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India’s new monetary policy regime has finally taken institutional shape, with the inaugural meeting of the recently constituted Monetary Policy Committee (MPC) headed by new Reserve Bank of India (RBI) governor Urjit Patel. The MPC is charged with setting the policy interest rate to achieve the inflation target. India has thus officially joined the club of economies with inflation-targeting central banks.

Yet, India has joined this party rather late: like a late-night reveller who arrives just as most of the guests have passed out on the floor and others have already made for the exit. Inflation-targeting is increasingly coming under scrutiny, as well it should. The monetary policy orthodoxy rationalizing inflation targeting as the sole objective of optimal monetary policy goes back a quarter century, and has, remarkably, survived the great financial crisis. But a new financial crisis may be brewing due to unconventional monetary policies (UMPs).

This is increasingly problematic. As has been noted by many observers, including the leader in a recent issue of The Economist, UMPs without end, and with no obvious exit strategy, may well be fuelling asset prices bubbles that threaten to destabilize the global economy. Indeed, it was just such bubbles that were allowed to grow and then burst under the watch of the inflation-targeting US Federal Reserve, which got us into the mess of the global crisis to begin with.

With some justification, central bankers are increasingly fretting that they are being asked to do more than just target the inflation target and reduce the output gap. They are being asked as well to combat asset price bubbles, ensure a stable financial sector, and, in some instances, even correct rising wealth and income inequality. What is the way out?

There is a fundamental proposition in the theory of economic policy named in honour of the late Jan Tinbergen, who shared the very first Nobel Prize in economics in 1969. The Tinbergen principle states that a policymaker generally needs at least as many instruments as she has objectives to be successful. The immediate implication for our problem at hand is that to achieve the multiple objectives of (let us say) a stable inflation rate and avoiding asset price bubbles from getting out of control, a policymaker will need minimally two instruments: the policy interest rate, for the first objective; and another instrument, such as the power to regulate or otherwise dissuade speculative purchases of real estate and other bubble-prone, risky assets, for the second. This latter might fall under what the International Monetary Fund describes as macro-prudential regulation.

The open question is whether these additional policy levers should be invested in the central bank, or in another agency of government. In terms of the economics, the former solution would seem best able to mitigate the coordination problem that would arise if instruments were dispersed across agencies.

However, in terms of political economy, it would run the risk of creating the impression that the central bank has arrogated too many powers to itself and create a backlash against its putative independence, questions of democratic deficit, and so forth.

There is a larger systemic question at play. Since the collapse of the Bretton Woods gold-dollar exchange system in 1971, the global financial system has really been a non-system, as our friend and Nobel economist, Robert Mundell, has been wont to describe it. Indeed, what we have seen is that, without the restraint of the fixed exchange rates imposed by Bretton Woods, the reality of central banks each trying to achieve its own objective—inflation targeting being the objective that is in vogue at present—the result has been an increase, not a decrease, in global financial market instability.

Far from being a stabilizer, as argued by another Nobel-winning economist, Milton Friedman, the system—or non-system—of flexible exchange rates has led to increased global volatility, as exchange rates routinely overshoot their fundamental values, both when they appreciate and when they depreciate.

Some observers, Mundell notable among them, have argued for a return to some form of a global unit of account—call it a world currency, a return to some system of fixed exchange rates, or some other variant—but we need not delve into this hoary debate between flexible and fixed exchange rates, a topic on which we have both written at length.

Rather, a more salutary short-term focus might be on fostering genuine international cooperation, even coordination, not of monetary policy per se, which is likely to be impractical, but of, for instance, short-term capital flows, an idea to which even the IMF appears to be amenable.

If capital controls appear unappetizing to advocates of laissez faire, let us recall another of Mundell’s great contributions, the “impossible trinity": One cannot have independent monetary policy, control over the exchange rate, and free capital mobility all at once; rather one must pick two out of three. In other words, a workable but not terribly pretty solution to our current conundrum might involve inflation targeting, a flexible exchange rate, and control over short-term capital flows.

James W. Dean and Vivek Deheji are, respectively, professor of economics emeritus at Simon Fraser University in Canada, and a Mint columnist.

Comments are welcome at theirview@livemint.com

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