After the Great Depression, the world agreed to abandon the gold standard and orthodox monetary policy. There followed an era of fiscal policy leading monetary policy. Central banks became adjuncts of the Treasury. Keynesians were worried about a glut of savings and the need to drive interest rates to as low a level as possible with the euthanasia of the rentier as long-run policy goal. Of course, very soon it became clear that there was no such glut of savings and growth was the priority where savings mattered. Incomes had to be sustained to guarantee savings. Full employment was the aim and, hence, monetary policy lagged behind fiscal policy.
In India, RBI had little to do except to make sure that the deficit financing needs of the government were met in an orderly way by a captive banking sector. Fighting inflation was not thought to be a task of monetary policy but tackled by rationing and price controls. The received wisdom used to be that physical planning had priority over merely financial accounting. RBI was a good research centre, but little else.
Then, after the Great Inflation of the sixties and seventies, we had monetarism, with central banks pursuing money supply targets. The success of the Bundesbank made it the model and central bank independence became fashionable. Central banks had to fight inflation with money supply tools. Governments were advised not to monetise deficits. This became the Great Moderation. But we had not reckoned with globalisation and the impact of financial flows across borders. Grief was to follow.
The Great Recession has made us aware that price stability was not enough. We need financial stability much more. Attention shifted from the macro-economy to the financial sector. Globalisation makes the problem, one that requires supra-national regulation. Hence, Basel x where x takes the value from 1 to 2 to 3 and may go on to 4 and 5, etc.
Central banks in the US, the UK and even the Eurozone have taken to the complete reverse of the old policy of controlling money supply and are resorting to quantitative easing (QE). Central banks are still monetarist, but now pump money in the economy hoping for inflation. Yet, with globalisation, the link between money supply and inflation is not just national but global. So, they have ended up exporting inflation, if anything.
RBI is in an unenviable position as it is expected to control inflation but all the time being expected by the government to relax sooner than prudent so that growth can revive. RBI is just learning to be in charge of monetary policy after decades of being browbeaten by the ministry of finance. The RBI Governor was very clear in Patna recently that he saw inflation as a demand-side problem, despite the various supply-side defects in government policy. He singled out the budget deficit as an indicator of the demand pressure. He was clear that unless he had a signal that the budget would take deficit reduction seriously, he was not minded to cut interest rates. This is real old-fashioned central banking and good for him.
Yet, some of his problems are due to the QE policies being pursued by the the UK, the US and the EU. Their banks are also finding that even their economies are not insulated from external events such as the Eurozone crisis. It could be that it is futile to think of central banking in national terms any more. There is already a lot of coordination among the G7 central banks. The next move will have to be a G20 coordination, whereby the central banks of G20 can discuss the global inflationary situation. It cannot be that one part of the world can seek to increase inflation and the rest to control it. If real interest rates continue to be negative in the OECD countries, we may only be sowing the seeds of a repeat of the last bubble.
The next crisis will increase the need for a single regulatory framework for banks and some way of constant coordination among central banks. Keynes dream of a global central bank may yet be too far, as it presumed a single currency. The IMF needs to become a global coordinator rather than a European fire brigade. The task of developing a global monetary policy perspective via coordination among the G20 central banks should be its principal aim. Perhaps it is time the lead was taken by the central banks of China, Japan and India.
The author is a prominent economist and Labour peer