Central banks need self-awareness

'The Reserve Bank of India has a lot of experience in trying (and failing) to guide fiscal policy', says the author

Economics, though it’s called the “dismal science”, can be a source of endless entertainment. This is because it is only in economics that some very good people come up with some very bad ideas, very consistently.

Having written about this phenomenon quite often, I shall refrain from listing all such instances. But if you are interested, please google funny research in economics. You will wonder why you are not an economist.

So let me confine myself to a new bad idea being propagated by the tribe. It must surely be in the top 10 of the “Worst Ideas” category. The idea is this: Monetary policy, of which central banks are in charge, must help mitigate climate change. The idea has found many adherents amongst central banks.

Not surprisingly, two very well-known and highly qualified Indian economists, both occasional columnists for this newspaper, have held forth on the topic last week. It was like an undergraduate debate: One for and one against.

The case made out by the economist for the topic was persuasive in and within itself. But it was blown to smithereens by the economist against it. He was brutal in his criticism of the idea.

That said, both refused to get to the core of the issue, which is that trying to achieve climate objectives via economics is like using an inch tape to measure the circumference of the earth. Within economics, using monetary policy to mitigate climate change is like using Vernier callipers to measure the earth’s circumstance: Futile to the point of being ridiculous.

Yet, many central banks in Europe have embraced the idea. Just what they will do, and how successful whatever they do will be, remains to be seen. I hope they succeed but it does seem as if they are falling for a fad, quite forgetting that things ended badly for the boy who stood on the burning deck.

A question of credibility: This then is the real danger for central banks — their credibility. If they try to build climate change parameters into monetary policy, they could end up looking even sillier than they are looking now with those bloated balance sheets.

And if they lose even more credibility with their ridiculous balance sheet expansion policies of the last 12 years, they will fail as one of the key institutions of State. That won’t be at all nice.

The point is this. It’s one thing if you mess up because of an honest mistake and quite something else because you adopted a political fad. And make no mistake: That’s exactly what it is.

This has been pointed out very ably by an economist called Lars Peter Hansen. He has written a working paper for the Becker Friedman Institute of Chicago. It is called “Central Banking Challenges Posed by Uncertain Climate Change and Natural Disasters”.

He says monetary policy is a weak substitute for sensible fiscal policy and “central banks which overstate their ability … run the risk of both losing their distance from the political arena and providing false hope … clarity of ambition and execution will help to ensure that central banks maintain credibility … Their credibility will be further enhanced by avoiding the temptation to exaggerate our understanding of climate change”.

According to him, there are three problems that central banks can’t solve. One, “hastily devised policy rules unsupported by empirically grounded quantitative modeling; two, attempts to take on a broader mission without formal and well-defined mandates; and three, climate change mitigation targets added to currently well-defined mandates generating excessive expectations and unwarranted confidence in the abilities of central banks”.
 

Two suggestions: So given that we are all in it together, how can central banks contribute? In two ways, says Hansen.

One, they should recognise that fiscal policy is a better instrument than monetary policy; and two, they should help support quantitative research into exactly how fiscal policy can help.

The Reserve Bank of India has a lot of experience in trying (and failing) to guide fiscal policy. So while it can ask the government to go slow with expenditure, if the past is any guide it is unlikely to have significant success after this year because of the forthcoming 16 Assembly and one general election. 

That leaves economics research, at which it is quite good. So it might be a good idea for it to set up a unit that provides focused inputs to the government on how exactly fiscal policy can be used. 

Why, it can even collaborate with the National Institute of Public Finance and Policy, whose present chairman is a former RBI governor. He is also a world-renowned climate economics expert and, above all, a fiscal policy wizard nonpareil.