Why Raghuram Rajan’s warning on low interest rates doesn’t hold up to scrutiny
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As governor of the Reserve Bank of India (RBI), Raghuram Rajan seems to have done a lot of good things. Unfortunately, his political adversaries forced him out of office, which he left on Sunday. During his tenure, Indian growth was steady and robust, while inflation fell:
This is the kind of record that every central banker hopes to achieve. Rajan also pushed for a number of important financial reforms. Despite serving just three years, Rajan should be regarded as one of the more successful central bankers in recent times—India has been an island of calm and consistent growth even as China and many developed countries have stumbled. He will be missed.
However, I have to take issue with Rajan’s recent warning about low interest rates:
Low interest rates should not be a substitute for “other instruments of policy” and “various kinds of reforms” that are needed to encourage growth, Rajan said in a recent interview with the New York Times. “Often when monetary policy is really easy, it becomes the residual policy of choice,” he said, when deeper reforms are needed.
Of course, on its face, Rajan’s statement is correct. Countries shouldn’t look to macroeconomic stabilization as a substitute for other kinds of policy. They should attack poverty, unemployment and stagnation on all fronts, not just one.
But in this warning, Rajan appears to go beyond that obvious truth. He raises the possibility that low interest rates might get in the way of adopting needed reforms. That idea could lead some central bankers to conclude that they should raise rates higher than otherwise in order to push other branches of government to implement sound economic policy. This is a common enough notion already, in fact. But it doesn’t really hold up under close examination.
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Central banks keep interest rates low when growth is slow and inflation is low. They avoid raising rates out of concern that doing so would be a drag on the economy. And there may be precedent for this: Many economists believe that former Federal Reserve chairman Paul Volcker’s interest rate hikes in an effort to throttle inflation in the early 1980s were responsible for the two sharp recessions in those years.
The problem with adding structural reforms to this list is that it greatly complicates the task central bankers face. In addition to forecasting how their interest rate changes would affect unemployment and inflation—a very difficult task at the best of times—they would have to anticipate what interest rate level would be sufficient to force the legislature and the bureaucracy to enact reforms. They would also have to figure out how effective those reforms would be. Those are difficult if not impossible things to calculate.
In fact, keeping rates high might backfire. Structural reforms have different effects in good and bad economic times. As economists Aida Caldera, Alain de Serres, and Naomitsu Yashiro at the Organization for Economic Cooperation and Development have documented, many reforms that have positive impacts amid booms cause added pain if enacted during recessions.
If central bankers keep rates high, and growth slows, that may increase the short-term costs of needed reforms, making legislatures and bureaucrats less likely to carry out those policies. Historical examples of this abound. For example, when growth was slow and unemployment high in the 1990s, Japan implemented relatively few reforms to its labour markets, corporate governance and financial system. Only when growth finally accelerated in the early 2000s was the administration of prime minister Junichiro Koizumi able to make some structural changes.
So if high interest rates lead to slower growth, they might make reforms more painful, as well as making them less politically palatable.
In fact, some economists have had a recent bad habit of pushing nations to carry out long-term reforms at the wrong times. The International Monetary Fund (IMF) has recently admitted that its long-standing policy of encouraging countries to implement austerity during economic downturns was probably a big mistake. That policy won the IMF few friends in developing countries.
In general, the idea of intentionally pushing a country’s growth lower in the short term in order to force politicians to do the right thing over the long term just doesn’t pass the smell test. The chain of causality is too weak and uncertain, and the risks are too high, to make politics a target of interest-rate policy. Instead, central bankers should stick to what they do best, and what Rajan himself accomplished wonderfully—namely, keeping growth steady and inflation low. Bloomberg