Kaushik Das: Short-sighted by choice

Why do central banks prefer erratic, short-term policies over long-term ones?

India's burgeoning foreign exchange reserves ($ 129.69 billion as on December 10, 2004) have raised serious concern among policy-makers and economists alike and has for long been a subject of incessant debate.

The main reason for this "excess" accumulation of reserves is the Reserve Bank of India's (RBI's) intervention in the forex market through its sterilisation policies (to keep the rupee from appreciating), under the aegis of the National Democratic Alliance (NDA) government for the past two years.

Any kind of intervention has its ill-effects and, in this case, the overhang of the excess liquidity led to inflationary pressures, which forced the RBI to raise interest rates. What followed was a liquidity crunch that compelled banks to draw down the RBI's repo window for liquidity support.

This liquidity crunch also prompted the RBI to intervene in the currency market again, thus infusing surplus liquidity in the system and thereby completing the full cycle.

Planning Commission Deputy Chairman Montek Singh Ahluwalia has proposed using $ 5 billion each year for three consecutive years from the reserves for infrastructure projects. That will take care of two problems "" excess forex reserves and the glaring infrastructure gap in one master stroke.

But what about the fiscal deficit? Wouldn't it increase, thereby marking a stain on the recently passed Fiscal Responsibility and Budget Management Bill that envisages fiscal consolidation? What about inflation? Wouldn't such a plan lead to excess liquidity in the system and thereby increase inflation?

Ahluwalia feels "a temporary deviation is acceptable since the money would be used to fill critical infrastructure gaps". This brings us to an important question: whether the government's/RBI's (or for that matter most central banks the world over) short-term, discretionary and interventionist policies benefit the Indian economy in the long run.

Edward Prescott and Finn Kydland "" winners of this year's Nobel prize for economics "" provide the answer to this question. Their research work has revealed that economic policy-makers who cannot commit to a rule in advance often will conduct a policy that gives sub-optimal results, despite their stated objective of achieving the best possible outcome.

This is because of the "time consistency problem" in government policy-making. Their conclusion is that time inconsistency between decisions at different points in time can be highly disadvantageous for society.

The theory propounded by the Nobel laureates is anti-Keynesian in nature: that is, they do not support short-term discretionary and interventionist policies by the government, for instance, "trading off" inflation with unemployment as prescribed by Keynes. On the contrary, Prescott and Kydland advocate "long-term rules" that the government should follow to achieve stable economic growth.

Prescott and Kydland's research has helped to shift the focus of economic policy design away from isolated measures towards a discussion on how to develop an institutional design that will create long-term commitment mechanisms aimed at stable monetary policies.

This means that the Nobel laureates believe it is possible to have an independent central bank that will take decisions solely for the benefit of the citizenry without succumbing to pressures from the party in power, if only there is some proper institutional design in place. This brings us to an even more important question "" is it possible to have an independent central bank?

In reality, it is impossible to have a central bank independent from the pressures of the incumbent political party for the following reasons:

The central assumption that forms the edifice of Prescott and Kydland's research is that governments choose policy in order to maximise the welfare of their citizens.

Based on this, the duo arrive at the conclusion that a long-term policy based on certain "rules" will lead to a more stable outcome than erratic short-term policies.

Now, what is so great about this discovery? Everybody knows that a stable, long-term policy will render better results than erratic, short-term policies.

This has been proved time and again after faulty short-term Keynesian policies followed by governments all over the world revealed the persistence of the "political business cycles".

The more important question one should ask is: do governments actually work for the benefit of citizens? Another Nobel laureate, James Buchanan, came up with the "public choice theory" by challenging the prevalent belief that governments work for the benefit of their citizens.

On the contrary, he has emphatically proved that all political market players "" politicians, bureaucrats, special interest groups and voters "" act in a self-interested manner.

Following this line of logic, it does not require great intellectual aptitude to understand that the central banks all over the world would never embrace long-term policies, simply because it goes against their self-interest.

The famous BBC series Yes Minister was inspired by the public choice theory and showed self-interested behaviour on the part of politicians and bureaucrats. But that was in the UK. What of self-interested behaviour by governments in Third World countries? What of "predatory states"?

There are precious few good governments in the world, just as there are precious few good police forces. The Kydland-Prescott assumption means looking at governments with rose-tinted glasses.

In reality, central banks are cartels that create credit out of thin air. Fractional reserve banking, which central banks institute, is a curse on society, as it creates a "moral hazard" for every banker.

The fiat money central bankers issue worldwide is not worth the paper on which it is printed. No central bank in the world nor, for that matter, the International Monetary Fund-World Bank combo can deliver "sound money" "" that is freely convertible and free from inflation "" which is a must for the globalising world, for there cannot be free trade without freely tradeable money.

If the short-term, discretionary and interventionist policies of the central bank lead to sub-optimal outcomes and if it is impossible to have an independent central bank based on some "long-term" commitment mechanisms, the only logical conclusion, therefore, can be to put an end to the pervasive central bank system and replace it with a "free banking" system.

In conclusion, the problem of "excess" forex reserves and the debate on whether a part of the forex reserve should be used for infrastructure projects would not have surfaced if the RBI did not intervene in the forex market in the first place.

This by no means undermines Ahluwalia's genuine concerns and good intentions to strengthen India's infrastructure base but, as the saying goes, the road to hell is paved with good intentions.

(The author is a research fellow at the Centre for Civil Society)