Why do arguments persist despite contrary evidence?
Why is the debate uninfluenced by the data? Why is it that as we seem to be bringing inflation under control, public voices to abandon the fight are loud? I don't know for sure but let me hazard a guess: Is it possible the political economy of inflation is different from the received wisdom we were taught in class as students? And are there parallels to the political economy of bank clean-up?
Specifically, despite all the public commentary against inflation and its pernicious effect on the weaker sections, there seems to be surprisingly little anxiety in public commentary about inflation so long as it stays in the high single digits. Industrialists welcome negative real rates of interest for obvious reasons. Many middle class savers value the high nominal interest rates on their fixed deposits, not realising that their principal is eroding significantly every year. The Keynesian economist is happy because monetary policy is extremely accommodative. The analysts cheer every cut in interest rates because markets are assumed to have a Pavlovian positive response to them. Even the poor are inured to their fate of seeing real incomes erode, and are only aggrieved when the price of some food staple sky-rockets. Interestingly, short-term spikes in food staples are not really controllable by monetary policy, which leads to the incorrect generalisation that since monetary cannot control the politically most important aspects of inflation it cannot control inflation in general.
With no powerful and vocal political constituency getting agitated about generalised inflation so long as it is only moderately high, opponents of disinflationary policies are free to frame the debate as they wish. The persuasive way is to claim that interest rates are hurting growth. The argument is hard to refute because there is always some sympathetic borrower who is paying seemingly excessive rates. The high prevailing borrowing rate of some small borrower - say 15 per cent today - is held out as Exhibit A of the central bank's inconsiderate policies, never mind that the rate charged includes the policy rate of 6.5 per cent plus an additional spread of 8.5 per cent, consisting of a default risk premium, a term premium, an inflation risk premium, and the commercial bank's compensation for costs, none of which are directly affected by the policy rate.
The press is constantly urged to frame the debate as inflation versus growth, and with inflation still moderate, only the excessively conservative central bank could be against growth! Never mind that overly accommodative policy today will set up inflation for the future; never mind that the last 40 years of economic theory and practice suggests that the best way central banks can support growth over the medium term is by keeping inflation low and stable.
The reality, of course, is that high inflation is not stable. As we have seen in India's own past, and in other emerging markets, moderately high inflation tends quickly to become very high inflation. The currency then becomes volatile, leading occasionally to external stress. After all, one of the reasons we were termed the Fragile Five in the summer of 2013 was because of our high inflation. Moreover, the saver eventually recognises that high inflation erodes the value of his financial savings and switches to real assets like gold. Since we do not mine gold in the country, this also puts pressure on the current account. In sum, the fragilities associated with high inflation accumulate, and eventually could lead to crisis. However, the belief that there is a strong powerful domestic constituency against inflation in India, which was drummed into our heads as students, may be a myth, certainly at moderately high levels of inflation.
Unlike more authoritarian Asian economies that used severe administrative measures to deal with bouts of high inflation during their growth phase, our democratic structure rightly does not permit such measures. So it is better that we tackle inflation up front by building the necessary institutions. Perhaps this is why successive governments, in their wisdom, have given the RBI a measure of independence. Certainly, such concerns would support the current government's decision to enshrine its commitment to low inflation through a formal inflation target and the creation of an MPC.
Interestingly, a similar public dynamic seems to be at work in attitudes towards cleaning up the public sector banks. Clearly, over-levered promoters have no incentive to see the banks tighten screws and demand repayment. Some public sector bank CEOs with a short remaining tenure would prefer not taking stern action and recognising NPAs (non-performing assets). They might indeed prefer transferring any problems to their successor. Investors in bank shares, at least initially, do not welcome disclosures of loan losses. And depositors, knowing the government stands fully behind public sector banks, are rightly unperturbed by the quality of bank balance sheets.
So it is easy to ignore the problem of loan losses and hope it somehow goes away, much as it is easy to ignore moderately high inflation. But as with inflation, loan losses have a tendency to increase. The lesson from other countries is that by the time losses get too big to ignore, they are too late to manage, and the system is in crisis.
Fortunately, after an initial reluctance, banks have entered the spirit of the clean-up and some have gone beyond what was demanded of them. The stock market, after reacting negatively initially early this year, has been more supportive of public sector bank stock prices, probably reflecting the belief the clean-up is good over the medium term. Promoters are selling assets and paying up, and new asset reconstruction companies are being started to buy assets. To restore bank balance sheets to health, it is important this process be taken to its logical conclusion.
Edited excerpts from an address by RBI Governor Raghuram Rajan, July 26, at the 10th Statistics Day Conference 2016, RBI, Mumbai