Photo: Indranil Bhoumik/Mint
Photo: Indranil Bhoumik/Mint

The economics of Raghuram Rajan

The RBI governor has at times challenged the mainstream economics consensus, and at times bowed to it

Raghuram Rajan, who has decided to step down as the governor of the Reserve Bank of India (RBI) when his term ends in early September, is going to be remembered for a long time to come. Taking charge of India’s central bank at a time when the economy was battling a currency crisis, Rajan deftly stabilized the economy with the help of the government and has helped restore the RBI’s credibility by bringing down inflation considerably since then.

However, more than his statements on monetary issues, it is his speeches on public policy, covering a wide ambit of issues ranging from the need to safeguard India’s liberal values to the need to check crony capitalism, that have garnered the most attention and cemented his place as an important public intellectual of our time.

Rajan started his career as a professional economist in 1991 at Chicago University’s Booth School of Business. In the world of economics, the Chicago school is usually associated with the legacy of Milton Freidman, who advocated a minimalist state and rejected the Keynesian demand management policies that were dominant across the globe till the 1970s.

In some ways, Rajan represents the best of this tradition as his 2003 book, co-authored with colleague Luigi Zingales, Saving Capitalism from the Capitalists demonstrated. The authors warned presciently that the popular approval for capitalism globally may well be a passing interlude, and that the blowback against it may be just around the corner.

They argued that the challenges to a well-functioning market economy come from two main groups: the incumbent and the excluded. The duo argued for pro-competition rather than pro-business policies—that is, ones that did not necessarily favour incumbents, but allowed the most efficient firms to succeed—and advocated social safety nets for the excluded so that they did not feel resentful about the ruthlessness of the capitalist system.

Soon after writing that book, Rajan was appointed as the chief economist of the International Monetary Fund (IMF), the youngest person ever to be in that chair. The IMF had by that time begun facing criticism from the likes of Nobel laureate Joseph Stiglitz, who criticized the “structural adjustment programmes" of the Fund as having harmful rather than stabilizing influences on developing economies.

The IMF was widely seen as the torchbearer of the neoliberal orthodoxy, which emphasized fiscal consolidation or austerity and openness to financial and trade flows. In the wake of the 1997 Asian crisis, the bitter pill that IMF officials made them swallow prompted many emerging markets to build their own buffer in the form of huge forex reserves rather than depend on IMF economists, working “under the thumb of the US Treasury" in the words of economic commentator Martin Wolf.

In recent years, the IMF has scaled back its positions and some of its own economists have begun questioning the orthodoxy. The change in the IMF’s stance, however, took place after the great crash of 2008 during the tenure of macroeconomist Olivier Blanchard.

During Rajan’s tenure, the IMF largely stuck to the old orthodoxy. It was under his watch that Asian economies learnt their lesson from the 1997 crisis, but not the one that the IMF and Western economists wanted to teach; as Wolf put it: they learnt to self-insure rather than rely on the assistance of IMF and the demanding conditions that entailed.

As a result, their reserves accumulation grew stupendously in the mid-2000s, contributing in part to the global imbalances that culminated in the great economic crash of 2008.

However, in several instances, Rajan did depart from the mainstream consensus and the conventional wisdom of the time. The most famous of these departures occurred in 2005 at the annual Jackson Hole conference meant to honour the legacy of Alan Greenspan. In a provocative speech, Rajan argued that the financial developments over the past few years may have made the world riskier and presciently warned of a “catastrophic meltdown".

“… Even though there are far more participants who are able to absorb risk today, the financial risks that are being created by the system are indeed greater," he said. “And even though there should theoretically be a diversity of opinion and actions by market participants, and a greater capacity to absorb risk, competition and compensation may induce more correlation in behaviour than is desirable. While it is hard to be categorical about anything as complex as the modern financial system, it’s possible that these developments are creating more financial-sector induced pro-cyclicality than in the past. They may also create a greater (albeit still small) probability of a catastrophic meltdown."

Although Rajan did not worry about global imbalances, he was deeply worried by the risk-taking incentives created by low interest rates and the evolution of the global financial architecture. At that time, his arguments were dismissed by notable economists, but history vindicated him. He was among the few economists whose reputation was burnished rather than diminished by the great crash of 2008, almost entirely because of his famous Jackson Hole warnings.

This was not the only instance of Rajan’s dissent. In a 2007 National Bureau of Economic Research paper, co-authored with Cornell economist Eswar Prasad and India’s current chief economic adviser Arvind Subramanian, Rajan argued that non-industrial countries which opened themselves to foreign capital outflow did not necessarily grow faster than those which did not. In fact, the reverse was true—i.e., countries which relied less on foreign capital grew faster, the paper found.

The authors attributed this to inadequately developed financial markets in the non-industrial economies and overvaluation of exchange rates due to capital inflows. Having said this, the paper does not call for putting restrictions on the movement of capital and finance across countries. Instead, it calls for policies which can help developing countries mitigate these effects.

Such conclusions are a hallmark of most of Rajan’s writings and speeches, in which he exposes faults with the current capitalist system, but rather than calling for restrictions, argues for developing robust institutional structures to facilitate greater liberalization.

In 2005, Rajan and Subramanian—both of whom were at the IMF—had created a controversy of sorts when a jointly written paper contradicted the World Bank’s research and questioned the efficacy of aid in fostering development.

Once again, the link between aid and growth was overvaluation of exchange rates. The fact that the paper was released days before a summit of major aid-providing countries was to begin only made matters more piquant. Since then, many more economists have questioned the efficacy of aid programmes.

Just like his engagement with the wider world, Rajan’s engagement with India has demonstrated that he can be refreshingly original at times and boringly conventional at others.

He was among the first to warn about the threat of crony capitalism in the country. In a 2008 speech to the Bombay Chamber of Commerce, Rajan warned about the fault lines in the Indian economy at a time when most commentators were exuberant about India.

“My former classmate from IIT, Jayant Sinha, recently sent me a spreadsheet he had compiled," said Rajan. “It lists the number of billionaires per trillion dollars of GDP for the major countries of the world. Guess which country tops the list? It is Russia, with 87 billionaires for the $1.3 trillion of GDP it generates. ‘Of course!’ you will say—these are the oligarchs who stole the country’s mineral resources, who participated in the Loan for Votes scheme, etc. But guess which country comes second? It is India with 55 billionaires for the $1.1 trillion it generates."

Rajan then went on to argue that given the size of India’s economy, the number of billionaires it produced was extraordinary compared with emerging market peers such as Brazil, or with developed market peers such as Germany. Moreover, the fact that most billionaires gained wealth because of their access to natural resources such as land or government contracts raised disturbing questions about the nature of India’s growth process. If Russia is an oligarchy, how long can we resist calling India one, questioned Rajan.

One of his early official responsibilities in the country was to chair a committee set up by the erstwhile Planning Commission on financial sector reforms. In a report submitted in 2008, he argued for faster and more reforms, including a move towards inflation targeting, greater capital account convertibility (including the removal of restrictions on foreign ownership of public debt), the setting up of an appellate tribunal to review the actions of all financial regulators and the privatization of public sector banks.

As the RBI governor, Rajan had a chance to implement or at least pursue all of these steps, but apart from one (inflation targeting), he hasn’t really shown much interest in following up on his own recommendations. In fact, he has fiercely opposed the idea that an appellate tribunal should review the central bank’s decisions. Perhaps the RBI has changed him as much as he has changed it. Or perhaps, a stint in government has made him more aware of political economy considerations that underlie any successful reform initiative.

It is not surprising perhaps that in many of his speeches and writings, Rajan has focused on the big political economy issues of the day. In a 2014 speech delivered in Mumbai, Rajan tackled the problem of corruption in public life.

“Of course, there are many politicians who are honest and genuinely want to improve the lot of their voters," said Rajan. “But perhaps the system tolerates corruption because the street smart politician is better at making the wheels of the bureaucracy creak, however slowly, in favour of his constituents. And such a system is self-sustaining. An idealist who is unwilling to ‘work’ the system can promise to reform it, but the voters know there is little one person can do. Moreover, who will provide the patronage while the idealist is fighting the system? So, why not stay with the fixer you know even if it means the reformist loses his deposit?"

“So, the circle is complete. The poor and the underprivileged need the politician to help them get jobs and public services. The crooked politician needs the businessman to provide the funds that allow him to supply patronage to the poor and fight elections. The corrupt businessman needs the crooked politician to get public resources and contracts cheaply. And the politician needs the votes of the poor and the underprivileged. Every constituency is tied to the other in a cycle of dependence, which ensures that the status quo prevails."

Rajan then went on to argue that the key to eliminating the problem is to minimize the role of government in providing important services and instead use direct cash transfers to help the poor. Rajan’s views on skewed incentives of public officials also led him to suggest in his widely cited book Faultlines that fiscal expansion may not be always desirable during a recession.

“More problematic, when politicians exercise discretion at a time of great necessity, it leads to inventive abuse," he wrote. “Specifically, politicians bring out all their pet projects during a downturn, and then some more, under the guide of stimulus to support recovery. Significant elements of spending are simply paybacks to powerful political groups, or fulfilment of election promises with little need to justify their short-term benefit."

Rajan’s views on the role of government appear to be deeply influenced by public choice theory, a sub-stream of economics developed by Nobel Prize-winning economist James Buchanan. Public choice theory uses the tools of economics to deal with problems traditionally addressed by political scientists and has come to influence both disciplines heavily.

This theory dealt a body blow to the romantic notion of public-spirited individuals assuming public office and replaced it with the notion that public officials are driven primarily by their own selfish interests: of being re-elected or promoted to senior positions. It is public choice theory that helped popularize the powerful idea of a rent-seeking state.

While public choice theory remains an important analytical device to explain the actions of public officials, it has faced criticism in recent years from both economists and political scientists who view its conception of individuals as incentive-driven agents to be too simplistic, and its account of political decision-making as a limited and partial view.

In a 2004 paper, Keynesian economist Steven Pressman argued that while public choice theory could anticipate and explain why politicians would campaign on an agenda of big government, it could not explain why several candidates run for office promising less government, nor does it help understand the actual votes cast by politicians or their actual policy choices.

In her 2004 presidential address to the American Political Science Association, Chicago University political scientist Susanne Rudolph argued that the use of public choice or “rational choice theory" suggests a kind of universalist ethos driving political change, which is at odds with the history of the world. This has led formal theories of such change to attribute motives rather than to investigate them, she contended.

“The assumption that actors’ preferences and choices are determined solely by calculations of rational self-interest is problematic not only because it ignores the role of sentiment, passion, and commitment in behaviour, not only because ‘rationality’ itself is scarce rather than ubiquitous, but also because it is diversely defined by different cultures," she said.

Rajan himself seemed to highlight the importance of sentiments and passions in economic decision-making when he exhorted students at the Indira Gandhi Institute of Development Research to consider a career in public service, arguing that it was wrong to think about the public sector only from the perspective of what rewards it offers or with a “what’s in it for me" attitude.

“The more the world is made better off, the more you will feel that you have made a difference and that is a good feeling to have. I won’t look at it purely as a trade-off or sacrifice. I would see it as perhaps a way of fulfilling yourself," Rajan said, emphasizing that the rewards of public service should be measured in terms of the legacy one leaves behind rather than the immediate rewards one enjoys.

The most important legacy of Rajan will perhaps be his refreshing habit to ask the big questions, and his genuine attempt to answer them as best as he could. Rajan’s analysis of public policy issues facing the country may not always have been comprehensive or consistent, but the fact remains that unlike many economists of his generation, he has not shied away from confronting the big questions of the day. That trait alone makes his contribution to India’s public discourse immensely valuable.

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