The traffic square connecting Raisina Hill in New Delhi—home to the finance ministry—and the stretch of road going all the way to India Gate is an interesting place to observe the behaviour of motorists. During the day, the flow of vehicles is pretty much tightly regulated by the traffic police. After dusk, when the police retreats, a free-for-all ensues. Add the Delhi fog to the equation, anarchy is the result. Many drivers simply step on the accelerator, ignoring other vehicles. This “speed” strategy forces others to slow, for unless they do that a crash is certain. Ideally, everyone driving slowly is best. But that’s never been an equilibrium in this part of Delhi. So, of all the “strategies” in this game of chicken—chickening being slowing in face of a speeding automobile—one vehicle speeding away and the other slowing is the most frequent solution.
A similar game has been played for a while between the finance ministry and the Reserve Bank of India (RBI).
It is, of course, rash to try and understand monetary and fiscal policy coordination failures by looking at vehicular aggression on Delhi roads. But the behaviour of India’s fiscal authority—its finance ministry—is not very different from that of speeding drivers. Consider two recent episodes—useful for analysing the repeated play of the chicken game.
Just days before the 2012-13 monetary policy statement on 17 April, then finance minister Pranab Mukherjee sounded upbeat about RBI taking steps to ease monetary conditions. In the chicken game, he was playing the “speed” strategy. The central bank blinked. Its Macroeconomic and Monetary Developments in 2011-12 had a hawkish stance on inflationary concerns. Yet a day later, governor D. Subbarao resorted to monetary loosening when he announced a 50 basis points cut in the repo rate.
Zoom ahead to the second quarter review of monetary policy 2012-13 on 30 October. Once again, the finance minister, this time P. Chidambaram, engaged in “speed” strategy. He unveiled a fiscal consolidation roadmap before the policy announcement. This time RBI did not blink and, in turn, played “speed”. The result: the fiscal authority had to back off. Chidambaram talked of “walking alone”.
It is tempting to look at these instances as examples of interplay between a cussed central bank governor and recalcitrant finance ministers. This personality-driven explanation is not useful.
In fact, these are not isolated instances. There are sufficient data points—spread over the tenure of two very different governors Y.V. Reddy and now Subbarao—to conclude that “antagonism” is now part of the central bank’s institutional memory. From the perspective of a repeated play of the game of chicken by the finance ministry and RBI today, persistent playing of a “speed” strategy, which rules out close coordination of monetary and fiscal policies, is largely due to heavy discounting of future possibilities by the finance ministry. A discount factor indicates whether a person’s preferences are short or far-sighted; whether he values the present more than the future or the other way round.
The key in explaining this behaviour that shows lack of cooperation does not lie in picking some arbitrary discount factor whereby the finance minister and the RBI governor start “cooperating” or “fighting”. Any game theorist will tell you that will be cherry-picking data to fit preconceived notions. The interesting, but hard, part lies in explaining the genesis of discount factors. In markets, constant flow of information influences the formation of discount factors.
In social situations, explaining the origins of discount factors is much harder. The Nobel Prize-winning economist Gary Becker sought to explain this in terms of devoting sufficient resources to imagine the future, bright or dark. Positive anticipation of the future generates discount factors that ensure cooperation.
The adverse discount factor in the game being played between RBI and the finance ministry is largely due to the belief in government that lower unemployment is preferable even if it leads to ruinous inflation. This government, in particular, knows it is running out of time. Hence, its repeated efforts to get RBI to lower policy rates even when inflation remains sticky. The instances mentioned above are part of this pattern.
The results are interesting, if somewhat mixed: the finance ministry tries the speed strategy and so does RBI. But in most instances, the ministry has to back off, leading to a “win” for the central bank. This is interesting because evidence across the world shows that dominance by the fiscal authority is the norm and that by the central bank, an exception. But that’s another story. In the instant case, the switch from a speeding to slow strategy by the finance ministry avoids a crash but it has not led to a reevaluation of its belief in this non-optimal strategy. This is a no-win situation for the country.
It is no one’s case that there should be poor coordination between the fiscal and monetary authorities. But purely from a game theoretic perspective, the enabling conditions that foster cooperative behaviour are missing in India today. It will be wrong to blame the persons involved or ego problems for lack of coordination. But it is obvious the problem lies with the government and not RBI. In this story, rash driving—both of fiscal policy and vehicles—is a Delhi phenomenon.
Siddharth Singh is Editor (Views) at Mint. Reluctant Duelist will take stock of matters economic, political and strategic—in India and elsewhere—every fortnight. To read Siddharth Singh’s previous columns, go to www.livemint.com/reluctantduelist-