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Lagarde, Yellen and now Draghi: What do these appointments change the Central Bank-Government relations?

Summary:
Over the weekend, Mario Draghi former President of European Central Bank was elected as Prime Minister of Italy. Draghi joins Yellen in a central bank turned politician. In Europe, the appointment has also been the other way round. Christine Lagarde was Finance Minister of France and later appointed as President of European Central Bank. All this is interesting for two reasons. First, post 2008 crisis there was a thinking that central bankers are becoming too powerful and governments should cut their powers. However, what we are seeing is the opposite. The Governments are actually reaching out to former central bankers to resurrect both economics and politics.  US and Italy have both become highly divisive and Yellen & Draghi have a tough job at hand. Same with Lagarde as well who is

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Over the weekend, Mario Draghi former President of European Central Bank was elected as Prime Minister of Italy.

Draghi joins Yellen in a central bank turned politician. In Europe, the appointment has also been the other way round. Christine Lagarde was Finance Minister of France and later appointed as President of European Central Bank.

All this is interesting for two reasons.

First, post 2008 crisis there was a thinking that central bankers are becoming too powerful and governments should cut their powers. However, what we are seeing is the opposite. The Governments are actually reaching out to former central bankers to resurrect both economics and politics.  US and Italy have both become highly divisive and Yellen & Draghi have a tough job at hand. Same with Lagarde as well who is trying to balance the economics and politics of European Central Bank. It has to be seen whether collectively they can infuse confidence in their respective countries as Super Mario did for Euro with his “whatever it takes” comments followed by action.

Second, over the years we have grown to this idea of central bank independence (CBI). CBI implies that the government sets goals for the central bank such as price stability and leaves it to central bank management to achieve the goals without much interference.

Over the years, there has been a fair bit of research on what comprises CBI and its impact on central bank goals. While it is not stated clearly, one of the elements of CBI was to ensure Finance Ministry and Central Bank appointments are kept separate.

If there is a revolving door between the two highest offices of nation’s financial matters, one can never ensure even basic autonomy leave alone independence. The problem is likely to be more if former Finance Ministers becoming future Governors compared to former Governors becoming Finance Ministers.  This is because former Finance Ministers turned Governors are likely to be more sensitive to the cause of the Government. However, even former Governors turned Finance Ministers can pose problems as they know the pressure points for making central bank compliant.

Yellen is not the first to be appointed to these twin roles. The first Chair of Federal Reserve William Gibbs McAdoo was appointed as Treasury Secretary in 1913 and as Federal Chair was also established in the same year, he served as Chair of the central bank as well till 2014. Later, G. William Miller served first as a Federal Reserve Chair between 1978-79 and then went onto become Treasury Secretary in 1979-81.

Given this brief, how do we analyse these two appointments in US and Europe? One could treat them as exceptions to the available wisdom on CBI, but this might ignore a possible development in future. After all, these two are not just the largest economic blocks but also their central banks seen as highly independent as well. So, other countries might also begin to appoint similarly. Malta for instance has appointed a former finance minister as its new central bank governor.

Looking at world economy trends, there is a strong reason for governments to appoint former Finance Ministers/government officials to be appointed to the central bank. There were differences between governments and central banks in quite a few countries. The two authorities buried their differences due to the pandemic with most passing a combined fiscal and monetary stimulus to support the economies.

Going ahead in 2021 and beyond, governments are under increasing under stress due to stagnant economies. This will make them again rely on central banks to continue providing liquidity by buying government bonds from markets. The best way to ensure this is to appoint a compliant Governor preferably from the finance ministry.

One need not appoint a Finance Minister as Governor but even junior appointments will do. Mexico for instance also appointed a Finance Ministry official as Deputy Governor.  The Mexican Government is considering passing a law that will require the central bank to buy the money that commercial banks cannot return to the financial system. The Central bank believes this unabsorbed money belongs to the criminal world leading to frictions. This new appointment might support the Government’s cause.

What does all this mean for Indian monetary policy? Well, we are not new to this revolving door between government and central bank. Two RBI Governors – CD Deshmukh and Dr Manmohan Singh – went onto become Finance Ministers. We have not had a case of former Finance Minister being appointed as a RBI Governor. But this does not mean the Government/Finance Ministry influence on RBI has been any less. Of the 25 RBI Governors, 12 were members of Indian Administrative Services with quite a few serving as Finance Secretaries in the Finance Ministry.

Hence, if this trend of cross appointments does pick across other economies, we are unlikely to be impacted as other central banks. Though, RBI could provide some lessons for central banks which could see appointments from finance ministries.  Despite such a strong government involvement, RBI has not done as badly as it could have done. This is because RBI’s institutional structure is such that whoever comes in broadly ends up following established policies and principles.

It has to be seen whether the central bank-government relations will change once again or not. This is a space which is never short of action.

Amol Agrawal
I am currently pursuing my PhD in economics. I have work-ex of nearly 10 years with most of those years spent figuring economic research in Mumbai’s financial sector.

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