TCA Srinivasa-Raghavan: Tu-tu, mein-mein - macroeconomics style

OKONOMOS

"If economists could get themselves thought of... on a level with dentists, that would be splendid": Keynes, 1931

The Reserve Bank of India's (RBI's) current concern is inflation. If it thinks that by making money more expensive, it can curb demand and, thus, slow down the rate of increase in prices, it will do so. But will such an increase, now or a few months later, work?

Eventually, if you go on increasing any price, demand will begin to dip. But the problem with money is that the demand for it in the short run is inelastic. This makes a central bank's work that much harder because it can neither predict by how much it must raise interest rates or when the cumulative impact of a series of small increases will begin to have an impact on demand.

The US Federal Reserve has had to raise rates 17 times, no less, but nothing appears to be happening. In short, central banks are out on a wing and a prayer. The RBI cannot be an exception to this rule. This uncertainty has divided economists into two groups. Those who think monetary policy works, and those who think it doesn't. This has led to a further sub-division amongst those who think central banks must be bound by rules and those who think they must have discretion.

The skirmishing between old and new macroeconomics has also resulted in some excellent wisecracks. Thus, Robert Solow once said, that it was "foolishly restrictive" to think that markets would always clear.

Referring to the existence of wage and price rigidities, he told the AEA "I remember reading once that it is still not understood how the giraffe manages to pump an adequate blood supply all the way up to its head; but it is hard to imagine that anyone would, therefore, conclude that giraffes do not have long necks."

Another good one was when he said "Suppose someone sits down where you are sitting right now and announces to me that he is Napoleon Bonaparte. The last thing I want to do with him is to get involved in a technical discussion of cavalry tactics... If I do that, I'm getting tacitly drawn into the game that he is Napoleon Bonaparte."

A recent and masterly survey of macroeconomics* "" everyone who reads this column must read it "" by N Gregory Mankiw, a Harvard professor, which captures all this says "An independent central bank is not the same as a rule-bound central bank." He then cites the example of the US Fed that has refused to commit itself to a policy rule. He quotes Ben Bernanke who calls it "constrained discretion." He also says that "Greenspan proves that central banks can produce desirable outcomes while wielding substantial discretionary powers."

Mankiw says studies show that the recent low inflation has not been because central banks have successfully targeted inflation. "Monetary policy has improved both in those countries that have adopted inflation targets and in those that have not. This world-wide improvement in inflation outcomes could be because the world economy has not had to deal with (major) supply shocks... the evidence shows that inflation targeting is not a prerequisite for good monetary policy."

That said, the question arises: why is discretion to be preferred to rules? The answer is that all central bankers "" except, perhaps, the ones in New Zealand "" have to deal with a monkey on their backs, namely, finance ministers who are not bound by rules and who eventually determine the level of the fiscal deficit and, thus, the range within which the rate of interest must lie.

Mankiw provides a view of macroeconomics from this perspective as well. Finance ministers decide fiscal policy, whose main objective is to do things that will increase employment. They can do this spending money themselves as the UPA does; or they can generate a system of tax incentives that leads to the same outcome, as the NDA did.

Mankiw ends on a gloomy note. "The real world of macroeconomic policymaking can be disheartening for those of us who have spent most of our careers in academia. The sad truth is that the macroeconomic research of the past three decades has had only minor impact on the practical analysis of monetary or fiscal policy."

So what might be the problem? The answer according to Mankiw, lies in how economists view themselves "" whence the title of this paper "" as engineers or scientists.

To which I would say that it also lies in a deadly combination of their arrogance and naivete. Or as Keynes said, "If economists could manage to get themselves thought of as humble, competent people on a level with dentists that would be splendid."

* The Macroeconomist as Scientist and Engineer, NBER Working Paper No. 12349, June 2006