Raghuram Rajan Has Got it Wrong on Inflation and Interest Rates

File picture of Raghuram Rajan. Credit: PTI

File picture of Raghuram Rajan. Credit: PTI

Raghuram Rajan has again refused to lower interest rates, insisting that cuts must wait till ‘fresh inflationary pressures’, being generated by the drought, abate. His decision has not come as a surprise because it was preceded, as every policy review in the past three years been preceded, by a drumroll of propaganda, orchestrated by Dalal street, to show how India’s economic difficulties have been of its own making, how these left Governor Rajan with no alternative but to take drastic measures to stabilise the economy, and how not extending his term now will send the wrong message to the ‘ global economic community‘ and sap confidence in the Modi government’s capacity to manage the economy .

Missing from this is any mention of economic growth and employment generation. Rajan has often said in the past two years, that India’s real rates of inflation – i.e nominal interest rate minus the rate of inflation — is not really high, and that growth will automatically revive when inflation has been tamed. But inflation, measured by its most comprehensive yardstick, the GDP deflator, has been virtually zero for the last two years, and the economy has shown absolutely no sign of reviving. On the contrary every single physical indicator – abandoned projects, accelerating bankruptcy in the corporate sector, a log-jammed financial system, and a near-zero growth in employment, shows that it is being locked ever tighter in the grip of stagnation.

Thus, before extending his term it is imperative to decide whether he has been the Indian economy’s saviour, or its destroyer. Rajan could have been be judged its saviour without a moment’s hesitation, if India’s inflation had been high, if the high inflation invariably slows down growth and employment generation (or makes it unsustainable), and if there had indeed been no other way of bringing it down except by raising interest rates. If even one of the answers is a negative it invalidates every premise upon which the RBI has determined interest rates in the past five years and makes the UPA, and BJP, governments guilty of having wantonly forsaken not only economic growth, but also denied poor families the chance of offsetting the inflation by securing more employment or higher money wages.

Do high inflation rates invariably impede growth, and has India’s inflation rate really been high enough to do so? The answer has been given, tellingly, by Kaushik Basu, Rajan’s predecessor as Chief Economic Adviser to the GOI, in a book published last year, “An Economist in the Real World”. Basu points out that while hyper-inflation has destroyed entire economies, not to mention growth, in several countries during the 20th century, its accepted definition is a price rise of 50 percent per month. India hardly comes into that league.

All the evidence collected from industrialising countries has shown that inflation rates of below ten percent a year have not only had no effect on growth, but have accompanied, high rates of economic growth. In South Korea, which has achieved an even more successful industrial transition than China, the inflation rate throughout its three decades of ‘breakout’ was always well above 10 percent , and went as high as 28 percent in the 1980s. It was not till 1997 that the Korean economy experienced a short–lived systemic failure, but that too was only through contagion from the financial crash in Thailand.

India’s inflation not high

By world — but particularly developing country — standards India’s inflation has not been high. What India has actually suffered are two episodes of high inflation encased in two decades of moderate inflation. The first lasted for eight months between March and December 2008, and the second for a bare five months from December 2009 till April 2010. Before these episodes India had had very little inflation for a dozen years. After April 2010 too, wholesale price inflation fell gradually for the next three-and-a-half years and then collapsed suddenly into deflation at the end of 2014. Despite this Rajan has remained determined not to lower interest rates more than a grudging minimum. As a result Indian entrepreneurs now labour under some of the highest real interest rates in the world.

Were these inflationary ‘episodes’ caused by economic overheating, i.e an excess of demand ‘somewhere in the economy’, as Rajan has unswervingly asserted ? Did they remain episodes only because of the swift response of the RBI? In retrospect it is easy to see that neither bout of inflation was a product of excess domestic demand but of what economists have begun to call ’Salad bowl Stagflation’. This is the phenomenon, new to economics because it is a product of a globalised world market, of fiscal stimuli in one country failing to cure stagnation there but triggering inflation in other countries where the new purchasing power finally ends up.

The pump priming, on both occasions, was done by China whose investment spree went out of control in 2007-8, and even more spectacularly during its Fiscal Stimulus programme in 2009-11. This not only pushed up global crude oil, minerals and industrial raw materials prices all over the world but also global demand for foodgrains, sugar, fruit and dairy products. The latter was a siren song to which Indian exporters of everything from rice to onions and dairy products responded with alacrity, leaving the entire resulting burden of supply shortages to fall on the domestic population.

That was the global excess demand that three RBI governors in succession, beginning witth Mr Y.V Reddy in 2007, tried to fight by curbing domestic demand and investment. To quote a Nobel Laureate who shall remain unnamed, what the RBI did was ‘unforgiveable’.

Basu points out that fighting salad bowl stagflation requires completely counter-intuitive thinking. In 2009 and ’10, first Turkey and then Brazil learning from Turkey, chose to lower their policy interest rates in the face of rising inflation. Both brought prices down and in 2010 Turkey recorded the fastest growth in the world of 10.1 percent.

Turkey got it right

The reason why Turkey, in particular, got both growth and lower inflation is simple: Lowering interest rates encouraged production. This eased the domestic supply shortage and stabilised market prices. Elementary, my dear Watson. But three RBI governors and their entire kitchen cabinets did not get the point.

How did they, and a prime minister who won the Adam Smith economic prize at Cambridge university, get Indian inflation so wrong? Basu gives an oblique answer. “ People find inflation frightening because they cannot see where it comes from. (But) what they do not know, and would be even more alarmed if they did, is that the understanding of experts is also very incomplete. On many large subjects we (the experts) have little more than rules of thumb: if there is stagnation, lower interest rates and inject liquidity; if there is inflation raise policy rates and the cash reserve ratio of banks. These rules of thumb remain because they work most of the time. Those that do not get discarded over time. We build our inflation, and for that matter most of our policies, in the same way as birds build their nests”, i.e by trial and error.

There was nothing wrong in doing that so long as India was a largely closed economy in a world of nation-based economic systems. But that world has disappeared. Both for the old industrial powers and the new, the rules of thumb that had worked in the past no longer do so. This is because, today, virtually every sector of our economy is affected by policies and developments in other countries that we have absolutely no control over.

We never get tired of saying this, but only as an alibi for the failure of our policies. The truth is that, unlike the Central Banks of Turkey and Brazil, the RBI has not broken the mould of earlier policies and gone back to first principles in economics to frame a different response.

Nor, under Raghuram Rajan, is it ever likely to do so. For Rajan has never so far admitted that his policies are not working and that there might be a need to think afresh. Instead he has turned his battle with India’s dying industry into a personal one of proving them wrong and himself right.

This inability to think out of the box has cost India twelve irreplaceable years of industrial growth, millions upon millions of jobs for its youth and, for the reasons that Harvard economist Dani Rodriks has pointed out, all but destroyed its last chance to make the ‘industrial breakthrough’ that countries like China, Taiwan, South Korea and Malaysia made before the constraints imposed by a globalised economy   made “catch-up” industrialisation   close to impossible. India simply cannot afford to waste another two years with Rajan clinging to his policies because of his need to prove himself right. That is why he must be allowed to go.

  • Shashidhar V

    Excellent Article , Rajan or RBI policies of have higher interest rates would lead to lower growth and lower employment

  • sundar

    so it wasnt just Mr.Swamy who had issues with RBI guv’s decisions. other economists (from harvard too) have questions. so now will the PM show some pragmatism, discuss with other economists and ease mr. rr out? he’s had a fairly long stint and doesnt seem to trust the indian small entrepreneur to move the economy along. the pm doesnt have to fear about ‘wrong signals’ and should trust the overseas investors to also trust our decisions. afterall they know economics too and get all info from everywhere else

  • Hypocrite

    ‘accepted definition is a price rise of 50 percent per month’. So we wait for that amount of rise to happen and then say ‘whoa, he was right.’? The point is lowering interest rates should be the last trump card and should be used only when you are pushed to the wall especially in an environment where banks do not pass lowered rates to the consumers and the RBI has to beg them repeatedly. Instead he would be better placed by granting more banking licences and thus creating a competition amongst banks instead of the existing monopoly cartels of a few banks who decide what the rates should be. Only creating more financial institutions will result in result in lowering rates on the actual ground. The RBI lowering rates will have no effect on the others who are only seeking to get more paper profit by lobbying against the current governors decision.

  • S.Thiyagarajan

    The author is trying to shift the entire blame for the sluggish industrial output on one criteria, viz., RBI interest rates. He puts the entire blame for the ailing and failing industries on one person, namely RBI gov., whether it is YVR or RR. So by author’s assertion, just by manipulating interest rates, up and down, we can create millions of jobs, increase the industrial output to astronomical levels and put the Indian economy in the economic superhighway and in the 5th gear. I never thought that economics will be such an easy affair. Thanks to the author for simplifying economy so much. He has failed to mention and appreciate that for the 15years, under three different Gov.s, Indian economy has outperformed many of its peers and even now racing neck and neck with the hghly controlled Chinese economy and poised to outperform it in the very near future. Does he think all this are failures? The author is writing series of articles on just one point, viz., RBI interest rates and personally gunning for RR. Can he not think of any other flaw in the system for the supposedly stagnant economy? Can he provide any tangible evidence to show that the maladies he is mentioning like loss of millions of jobs, irreplaceable loss of industrial growth etc., are because of this single fault of RBI. He considers all these industrialists as angels desecended directly from the heavens to help India and the RBI is curbing their wings and make them fall into the ground. Does he think that the failures of companies like KFA, AIRINDIA, and scores of other companies etc., are solely becuase of the interest rates? Why he is not mentioning gross and blatant mismanagement and siphoning of funds by the promoteres, even as ONE of the reasons for the failures of the company and loss of jobs. If you go and tell the KFA employees that they have lost the jobs becuse of RR, they will laugh at you. PSJ himself says that ” India is no more a closed economic system and virtually every sector of our economy is affected by policies and developments in other countries that we have absolutely no control over.” Finally one question to Mr.PSJ, what is his answer to millions of pensioners and senior citizens who are solely depended on bank interest returns for their very survival who are facing ever decreasing and even negative returns form their bank deposits because of ever lowering of interest rates to rich industrialists. Does he wants to sacrifice the pensioners and senior citizens at the altar of his favourite industrialists? I only hope that Mr.PSJ will try to answer this question in his next article. I request the author to use his vast economic and administrative knowledge to write objectively about the malady and analyse all aspects that he thinks has led to the supposed failure of economy instead of indulging in subjective writing and engaging himself in personality bashing of RR.

    • Ganesan S

      I think you’re missing the point. When other major problems have been (or are being) sorted out (by and large), interest rate assumes significance. I agree that, if we had continued with UPA regime, Rajan’s policies would not have made a huge difference, though it still would have made some difference. Some people don’t seem to understand the importance of interest rate in pricing and hence today’s global competition (which is not only important for exports, but also important within India to prevent loss to imported goods). Surely MSMEs and non-crony capitalist companies are losing out due to high interest rates. We don’t have an industry-facilitating environment, and interest rate is a key element of such an environment.

  • vizeet

    Rajan only have control of monetary policy. Economic policy is controlled by government. Industry is suffering because of ever increasing taxes and corrupt system which encourages middleman. Even government will have difficulty in proving that they did anything for “Made in India”

    • Ganesan S

      If you make this kind of statement TODAY (I’m not referring to Congress years), that “Industry is suffering because of ever increasing taxes and corrupt system which encourages middleman”, either you are a Rip Wan Winkle not knowing what is happending in India for the last 2 years, or you’re a motivated campaigner. Rajan is a major part of the problem. I don’t subscribe to the Conspiracy theories about him, but I believe his economic thinking is out of tune with today’s India’s needs.


      I think very rightly said by the previous commentator. RBI has ‘locus standi’ and control over only and only monetary policy. An economy comprises of extremely complex variables and it is the result of behaviour of all these variables which result into economic growth of a nation. Most of the policies are controlled by the government. And to blame only RBI for the state of affairs is wrong. It seems that the affected parties of this non-performing drive including the banks who lent them are driving this campaign to ease off RBI Guv. Whether right analysis and right

  • Ganesan S

    I completely agree with this article.

  • Arvind

    My thoughts:
    1. RBI has been mandated to control CPI inflation. Interest rates are the main tool.
    2. We should avoid taking instances of other countries. Also, avoid too much economic theory.
    3. Catch-up industrialisation etc will not happen due to monetary policy. India will find its own way, very quickly, with the good (asset creating) policies in place.
    4. Mismatch between CPI inflation and GDP deflator is a serious concern. Govt borrows at CPI + 1.25% (say 6.5%), whilst its debt depreciates at GDP deflator (0% as per article).
    a) If CPI was equal to GDP deflator … people would see no price rise … Govt would borrow at 1.25% –> it could cut the fiscal deficit and raise capital expenditure
    b) if GDP deflator was equal to CPI … all is the same, except govt revenue will increase by 5% during the year –> it could cut fiscal deficit and raise capital expenditure.
    c) The same applies to industry borrowers

    The mismatch between CPI and GDP deflator has hurt the NDA. Once this corrects itself – (which hopefully happens , with GDP deflator rising to CPI levels), we shall see significant benefits for govt and industry.

  • forsanity

    I do not understand why the so-called experts do not focus on both sides of the coin. Those two sides are supply and demand. Rajan can influence only the demand part of it by lowering interest rates. The supply side has to be boosted by the executive. Supply includes not only actual production of goods but the means to get them to the right places quickly without rotting, and without too much delay and providing adequate power supply etc. For ages, that has been the problem with the Indian economy. As soon as demand perks up, inflation rears its head because our supply chain is broken. Without making an effort to fix that, we have to move gingerly with the interest rates in order to sustain GDP growth while containing inflation. This is what Mr. Rajan is trying to manage. This was also the bone of contention between Chidamabarm and Subbarao in the previous regime (‘I will walk alone’ rhetoric). We need a plan to show that we are ready to fix the supply side problems before we let the tigers of growth loose. Simple comparisons to the international situations does not reflect this reality and Mr. Rajan knows that.

  • dinesh pethkar

    more than 50% of our economy is cash (black) and how do you keep control on that by keeping interest rate high. Mager portion of the inflation come from food and that can not be controled by interest rate.

  • ssc

    Not quite correct to have opinions when working on economical factors.. There need to be clear discussion across all the economists & come up with best figures.

  • economics

    Food inflation eventually spills into core inflation. That causes inflation to go up in the system and destroys the purchasing power of all the people. To maintain that, RBI has to keep rates higher than inflation so that the FD rates can beat inflation. If RBI keeps loose monetary policy, people will start buying more gold and real estate. That would encourage hoarding and reduce the demand, thereby reducing GDP.

    Rajan’s intention was exactly this in keeping rates where they are currently. Rajan is much better than ‘nobel’ winners who always want to print money. US Fed policy is a failed policy. It has further reduced common man’s purchasing power without creating any jobs. The labor participation rate has gone down.

    Governments think loose monetary policy helps big borrowers such as government, but in practice, positive real rates policy always benefits govt in the medium to long run resulting in low inflation and low rates.

  • Akbar Mohamadzai

    Excellent article. Kudos.

  • Rajat Bhatia

    Excellent article. I could not agree with it more despite the fact that Raghu is my classmate from IIMA