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Raghuram Rajan. Photo: Bloomberg
Raghuram Rajan. Photo: Bloomberg

Raghuram Rajan as an economic craftsman

Unlike many econocrats or economists working as bureaucrats, Rajan as governor positioned himself as a brilliant craftsman of the discipline of economics

In a book, Saving Capitalism from the Capitalists, written in 2003, Raghuram Rajan and Luigi Zingales argued that freer markets—perhaps the most beneficial economic institution known to humankind—rest often on fragile political foundations that ultimately lead to the exacerbation of most socio-economic problems in developing countries. This is most noticeably so in areas of employment generation, food inflation, tackling food security and poverty alleviation. Rajan and Zingales focused on the critical roles of bureaucrats and politicians as the necessary visible hands needed to guide the invisible hand of the market for yielding economic efficiency from a long-term perspective.

This is particularly pertinent in the light of Rajan’s decision to return to his academic role at the University of Chicago after the completion of his term as Reserve Bank of India (RBI) governor in September. Unlike many econocrats (economists working as bureaucrats in government), Rajan, as governor, positioned himself as a brilliant craftsman of the discipline of economics.

In Fault Lines, written by Rajan in 2010, he dissected the causes of the 2007-08 financial crisis. He elucidated the need to continually address and balance a number of hidden fractures inherent in an economy’s financial sector through the enforcement of effective countervailing measures by the central bank and other institutions. He explained how the process of working with the US government to push for financial deregulation made the Federal Reserve equally responsible for the crisis.

This underlines how a process of maintaining periodic deliberation, including points of policy disagreement, between the central bank governor and the government in power is healthy for the economy’s long-term pursuit of economic prosperity.

In keeping with this perspective—and as someone who deeply understands the complexity of financial systems today and the vulnerability of emerging economies like India—Rajan’s cautious approach on various issues such as inflation and avoiding short-term interest rate cuts was driven by a longer term vision for the economy. His decisions as the RBI chief boldly went against government pressure to allow cheap credit.

Quite often, economists and commentators ignore how important it is for the central bank to resist any loose monetary policy changes (through interest rate cuts or reducing reserve requirements) as quick fix actions during a period of economic boom or expansion. This is what helped him build the image of a credible central banker—one who based his economic policy decisions not on short-term circumstantial evidence but on a longer term perspective of what is desirable for India’s sustainable economic expansion.

The craftsmanship needed in applying economics today goes beyond relying on growth numbers and production metrics alone. With the injection of mathematical modelling and econometric techniques (discussed recently by Paul Romer as mathiness), there has been a growing tendency among econocrats to somewhat ignore the ancillary building blocks to efficient economic systems—for example, the institutional reforms needed in enforcement of contracts, rule of law and development of social and political institutions. Most often, these aspects are assumed to be static in the models formulated. This can lead to economic decisions having adverse consequences.

Rajan’s academic thinking always acknowledged this, and in his own time as an influencing authority, he gave due importance to both institutional and political reforms, and to going beyond growth metrics in an economy’s journey to prosperity and sustainable development.

There is nothing reductionist about the practice of economic modelling until we confuse a given model with the model in identifying a developing economy’s path to greater economic prosperity. Economic analysis, if skilfully crafted, can be very useful in identifying areas of potential gains and thereby help create new constituencies for change in resolving most developmental challenges for economies. And that’s what Rajan stood and argued for throughout his term as RBI governor.

Let me further explain the point by defining the practical application of economics as a craft. As an example, let us refer to the need for regulating the housing market (the financial deregulation of which was a major factor for the 2007 crisis in the US and the 1996 economic crisis in Thailand). While one economic model of the housing market (where demand and supply are perfectly competitive) shows that rent controls make housing harder to obtain, another specifies market conditions of insufficient competition in which modest ceilings on rents would increase the supply.

The challenge here as an econocrat will be to choose a model that best applies to the economic situation at hand in a given economy. Thus, the choice—which requires a degree of theoretical open-mindedness and empirical investigation by an econocrat—makes the very application of the discipline as much a craft as a science. The econocrats today need to acknowledge this and thus act accordingly.

The way economics is still taught in most graduate schools fails to acknowledge the above point. We have most mainstream economists teaching economics while being ideologues of the market economy or tending to view markets as inherently desirable and government intervention as inherently unwelcome. Because of this most of us typically study more about how markets fail because of government action than study the unorthodox conclusions of mainstream economic policies.

There is a need to include a study of more cross-country narratives with an increased exposure to the economic history of nations in advancing our thinking on complicated socio-economic issues like income inequality, rural-urban disparities in employment generation etc. Rajan’s own academic work has more often brought out useful cross-country narratives (say, his empirical explanation of “relationship capitalism" that worked in Japan and continental Europe after the Second World War in his book with Zingales).

In a certain way, perhaps, it will be good to have Rajan return to academia. It will allow him more freedom to write about his time as RBI governor, the political challenges faced and on the hidden fault lines in India’s financial system. What will be missed, though, is his bold, independent, tactful craftsmanship at the central bank.

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