Inflation: Central banks can't fix the mess that politicians have created

Only politicians can fix the problem because, contrary to public belief, it is they who create money, not central banks

It is quite amusing to read the latest issue of the IMF publication "Finance and Development", containing suggestions for central banks from several celebrity economists. Two of them are Indian: Gita Gopinath and Raghuram Rajan, current and past chief economists of the IMF.

All agree that the main and only problem now is inflation, a problem that they, the economists, helped create after the Atlantic financial crisis of 2008. So the answer, too, is to be found there only, in America, to be precise, the Great Satan of the 15-year-old global monetary turbulence. 

In 1980, faced with the same problem, the then chairman of the US Federal Reserve, the late Paul Volcker, raised interest rates savagely. The effect was dramatic. Inflation and output both came down, and unemployment went up. 

So now we must ask why what worked then can't work now. And the answer, as bank bailouts, among other things, show, is that the politicians won't let it. It worked then because, at the end of the 1970s, the world started moving to the economic right. Now it's already moved hugely to the economic left. 

If you will, we have the political equivalent of the Kondratieff cycle, which is a long-term economic cycle during which 40-60 years of prosperity alternate with a similar period of economic decline. We are now in the middle of the decline. That's why left ideas have gained so much traction. 

Technological change was central to the Kondratieff wave. That's true of the political Kondratieff wave as well, in my view. But let me not stretch the analogy too far. 

However, the point is clear: monetary policy is now mainly a political variable with economic consequences; it's no longer an economic variable with political consequences. 

Arguably, this was always so. Maybe. But never to such a degree. The enlargement of central bank balance sheets witnessed after 2008 has no precedent. 

This is because there is no longer any anchor — other than inflation — to money creation. And even that is ineffective because of the Left, which, regardless of the hue, is wholly divorced from the rules of economics. Its resurgence has made room for political manoeuvre for conservative governments extremely limited now. 

So, given that the 1980s type of supply-side policies and tough monetary solutions are no longer available to conservative political parties, how should economics respond to this political reality? That's something for better brains than mine to think through, but I do have some suggestions. 

First, economics has to include or absorb in its theoretical framework the idea of limitless money supplies. Thus, it becomes a public good whose marginal cost is assumed to be zero. 

Modern Monetary Theory proposes this, but it hasn't been incorporated into proper theory. Instead, it's been dismissed as a crackpot idea, whereas it is no more than the current reality. 

Second, this means that Keynesian theory, which has governed macroeconomic policies since the 1950s, has to be set aside. Keynes did give up the idea of balanced budgets in favour of deficits but only in specific circumstances. Now that has become a general prescription. In India, AAP is the flag bearer of this view. 

Third, therefore, one and two together mean that economic analysis must pay far greater attention to Total Factor Productivity than it has till now. TFP is that proportion of output that's not explained in terms of labour and capital inputs. 

The point, finally, is this. While the world is wondering how central banks can resolve the mess that the politicians have created, the short answer is they can't. Only politicians can because, contrary to public belief, it is they who create money, not central banks. 

Disclaimer: These are the personal opinions of the writer. They do not reflect the views of www.business-standard.com or the Business Standard newspaper