India’s new chief economic adviser Krishnamurthy has written on a host of subjects—ranging from the Reserve Bank of India (RBI) to agricultural income tax—as a Mint columnist. A look at his views on key issues.

On the Reserve Bank of India (RBI)

■ Inflation targeting by central banks across the world rests primarily on two key pillars: accountability and transparency. Given the importance of central bank communication in bringing about transparency, an important question that arises is: How much attention should central bankers pay to financial markets?

Prudent central bankers would profess that following the markets... would produce poor policy for several reasons...

If the central bank strives hard to please markets, it is likely to mimic the short horizon of market participants and thereby become myopic in its decision making. This can create a dangerous phenomenon of the dog chasing its tail forever, wherein the market reacts, or possibly overreacts, to perceptions about what the central bank might do, and the central bank looks to the market for guidance about what it should do.

The broader point is that central banks are provided independence by the country’s legislature—the Reserve Bank of India Act, 1934, in the Indian scenario—because central banking policy, by its very nature, requires a long horizon on the one hand, and the ability to take unpopular decisions on the other...

Therefore, when examining how far central bankers should follow financial markets, we should keep in mind this broader point about the need for the central bank to remain immune from short-term pressures and populism. (Read more )

■...Should monetary policy be guided by the goal of long-term growth and price stability or yield to short-term pressures to manage interest rates? Said differently, with respect to monetary policy, which of the following two options is better: insisting that our monetary policymakers stick to clear rules or granting policymakers broad discretion?

Of course, fiscal and monetary policies always involve some combination of rules and discretion. Policymakers never simply employ one approach or another by itself. But they do, at different times and in response to different pressures, tend to emphasize one over the other. When policymakers lean in the direction of rules, they pursue less interventionist, more predictable, and more systematic policies. In monetary policy, rules-based policymaking corresponds to adhering to a steady and predictable strategy for adjusting interest rates or the money supply. (Read more )

On demonetization

■ In the political battle that has emerged out of the demonetisation exercise, both proponents and opponents are ostensibly defending the interests of the poor. Some politicians are relying on anecdotal evidence to advocate the difficulties being faced by the common man... Our estimates suggest that the poor are likely to have visited a bank branch at most once to exchange their earnings in the old currency notes to new currency notes...

This conclusion then suggests that the long queues seen stem from two sections of the population: (i) people from the top half of the country’s income distribution, i.e. the richer folks, who want to exchange their honestly earned savings for new currency; and (ii) people who are acting as agents for the dishonest... Read More

On credit rating agencies

■ Rating agencies (CRAs) in India generate significant revenue through non-rating activities undertaken by their specialized subsidiaries. On average, about 40% of the total revenue of the rating agency stems from non-rating activities... Given the pernicious role of CRAs in the financial crisis of 2008-09, the Securities and Exchange Board of India (Sebi) should take note and appropriately regulate the CRAs to eliminate these conflicts of interest...

Despite maintaining a Chinese wall between advisory services and rating services, rating and non-rating entities have common ownership and top management...

CRAs maintain that while non-rating services do pose conflict of interest challenges, revenues from other services reduce dependence on rating service revenues and thereby enable them to maintain objectivity and independence. However, the evidence does not support their claim of objectivity and independence.

Sebi should therefore take strong note of the worrying evidence in this study and appropriately regulate the CRAs to eliminate these conflicts of interest. Overlooking this issue may sow the seeds for an Indian version of the destructive role that CRAs played in the financial crisis of 2008-09. (Read more

On Raghuram Rajan

■ On Teacher’s Day, Indians and young Indians in particular would do well to seek inspiration from former Reserve Bank of India (RBI) governor—he demitted his office on Sunday—and my teacher Raghuram Rajan. Rajan inspires as a teacher for both his professional and personal qualities.

As someone who has gained respect all over the world for his thought leadership, Rajan is worth emulating as a professional...

A teacher is someone who teaches not only through his ideas but also through examples. I have been privileged to learn from his ideas and by observing him even before he was a celebrity. Now, a lot of us have had the opportunity to observe him in public office. We would do well to learn from the teacher who happened to be the RBI governor. (Read more

On taxing agriculture

■ Taxing agricultural income has been an emotive subject in the Indian context. However, taxing agricultural income at minimal rates of about 5% can help rather than hurt our poor farmers.

Research has shown that bank loan officers in India rely mostly on informal networks created by social affiliations in order to elicit information about the borrowers. Thus, only those borrowers who are “connected" to the loan officers obtain optimal credit.

A more sustainable approach to financial inclusion involves enabling people to borrow from the formal system. We argue that taxing agricultural income can improve access to finance to a large section of farmers because verified income tax returns can provide a credible signal of the earnings potential of a farmer.

Thus, rather than listening to the powerful lobby of rich farmers, the government should seize the opportunity to benefit the small farmers by taxing agricultural income at minimal rates of about 5%. (Read more

On economic freedom

■ While political freedom has been given a lot of importance in India, economic freedom does not make headlines. Economic freedom is often dismissed as an elitist concept benefiting only big business at the expense of labour. In fact, many states in India that adopt a business-friendly approach are often dismissed as supporters of crony capitalists. Not surprisingly, India ranks a low 111th on the world economic freedom index published by the Cato Institute.

In this context, we examine a report, Economic Freedom in States of India... and relate the average economic freedom index score of a state (based on the last four reports) to the growth in the number of SMEs in the state...

...Four of the top five states in terms of economic freedom also occupy four of the top five ranks in terms of growth of SMEs. (Read more

On public sector banks

■ Some believe that PSBs are unnecessarily being made to look like villains by comparing them with private sector banks. The argument being that from the period 1997 to 2009, PSBs performed very well when compared to private sector banks. In this context, we should note that if private sector banks are used for comparing favourably the performance of PSBs during the period 1997 to 2009, it is then appropriate to use the same private sector banks for unfavourable comparisons now as well.

However, we must recognize that governance issues are papered over during good times. Therefore, it is dangerous to use the relative good performance of PSBs during 1997 to 2009 to advocate that structural reform is not necessary. Read more

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