Chief Economic Advisor Arvind Subramanian’s research paper on GDP estimation has been widely criticised on two grounds: one criticism relates to methodology. The other relates to the “smell" test. Few people outside the political opposition believe that real GDP growth was as much as 2.5 percent below the official estimates for the 2011-17 period. If it was really that bad, it is unlikely that Narendra Modi would have won such a mandate this year.
However, most economists agree that there could be some over-estimation of GDP in the new series, and have called for a relook at the data methodology to make it more credible. What no one has talked about is the larger implication of over-estimating GDP over so many years. In particular, we have to conclude that monetary policy was horrendously wrong. If we have been growing far slower than what the official statistics indicate, then monetary policy should have been much looser, much earlier. But the Monetary Policy Committee (MPC) was on its own trip, and did real injury to the economy.
This should lead to the assertion that the MPC has failed, and needs to be wound up. It serves no purpose beyond giving us a sense that it thinks differently from the government, even if it is wholly wrong. It’s like that chowkidar who is usually fast asleep, but periodically bangs his stick on the ground to tell residents that he is on the job.
Some economists work backwards from low inflation and credit the MPC for this success. But correlation is no causation. If there is no inflation, one can hardly credit monetary policy for it. Rates do not impact food or fuel prices, both of which helped keep inflation low.
The MPC’s irrelevance emanates from three realities, all peculiarly Indian: one, it was set up at a time when demonetisation made the Reserve Bank of India (RBI) seem like a hand-maiden of the executive, and hence the MPC had to look like it could thumb its nose at the government, even if that was not necessary in those economic conditions. The second, and more important, reason, is that the agreement with the government on inflation targeting is fundamentally flawed. Third, for any policy to work, both monetary and fiscal policy must be in sync. This calls for constant consultations between the finance ministry and monetary authorities, not constant conflict and a pretence of monetary independence. We bought into the idea of a separation of monetary and fiscal powers just because it works reasonably well (or does it?) in the West, but this arrangement is wholly unsuited to India at this stage of development.
There is an old saying that if you give someone a hammer, everything begins to look like a nail. This is what has gone wrong with the MPC. It was given an inflation, and inflation-only, mandate, and this made it focus, quixotically, on defeating an inflation that simply wasn’t there. Nothing else explains why it continued with one of the highest real interest rates in the world for so long. And if GDP growth was really much lower than what we had assumed it to be, the MPC was worsening the slowdown with its mindless assertions of monetary dogmatism.
On the other hand, consider how the MPC would have acted if it had been given not only a four percent inflation target, but also a growth target of, say, six percent. Would it still have kept an aggressive anti-inflation stance? If the MPC has a dual mandate, it would have adopted a more nuanced strategy.
The RBI, on which the MPC leans for policy support, also failed to ensure rate transmission, even while muttering darkly about it. They forgot two simple realities: that high real rates inhibit a reduction in deposit rates. And, two, without adequate capitalisation, banks will hardly be in a mood to lend more. Their first priority would be to retain margins and conserve capital. On the other hand, in a falling interest rate regime, banks could have cut down on losses by making treasury profits on gilts.
Faced with central bank (and MPC) intransigence, the finance ministry fought back in its own way to undercut monetary policy. For example, to get around the problem of high real interest rates, it offered rate subventions and fiscal relief for critical sectors like housing. To get around the problem of a credit freeze caused by the pile-up of bad loans at public sector banks, it encouraged a huge scale-up of lending to micro businesses through Mudra Bank. Some of this could pose further risks of loans going bad at a future date.
India’s is not a developed economy where the RBI/MPC and the finance ministry can act as if the other does not matter. This is why the old system of the governor being vested with all the power made sense, since the government could always engage him in a conversation. With a six-member MPC, that’s simply unlikely. There is no evidence whatsoever that RBI governors, when they were in sole charge of monetary policy, performed any worse than how they have fared with five more people to advise them on rate policies.
Clearly, the MPC must either be disbanded or given a new mandate that includes some responsibility for growth as well. As now constituted, the MPC is a huge waste of time and effort.
R. Jagannathan is editorial director, ‘Swarajya’ magazine