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The Importance of Being Raghuram Rajan

By: Boz

Mumbai: RBI Governor Raghuram Rajan at a press conference in Mumbai on Tuesday. PTI Photo by Shashank Parade(PTI12_2_2014_000031A)

Mumbai: RBI Governor Raghuram Rajan at a press conference in Mumbai on Tuesday. PTI Photo by Shashank Parade(PTI12_2_2014_000031A)

In 2005, at the annual meeting of bankers and financial czars in Jackson Hole, Raghuram Rajan was the only doubting Thomas who sounded a note of caution about the serious imbalances emerging in the US financial markets1. The august audience there was aghast. They had gathered there to bid farewell to Alan Greenspan, who had presided over the Fed during a decade referred to as ‘The Great Moderation’. Larry Summers, former Treasury Secretary under President Clinton, snidely referred to Rajan’s views as ‘luddish’2.

Ten years have elapsed since then. Events which unfolded in the USA in 2009 proved Rajan correct, and suddenly Raghuram Rajan had become a finance rockstar and a household name among economists. This columnist was extremely pleased when he was chosen to succeed Kaushik Basu as the Chief Economic Advisor to the Government of India, since he was the first serious macroeconomist to be chosen for the post in over a decade. From there, his ascendency to the RBI Governorship was virtually assured.

Inflation, inflation, inflation

For the past year, Rajan has had a hard time explaining inflation targeting (estimating and making public a projected or ‘target’ inflation rate and then steering actual inflation towards it; distinct from ‘headline’ inflation, which is the measure of the total inflation in an economy) to a genuine bunch of Luddites in the North and South blocks. The new government rode on a popular wave of public displeasure at the failure of the previous UPA regime to control prices. Luckily for the new government, oil prices began to slide downwards at the beginning of 2015 which arrested headline inflation. ‘Core’ inflation in India was already low.

The difference between core and headline inflation has been seemingly opaque to our economists. Core inflation refers to inflation in sectors such as manufacturing, agriculture, and organised services. Interest rates can and do play a role in spurring production when there is excess capacity in any of these sectors, or moderating rising price levels. These relationships are fairly robust in advanced economies, since those economies have most of their manufacturing and services in the organised sector. In emerging market economies, these relationships are far more tenuous.

Headline inflation, on the other hand, is with regard to commodities in the consumption basket, over which domestic economic policies have no impact. Imported fuel is one of the most important of these items, as are imported foods like grains, sugar and edible oils. Obviously, domestic interest rates would have no impact on headline inflation whatsoever.

An economy boost and Central Bank independence

The NDA government was quick to capitalise on a completely unexpected bonanza of falling global oil prices. Rhetoric flowed on how the electoral promise of bringing down prices within the first hundred days of government had been achieved. But, now came the difficult part – boosting the core economy, especially manufacturing, which was in the doldrums. It was felt that lowering interest rates would do the trick, but Rajan was unwilling to play along with this. Being a Chicago economist of the ‘freshwater’ school of thought, inflation is probably what Rajan fears the most.

Understandably, the honeymoon period between Raghuram Rajan and the Finance Ministry was short-lived, and it was announced that the Reserve Bank Governor’s power to set interest rates would effectively be assumed by the government3. This was a direct assault on the independence of the Central Bank.

The pertinent question that will arise as the days go by is whether or not central bank independence is a good thing.

Has the concept of functional and operational independence acquitted itself so far?

Unfortunately, the evidence stacked against central banks looks overwhelming. Central banks had clearly not been able to anticipate the 2009 crisis. More significantly, it is now widely recognized that that the reign of Alan Greenspan at the Fed was far from The Great Moderation. Going on to 2004-05 there were fifty-seven Federal Open Market Committee meetings when Greenspan left interest rates untouched and at historic lows, that too at a time when easy money and cheap credit were playing havoc with housing mortgages. Also inexplicable, especially in hindsight, was why the Feds ignored the dangerous build-up of toxic assets on banks’ balance sheets. Some were over-leveraged to levels of 30:1 – thirty times debt to core equity4.

Most of the sophisticated central banks relied on models that were unable to factor in the effects of a plunging financial sector on the real sectors of economy. These models, called Dynamic Stochastic General Equilibrium models (DSGE), have been the bread and butter of Neo Classical economists such as Robert Lucas and Tom Sargent, as well as Real Business Cycle economists like Edward Prescott and Fynn Kydland. But, everyone was using their own variant of the DSGE, including the International Monetary Fund, which rolled out its Global Economic Model (GEM) when Rajan was the Chief Economist there. In the aftermath of the crisis, repeated cuts in interest rates left the economy unmoved till the rates hit close to zero. It was a classic Keynesian liquidity trap.

Politics and Economics

The question remains if monetary policies are the only tools needed when an economy is in crisis. Obviously not, as the Greek crisis proves. But, the more subtle, more important point is to realise that the choice between more inflation or more unemployment is a political one, not an economic one. Which is ‘better’? This is not a question which can be solved by economics. It can be informed by economics, but at the end of the day the preference for one or the other comes down to one’s own moral judgement. It is a political choice, and the way political choices are made in modern countries is through a democratic process, not through unelected, unaccountable technocrats.

During Greenspan’s ‘Great Moderation’, it appeared that one didn’t have to make a choice. Economies could have low inflation and low unemployment – a free lunch – all because of a genius like Greenspan or Jean Claude Trichet in charge. However, that choice has to be made in a balance sheet recession (individuals or companies collectively focus on saving and paying down debt rather than investing or spending). Most experts now believe that the Great Moderation owed much more to IT-driven productivity than to the ‘Greenspan put’.

Can politicians run economies?

But, the more subtle, more important point is to realise that the choice between more inflation or more unemployment is a political one, not an economic one.

There is the facile argument that politicians are incompetent to run economies. It is unfashionable to disagree, but if one studies three hundred years of recorded history, one finds that elected democracies have had a far better record of delivering public policy than despots, aristocrats or dictators.Politicians can and do take unpopular decisions for the common good when push comes to shove. Despite the standoff over relaxing the debt ceiling and the ‘fiscal cliff’, the Congress did ultimately vote for it, as it did for the TARP funds, even though both these decisions were unpopular among the public. During her tenure as Prime Minister, Margaret Thatcher was the one who set interest rates, but we don’t hear of any hyperinflation that rocked the British economy. In contrast, Jean Claude Trichet ran the Bank of France with an iron fist. Following a strong franc policy, he ruined a decade of growth for industries in France, only to be ultimately rewarded with the Presidentship of the European Central Bank, forcing a tight money policy, unemployment and misery upon the European Economic Community as a whole.

Where does this leave Raghuram Rajan?

If someone made the suggestion that national security and defence were technical fields best left to professional soldiers, then one would immediately perceive the dangers in such a line of thought. If one thinks that generals deciding the defence policy is anathema in a modern democracy, clearly recognising the supremacy of a democratically elected civilian government over the uniformed services, why should economists have a monopoly over interest rates?

Boz is the nom de plume of a former civil servant with many years of experience in the Ministry of Finance, financial institutions, and the IMF at Washington.

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