Gold). The Congress approved his plan

By 1863, $450 million worth of new currency was circulating in the Union

Even Milton Friedman, who was not just a great economist but also a fine monetary historian, acknowledged the central role of Treasury in monetary policy in the era before the Federal Reserve

We know about this through Anna Schwartz, his long time collaborator, who made Friedman's views public in a 2009 paper

The paper can be accessed here -

shadowfed.org/wp-content/upl…

Quoting Ms Schwartz

"Friedman points to the fact that ... the Fed was hardly ever the sole authority in the government that had essential monetary powers. Before the Fed existed, the Treasury exercised essential monetary powers, and at times similar to those of a central bank"

The Federal Reserve came into existence in 1913

But the creation of an independent central bank did not necessarily mean that the function of central banking was undertaken with any greater competence than before

Between 1929 and 1933 , the worst depression ever witnessed in the West post Industrial Revolution, happened under the watch of an "independent" Federal Reserve, less than two decades after its founding

The US economy shrunk by a third in the early 30s. The Fed did v little

Milton Friedman in fact held the Fed responsible for the Great Depression in his 1963 work - "A Monetary History of the United States" co-authored with Anna Schwartz

Despite the entreaties of the govt, the Federal Reserve let the money supply collapse, and failed to print enough money, thus deepening a recession into the worst Depression in living memory

The Central bank for all its competence, failed in its entrusted task. And there ensued a Depression of proportions that never happened in the whole century and a half preceding the creation of the Fed!

The recovery from the Great Depression was eventually made possible by the Treasury taking over the function of the Fed and engaging in monetary stimulus

Here's Anna Schwartz on the same -

"From 1933 to 1941, the Fed was passive and the Treasury predominantly took over monetary powers and engaged in open market operations of buying and selling securities. It created and destroyed money in its gold and silver purchases and sales"

(Contd..)

" It used the Exchange Stabilization Fund as another device for engaging in open market operations. In sterilizing it engaged in monetary actions"

So clearly the Fed's impotence had forced the govt to step in to engineer a recovery

Milton Friedman, a proponent in free market, and a small state, was nevertheless a critic of this notion of "Central Bank Independence"

In part because of his study of the Great Depression, and the role of the Fed in worsening it

We learn more about Friedman's views on Central bank independence from Anna Schwartz -

"It may be of some surprise that Milton Friedman, a believer in limited government, proposed subordinating the Fed to the Treasury department ..."

"He contended that it would result in a single locus of power on monetary and fiscal policies, and would establish accountability for mistakes in policy
that otherwise leave each institution free to blame the other for policy errors"

"According to Friedman, even if there were a central bank that had independence to the furthest extent, it would still be independent only if it had no conflict with the rest of government. If there were a conflict the bank would unquestionably give way to the fiscal authorities"

"Even if a fully independent bank could be established it would not be desirable to do so for political and technical reasons

The political reason is that in a democracy it would be wrong to place such concentrated power in a group free from any kind of direct political control"

"Friedman lists three more technical defects of an independent central bank:

- Shirking responsibility in times of uncertainty and difficulty
- Dependence on personalities which fosters instability
- Undue influence to the opinions of bankers"

"According to Friedman, it would be much more efficient if the Fed did all the borrowing and all of the managing of the debt and the Treasury, when it had a deficit, financed it by getting money from the Fed, and when it had a surplus handed it over to the Fed"

So clearly here's an image of Friedman, that not many people would be familiar with.

The great monetary economist, was very sceptical of central bank's discretionary powers, and arguably was more wary of them than the discretionary power of a democratic govt"

The Federal Reserve recently completed 100 years of its existence. But in this long period, the American economy has not necessarily been recession free

As we discussed the greatest depression in the post IR era happened under Fed's watch.

Besides that, there have been very deep recessions in the mid 70s, early 80s, early 2000s, and again in 2008

In some cases the recessions were caused by tight monetary policy as in the 30s and early 80s. On other occasions by excessively loose monetary policy as in the mid 2000s

While it is all very well to kowtow to the notion of "Central bank independence", it is also worthwhile to reflect on the many failures of independent central banks in the past 100 years

Human wisdom is suspect. Be it that of elected politicians or that of unelected technocrats.

Atleast with politicians, they face the feedback from the ballot box unlike Econ PhDs

Let's conclude with that thought