## Wednesday, February 25, 2015

### Going from strong as in scary to strong as in capable

by Suyash Rai and Ajay Shah.

The central question in India's journey, today, is that of constructing State capacity. How should laws, agencies, processes and accountability be designed, to engender high performance? In a recent speech titled Democracy, inclusion and prosperity, Raghuram Rajan talks about the joint process of evolution of economics, politics and the State. Rajan provides a brief summary of the framework articulated in the first of Francis Fukuyama's two volumes on political development. Fukuyama uses three pillars to trace political development globally: State-building, rule of law, and accountable government.

Late in the speech, he asserts that India is unique in having built democratic accountability and rule of law before building a strong government. He argues that there is a conflict between government accountability and government capacity, and since checks and balances make it difficult for the government to do its job, we should focus more on State-building and less on accountability. In other words, we have plenty of accountability but little capacity, and should therefore focus on the latter. The key text is:
An important difference from the historical experience of other countries is that elsewhere typically strong government has emerged there first, and it is then restrained by rule of law and democratic accountability. In India, we have the opposite situation today, with strong institutions like the judiciary, opposition parties, the free press, and NGOs, whose aim is to check government excess. However, necessary government function is sometimes hard to distinguish from excess. We will have to strengthen government (and regulatory) capability resisting the temptation to implant layers and layers of checks and balances even before capacity has taken root. We must choose a happy medium between giving the administration unchecked power and creating complete paralysis, recognizing that our task is different from the one that confronted the West when it developed, or even the task faced by other Asian economies.

For instance, a business approval process that mandates numerous government surveys in remote areas should also consider our administrative capacity to do those surveys well and on time. If it does not provide for that capacity, it ensures there will be no movement forward. Similarly, if we create a multiple appellate process against government or regulatory action that is slow and undiscriminating, we contain government excess but also risk halting necessary government actions. If the government or regulator is less effective in preparing its case than private parties, we ensure that the appellate process largely biases justice towards those who have the resources to use it, rather than rectifying a miscarriage of justice. So in thinking through reforms, we may want to move from the theoretical ideal of how a system might work in a country with enormous administrative capacity, to how it would work in the actual Indian situation. Let me emphasize, we need "checks and balance", but we should ensure a balance of checks. We cannot have escaped from the License Permit Raj only to end up in the Appellate Raj!
In this article, we disagree with this argument. We analyse RBI in some detail as an example of what is going wrong in the Indian State. We see the argument above as a restatement of the present mores of the Indian State. This way of thinking is integral to the poor outcomes that we see in India today, and yields low State capacity and abuses of power. The essence of making progress on the construction of liberal democracy in India, and of building State capacity, is to break with this position.

### The three big phrases in this debate

State-building. Fukuyama uses the term State' in the sense that Max Weber used it: An organisation deploying a legitimate monopoly of violence over a defined territory. He also borrows the definition of a modern state: A state that is subject to a rational division of labor, based on technical specialisation and expertise, and impersonal both with regard to recruitment and their authority over citizens. State-building essentially amounts to successfully extending the state's legitimate monopoly on force over the territory it governs, and modernising the use of this force by division of labor, technical expertise, and impersonal recruitment and authority. The state may use its force for benign ends, but it has the power to do the opposite. This monopoly is necessary but it is also dangerous, and therefore it must be constrained. That is why democratic accountability and rule of law become important.

Rule of law. For many people in India, the phrase rule of law means obeying all laws'. However, it means much more than this; it is about a deeper constitutionalism that pervades the working of the State. The essence of this complex and multi-faceted concept is the restriction of arbitrary use of power. When the power of the State is given to an individual, that individual is expected to use it in good faith for the precise purpose for which it was given, without undue intrusion into the people's lives. However, trust in good faith is not enough. If men were angels, no government would be necessary. Hence, the rule of law must be enshrined in procedures and policies. All use of power must be subordinated to established laws, and not based only on volition. The rule of law is strengthened when laws limit the use of power, and prescribe due process for use of power. Under the rule of law, the law is known, State behaviour is predictable and aggrieved persons have efficacious mechanisms for appeal.

Accountable government: In Fukuyama's words, accountable government means that the rulers believe that they are responsible to the people they govern and put the people's interests above their own. This moral concept of accountable government has formal manifestations. One major way in which this manifests itself in democratic societies is through the Constitution and parliamentary laws. The government is mandated to put the public interest above its own interest. If the government fails to meet the objectives satisfactorily or if it uses its powers for some other ends, the electorate would hold it accountable at the elections. Alongside this, well drafted laws create an array of additional accountability mechanism, which constantly keep government agencies and their employees under check.

### Ordering or interdependence?

While many countries developed strong governments before they strengthened government accountability and rule of law, there are important examples of countries where this was not the case. The US and UK saw the emergence of democratic accountability and rule of law alongside the rise of strong governments. Democratic accountability and rule of law helped decide what kind of strong and capable government the country needed. That is what protected the populace from a rapacious state. Even James Madison who wrote about enabling the government to control the governed, and then obliging it to control itself, helped build accountability and rule of law in the US Constitution from day 1, which helped shape the nature and extent of strengths of the US government (see Federalist 47-51 by James Madison).

There is a deep dialectical relationship between government capacity and government accountability, and not some simple ordering. Accountability may shape State capacity, and the opposite could also happen. As Tocqueville demonstrated in his book on the French Revolution, The Old Regime and the Revolution, the French monarchy unintentionally paved way for a democratic revolution by creating a rational, centralised state that weakened the feudal order and placed most citizens on equal footing, thus laying the foundations of democratic society.

Education in India shows us an opposite story: if so many people in the country had not exercised the "exit" option by taking their kids to private schools, and instead "voiced" their dissatisfaction with government schools, we would have seen much better performance from the government schools.

It is more risky to have the State build capacity in a vacuum as it is all too easy to misuse coercive power. State capacity must be built within the contestations and pressures of democratic accountability and it must operate within the bounds of rule of law.

### Strong as in scary vs. strong as in capable

At first blush, it seems that India has a weak State' and has rushed ahead on greater democratic accountability and rule of law. However, the precise sense of strong' or weak' needs to be carefully understood. There are two aspects of the 'strength' of a State.

1. One feature of a strong' State is having coercive power over citizens, the ability to force them to do certain things, and the ability to hurt them. By this definition, large parts of the Indian State qualify. Many regulators in the financial and infrastructure sectors are fairly strong in terms of their ability to make their regulated sectors follow their commands. The tax bureaucracy in India is very powerful, to the point where the phrase tax terrorism' has entered the lexicon. If we think of the word strong' as scary', then a lot of the Indian State meets the test.
2. Another feature of a strong' State is one that delivers the desired results. A strong' criminal justice system is one that delivers law and order. If we think of strong' as capable', most of the Indian State apparatus is faulty.
Rajan says that asking for more accountability and the rule of law will hold back the emergence of a strong State. At present, all too often, the Indian State is strong as in scary but not strong as in capable. A great deal of coercive power has been given to the government and its agents, but they do not build sufficient capacity to do their jobs. At the same time, they use the power as they wish.

How to map power into the desired outcomes? This is substantially about accountability and the rule of law. If results are not delivered, it is very likely because there is not enough accountability and the rule of law. The journey from a scary State (which has the coercive power over citizens) to a capable State (one that delivers on governance outcomes) runs through the bridge of accountability mechanisms and the rule of law.

### 'Leave it to the experts' or 'give them power and hold them accountable'?

Rajan says that since it is difficult to distinguish necessary government function from excess, the government should get a long rope. But it is precisely because government function is hard to distinguish from excess, that government and regulators can amass illegitimate power and use it excessively. Only when we build adequate checks and balances will the temptation for excess be curtailed.

To place Rajan's comments in context, in a recent debate [link, response, response, response, response], he opposed judicial review of regulations. Is such review an example of "excessive checks and balances"? In the working of liberal democracy, nobody has the ability to write law without checks and balances. As an example, a committee report led by Professor Rajan in 2009 strongly and repeatedly recommends the idea of an appellate system for all financial regulators. Now, Governor Rajan opposes the idea.

### Looking at the RBI through this framework

It is well and good to talk about high principles, the big picture and the long march of history. However, specific actions, real institutions and the current context also matter. When talking of the entire system, one is vulnerable to commit a fallacy of division, i.e. assuming that what is true of the whole must also be true of the parts. What is true of the overall Indian government may not actually be true of all its parts. Rajan is on a three-year term as the Governor of RBI. He has completed about half of the term. This is hence a good time to look at how issues of State capacity, accountability and rule of law are working at RBI.

Regulators such as RBI subsume within them legislative, executive and judicial powers. They make regulations, implement them and adjudicate over those they claim have breached the regulations. This devolution of authority from the Parliament is justified because of technical expertise required, and because there is a need for independence from day-to-day political intervention. However, if such power is not checked, it is a recipe for tyranny.

Is the grand narrative of the Indian state - high on accountability and rule of law, and low on capacity and strength - true of the RBI? RBI is strong as in scary. It lords over banking, payments, capital flows, etc with such strength that it is almost unimaginable that a regulated entity would do anything against RBI's wishes. Most employees of financial firms privately excoriate the RBI but are scared enough to praise it in public. There is a level of fear, and self-censorship, that is seldom found in argumentative India.

While India has high democratic accountability overall, this is not true of RBI. RBI is a set of unelected bureaucrats who are, in effect, largely unaccountable. Although it is supposed to be held accountable by the Parliament, one cannot see how such accountability can be enforced. At present, RBI pursues multiple, conflicting objectives, which give endless opportunities of offering alibis for non-performance. It is a central bank, manager of government debt, redistributor (e.g. priority sector requirements), regulator of banks, non-banking financial companies, payments and capital flows. It runs exchange and payments infrastructure. When failing on beating inflation, it can say it was keeping interest rates low on government debt. When failing on safety and soundness regulation, it can argue that it was busy ensuring banks lend to priority sectors where they incurred losses. Multiple objectives, and conflicts of interest, has given a loss of accountability.

What about the rule of law at RBI? RBI has taken undue advantage of what Rajan calls "the difficulty of distinguishing between necessary government function and excess".

Example: RBI has arbitrarily arrogated to itself the power to restrict competition in banking by giving only 2 licenses a decade, and there is no effective mechanism to question this power. This is partly because the RBI Act and the Banking Regulation Act do not impose sufficient procedural restrictions on such misuse of powers. If, for example, the RBI was mandated to conduct a cost-benefit analysis of its regulations, we would learn about the economic consequences of the restrictions it imposes, but no such mandate exists.

Example: RBI's actions on exchange-trade currency derivatives, which damaged the liquidity in the market, and increased currency volatility. These mistakes would have been less likely if there were better checks and balances.

Example: Under Rajan, RBI's intervention of the Rupee has grown manifold compared to that in the previous Governor's tenure:

This major shift in the actions of monetary policy has not been announced or explained to the public. This change in course is an exercise of arbitrary power conducted under opacity.

Example: In a recent case involving Docomo, RBI arbitrarily announced that one particular transaction was allowed to violate its own regulations. This violates the rule of law. See: Good sense on Docomo vs. the rule of law by Bhargavi Zaveri and Pratik Datta.

Example: RBI's notion of wilful default' is inconsistent with the rule of law.

Example: RBI repeatedly puts out orders which are arbitrary exercises of power.

RBI has almost completely unchecked powers. Judicial review would be a valuable check. The judiciary will not rewrite regulations or order, but it may strike down regulations and orders that are found violating the Constitution, some laws or regulations. This helps improve the quality of regulations and orders.

Rajan seems to be arguing that because RBI is low on capacity, the accountability mechanisms should be reduced. We have one interesting counter-example in the Indian experience. SEBI was weak, and issuing a stream of low quality orders. The application of constitutional principles led to the introduction of appeals against SEBI orders, in 1997, at the Securities Appellate Tribunal. In the years since the SAT was set up, to hear appeals from SEBI orders, the quality of SEBI orders has improved, and indeed, the quality of investigations and enforcement at SEBI has been pushed up.

In similar fashion, the highway to a superior RBI runs through subjecting RBI actions to judicial review. State capacity at RBI is 18 years behind the capacity which has come up at SEBI as a consequence of the pressure that SEBI faced in the form of appeals at SAT. We have Governor Raj'. If we add some Appellate Raj', we might get a good mix.

Accountability and rule of law are not just about judicial review. The rule of law is violated when RBI makes a regulation without proper cost-benefit analysis, without a two-way public consultation, without detailed reasoning for the regulation. This is arbitrary use of power. This happens, among other things, because the idea of rule of law is not properly embedded in the institutional framework of the RBI.

Take the example of payment regulation. At present, the RBI does not allow customers to waive the two-factor authentication requirement even for small value transactions [link, link]. So, if I want to be able to transact upto Rs. 1000 transactions every day without a second factor of authentication, I am not allowed to do that, even though it is my own money. We have the same level of security for Rs. 10 lakh transaction as for Rs. 100 transaction. This imposes undue transaction costs on small value transactions and makes many businesses difficult to do. If the RBI followed due process in making regulations (cost-benefit analysis, consultations, etc), it may have, in the process, modernised its regulatory approach and liberalised the sector.

Greater accountability and rule of law would help RBI build the right kind of capacity and to use it to regulate free markets optimally, and not to constrain the markets unnecessarily. Will more due process and judicial review slow down RBI? In fact, RBI will have to speed up its game. It will not be able to centrally plan the sectors it regulates, and therefore it will have to build systems to actually regulate the fast-moving innovations of the financial system, rather than slowing down innovations to make its own life easy. It is only in a police state that a policeman's job is easy. Our thinking on public policy should not cater to the convenience of an RBI official.

The RBI has recently allowed two more types of banks - payment banks and small banks. However, the basic framework of central planning by RBI, and the License-Permit Raj, is intact. RBI continues to decide what innovation the market will do, and market participants bend over backwards to modify their business models to accommodate RBI's notions of innovation. Once in a decade or so, a committee is set up to tell the market what kinds of business models it can pursue. Now that RBI has released two new types of business models that it was preventing from getting out, we are happy and thankful. Institutional reform would be to change this system of "innovation by committees". More pressures of accountability mechanisms is required, to break the edifice of central planning. We have not escaped from License-Permit Raj; more Appellate Raj will help break down License-Permit Raj.

### Four strands of thinking

There are four strands of thinking in India on the project of building the Republic:
1. At one end is the Left, which just wants an intensification of the socialist republic of India.
2. A second group wants to do direct democracy - get citizens to devote a large amount of their time to participate in governance in pursuit of the common good, just like ancient Athens. This group also wants to hand over arbitrary power to a watchdog agency - Lok Pal.
3. A third group wistfully looks back at the power concentrated in Nehru and Indira Gandhi and thinks "Gee, what would I do with that power!" This is not about the rule of law, it is not about the rule of men, it is the craving for the "rule of me".
4. A fourth group wants to construct a liberal democracy, where performance is obtained out of potent accountability mechanisms and checks-and-balances.
In India, some in the elite pay lip service to words like liberal democracy, rule of law, and free markets. At the same time, there is limited commitment to enlightenment values, and limited understanding of how a complex State works. For some in the elite, arbitrary power for the State means increasing their own power. We need to do more in terms of improving knowledge and the quality of the debate.

As Fareed Zakaria has emphasised, holding elections is not the essence of liberal democracy. The real story of liberal democracy lies in the internal machinery of checks and balances, of the intricate systems of rule of law, judicial review, separation of powers, freedom of speech and myriad accountability mechanisms. The main story of India should be about making these institutions work [example].

#### 1 comment:

1. I don't think it can be anybody's case that checks are unimportant in balancing the exercise of powers. But from what I have seen from within govt, in the Indian scenario, I think there does exist a case for having a reasonable balance of capacities in the power-wielding and checks-wielding institutions. Many governance institutions are to a larger or lesser extent exposed on their capacity deficit due to the institution's own transparency measures as well as due to the external voices of the press, judiciary, NGOs etc. There is a need to build this capacity in governance institutions through process setting with adequate and competent manpower with a lot more citizen-govt 'service' related interface happening in the digital space. You are right that only by creating feedback loops through accountability mechanisms (like SAT in SEBI's case), will there be a stimulus for better capacity creation in governance institutions. But this external stimulus is not fine tuned to the 'mind' of the organization. From that point, I can understand that many officials leading govt institutions may feel the need to be left alone to implement strategies for building capacity within the framework of the organization's culture. The external stimulus is much needed but also important is the space for internal reforms.

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