The demonetisation exercise has caused economic mayhem in India. This has been discussed threadbare in the media. In the last year, the Reserve Bank of India introduced a new monetary policy regime with some fanfare. Among other things, the RBI was to be given more autonomy in the conduct of policy. Through the demonetisation decision the central government has effectively killed this initiative. The whole exercise has done irreparable damage to the reputation of RBI. Reputations are built incrementally but can be destroyed overnight. Let me revisit the conduct of monetary policy in the last two months.

A little background on the intellectual underpinning of the monetary policy regime may be in order. Mainstream macroeconomics, as a reaction to the interventionism of Keynesianism since the Second World War, has moved to a very conservative position. In this view, politicians cannot be trusted to oversee the running of macroeconomic policies because they have vested (narrow political, as opposed to long term, national) interests. So the nitty-gritty of policy must be left to technocrats to help guide the market. These experts effectively stand outside the society and implement scientifically designed policies. Both requirements in the previous sentence can, and should, be challenged. Do the technocrats not have an agenda uninfluenced by self-interest or ideology? And do they implement cutting-edge policies? These are not trivial points. For instance, the International Monetary Fund for many years had opposed any kind of capital controls on foreign capital flows as a legitimate tool of prudential macroeconomic policy, acknowledging (sotto voce) only recently that they were in error. Similarly, there is a reluctance to accept what are called fiscal multipliers — that is that expansionary fiscal policy increases output, while admittedly under certain conditions it can cause debt problems.

Politicians are at least elected and, in a democracy, that should count for something. It is equally true that control of monetary policy by short-sighted politicians in developing countries has sometimes led to hyperinflation. It is also true that the working of a modern financial system is too intricate to be left in the hands untrained persons (read politicians). What we need is a structure where checks and balances are in place.

Anyway, over the last twenty years, or so, a consensus has appeared among the “cognoscenti” that the central bank (i.e. the monetary authority) should be “independent”. The independence is from the executive authority. Further, there is a preference for moving to a regime where the monetary policy objective (as distinct from e.g. financial stability) of the central bank consists primarily of targeting inflation. This exclusive focus on inflation comes from a belief that the central bank cannot affect output (or other “real” variables). So what determines these real variables? What if unemployment is unacceptably high? In this view the market mechanism will take care of the problem (and presumably, quickly). The monetary authorities need to focus on monetary variables (like inflation) because the invisible hand will take care of the rest. Although the flavour of the season, not every central bank has embraced this idea (e.g., the US Federal Reserve Board still looks at unemployment).

This view of the world has become untenable (if any proof to the contrary was ever required) after the crisis of 2008. The economic system shows no signs of going back to full employment on its own. Those who had committed themselves to inflation targeting are pursuing “unconventional monetary policy” for years on end. A damning indictment of what constitutes conventional monetary policy!

In India, historically the RBI was pretty much under the thumb of the Finance Ministry, so much so that it was almost always a retired Finance Secretary who became the Governor of the RBI. Until about two decades back, the RBI financed the required Government deficit automatically (through “ad hoc treasury bills”). Thus there was no notion of independence from the Ministry. It must be said to the RBI's credit that, unlike a lot of developing countries, this mode of financing did not generate high inflation. As financial markets developed, the RBI's elbow room in pursuing policy has also grown and the straitjacket of ad hoc treasury bills was given up.

The Urjit Patel Committee in 2014 recommended an inflation targeting framework for India. Several commentators including myself had commented on this subject. Without repeating the arguments in detail, I felt that the Committee had done a cut-and-paste job and lifted prescriptions unsuited for Indian conditions (e.g. a monsoon failure and the resulting inflation can only be cured by high interest rates and demand compression). The new regime was inaugurated in 2016, and a Monetary Policy Committee was formed. The functioning of this committee was going to be transparent and the minutes were to be made public. The financial press was rapturous. A new beginning was seen to be made. An independent central bank was about to be born. Before the noise had died down, the Modi government opted to go in for demonetisation. An independent central bank should have told the government that this is playing with fire. The RBI is the repository of data on payment patterns (regional, seasonal etc.) of households and firms. Whatever the gains from the policy that the government saw (even here the RBI should have a better idea than others how much black wealth was held as cash), the sheer magnitude of the dislocation caused and the timing (between two harvests, after years of drought etc.) should have warranted a rethink. But did the RBI do this? No, it just rolled over and had its tummy tickled by the Government.

Much has been written on demonetisation that I will refrain from reproducing here. I just wish to draw the attention of the reader to the abject surrender of the soon-to-be independent central bank to the whims and fancies of the executive. In fell swoop the Prime Minister has shown to the RBI that no such thoughts should be entertained. The contrast in the transparency that ought to go with independence of the RBI could not be starker. The RBI is very eager to release the minutes of the Monetary Policy Committee (that has so far been unanimous in recommending a policy stance) but will not budge on either the agenda or the minutes of the RBI Board meeting that caused it to capitulate to the government’s diktat. If the Governor knew about the plan to demonetise (and nothing in the public domain suggests that he did), then the ensuing chaos suggests sheer incompetence on his part. If he did not know about the plan, he should have sought time to implement the policy. Either way, the RBI has not covered itself with glory. The RBI was not able to prevent monetary policy — if demonetisation is not monetary, what is? — for being used for narrow political ends. It has also dragged its feet on putting out the numbers on new cash versus old extinguished notes. Monetary policy is back to the days of ad hoc treasury bills, except that it is now under the Prime Minister’s Office. If there was no talk of independence and transparency, then no one could have excoriated the RBI. Then it would be just another department of the government. It is the fancy talk preceding the demonetisation that constituted the petard with which it is now hoist. A few years back Queen Elizabeth had referred to that horrible year for her family as annus horribilis (the tabloids had translated this from the Latin for their readers as a “bum year”!). For the RBI, 2016 has indeed been an “annus horribilis”.

The writer is former Professor of Economics at the Delhi School of Economics.