TCA Srinivasa-Raghavan: Elbow room for the RBI

OKONOMOS

"Fiscal and monetary co-ordination is not necessary for macroeconomic stability"

Next Tuesday, the Reserve Bank of India will announce what the rate of interest will be for the next three months. A few weeks ago, the finance minister announced what the Budget deficit would be for this year.

For the past 25 years so, both variables have been the subject of intense debate amongst economists who ask: which is more important, the rate of interest or the budget deficit, in determining the course of economic events?

One lot has said this, another lot that, and the twain have never managed to meet. But now a couple of them have gathered the courage to say what has, perhaps, always been true: neither matters, at least not as much as we have been led to believe.

In a recent paper* Bennett T McCallum of the Carnegie-Mellon University and Edward Nelson of the Federal Reserve Bank of St. Louis argue that "fiscal and monetary co-ordination is not necessary for macroeconomic stability."

If true, Y V Reddy can do pretty much what he wants, now that the finance minister has done pretty much what he wants.

The source of the argument, as can be expected from economists pretending to be physicists, and grating on about equilibria and the like, is an arcane debate over something called the fiscal theory of the price level. (For instance: "The FTPL variants under the two rule types do share the characteristic that they generate equilibria where, in contrast to the monetarist equilibrium, an extra state variable appears in the solution expression for inflation.")

The theory says, broadly speaking, that it is not necessary for the government to observe any fiscal rules. As it bashes on regardless, other variables, including the price level, will adjust "" which is what George W Bush is in the process of more-or-less proving.

But even when it was, so to speak, equationised in the 1970s, it was old hat. This equationised bit, in consonance with pretensions to being a science on par with neutron physics, is grandly called "Ricardian Equivalence". The equivalence is reference to the method of financing the government's deficit "" by borrowing or taxation, it is all the same.

David Ricardo had said it much more simply about 200 years ago, that government budget deficits do not affect the total level of demand in an economy. Later he changed his mind.

Taking a cue from this, the real issue, say McCallum and Nelson, is different and depends on what you are looking at, namely, whether monetary policy rules are cast in terms of the nominal money stock or the nominal interest rate. They say "the FTPL under interest-rate rules is dissimilar to the FTPL under money stock."

In other words, depending on how you see the universe, inflation can be a function of fiscal policy or monetary policy (or, if I may add my two bit, both). In short, it doesn't matter.

"The main messages for practical policy", they conclude, "are that central banks can control inflation irrespective of fiscal policy and that detailed co-ordination between monetary and fiscal authorities is not needed for effective macroeconomic policy."

This paper goes one more step towards proving what I have maintained for several years now, namely, that this sort of hair-splitting, reminiscent of rabbinical and brahminical tendencies, is destroying economics that is, at its core, a set of simple relationships between demand and supply.

It was reassuring to see support for this view from a man whose honesty and intellectual calibre is beyond doubt and who, at 96, has no longer any axe to grind.

In a recent book** John Kenneth Galbraith points out, amongst other things, that central banking, especially the US Fed, and even more especially under Alan Greenspan, is a class act of mass mesmerism.

Nothing that the Fed (and by extension other central banks) does makes a difference, he says. The price of money is irrelevant because even when interest rates are high investment doesn't always stop; and it doesn't always pick up when interest rates fall. And so on.

For those interested in seeing economics for what it is should be and is not, this is a MUST book. It is, if you will, Shuddhi equivalence.

*Monetary and Fiscal Theories of the Price Level: The Irreconcilable Differences, NBER Working Paper No. 12089, March 2006
**The Economics of Innocent Fraud, Penguin, Pp 55, about Rs 100