New continents are not discovered every day. When Christopher Columbus died in 1506 in Valladolid, he was still convinced that his journeys had taken him to the coasts of India, not “America”. In Mumbai recently, Jean Claude Trichet, president of the European Central Bank, linked this factoid to the difficulty in identifying change. He called for utmost readiness in dealing with an ever-changing world.
But surely the lesson to be learnt from Columbus should be: Be bold and confident, venture out taking calculated risks, and if you don’t arrive at your intended destination, recognize the errors of your ways; don’t die in blissful ignorance. Is monetary theory falling into the same trap as Columbus?
One economist who has been working on the need for change in the stance of monetary theory and policy is Axel Leijonhufvud, whose guiding principle has been: Unless you think outside the box, how do you know you are in the right box?
In his paper on monetary and financial stability, reprinted in these pages (Mint, 19 November), he called on policymakers to reconsider the role of the central bank, this time in the context of today’s troubled world.
Central banks have increasingly accepted the sole objective of controlling inflation, but such a policy can lead to a blinkered view of the world as issues that endanger financial stability stay out of the purview of monetary policy. This is especially true in the current situation, where inflation has remained low even when the world is awash with funds with low interest rates. As money seeks out returns, it impacts asset prices and leads to a lowering of credit risk standards. The fallout of a crisis hits households who are at the end of the chain.
Leijonhufvud says that with the focus of current economic theory on constraining governments, the primary economic duty of the government has been overlooked —to avoid financial crises. In his prescient 1998 paper, Two types of crisis, he neatly outlined the possible scenarios. Financial crises can be of two types—deflation crisis, when widespread solvency and liquidity problems plague the private sector; and inflation crisis, which stems from insolvency of the national government.
In either case, economic growth is the casualty.
The Great Depression in the 1930s and 1940s convinced economists that the private sector cannot be trusted to provide stability in the economy. Governments were thought of as benevolent and the obvious agents for setting things right in a world of failed firms and busted banks.
Around 30 years ago, the fact that governments tend to indulge in high debt and unsustainable policies with an eye on the electorate convinced economists that it is the private sector that could be trusted to do things right. Governments should stay out of the picture and not destabilize the system with high deficits.
With increasing fragility in the system, Leijonhufvud predicts a shift back to emphasizing the role of the government in ensuring financial stability. We have seen this recently in Britain, the role model of independent banking and inflation targeting. The British government had to give a sovereign guarantee on all retail deposits to prevent a crisis.
Of these swings in economic understanding Leijonhufvud writes, “Although the impulses of external events play a causal role in bringing them about, their propagation internal to the economics profession seems subject to herd behaviour. If we are ever to stabilize the pendulum of economic opinion somewhere in the judicious—but ideologically always unsatisfactory—middle and recognize the capacity for good and its limits of both markets and governments, it will have to be through people who do not run with the herd but think for themselves and tirelessly follow their convictions.”
From a reading of the Report of Currency and Finance 2004-05, it would appear that the Reserve Bank of India (RBI) is doing the latter consciously: “From a historical perspective, monetary policy stance in India has been guided by the specific circumstances, at times deviating from the prevailing wisdom.” As of now, RBI follows a multiple indicator approach to arrive at its goals of growth, price stability and financial stability, rather than targeting inflation alone. This, of course, leads to criticism from mainstream economists. In its effort to balance many objectives, which often conflict with each other, RBI looks confused, ineffective and in many cases a cause of the problems it seeks to address.
But most of the reasons given by RBI for not following prevailing wisdom are practical ones, since inflation targeting requires certain prerequisites that are not in place in India. Though RBI and the government are in theory committed to reforms, the general pace has been so slow that even the simplest prerequisite of a reliable measure of inflation eludes us.
So, if Leijonhuvfud’s prediction does come through and constraining governments becomes less of an issue in macroeconomics, one wonders whether it is inertia that will align RBI’s views with the mainstream once again.
Sumita Kale is chief economist of Indicus Analytics. Comments are welcome at firstname.lastname@example.org