Monetary policy across the world is guided by flawed monetary theory that puts the cart before the horse, i.e., gets the direction of causality wrong, contends former chief economic advisor K V Subramanian, who is the executive director for India on the board of International Monetary Fund, in his latest book co-authored with K Vaidyanathan – Money: A Zero-Sum Game. Edited excerpts from an interview with ET's Deepshikha Sikarwar:
Central Banks have time and again relied on monetary stimulus to support and boost the economy. Your book questions the move's effectiveness?
A key postulate of monetary theory, which central banks use for conventional monetary policy, is the concept of "money multiplier." It captures the magnitude by which money multiplies through deposit and loan transactions among banks and their customers. Monetary theory posits that the money multiplier equals the reciprocal of the reserve ratio mandated by the central bank. Yet, using several instances across the OECD economies and India, we show that central banks decreased the reserve ratio and yet the multiplier decreased instead of increasing. A second postulate that has driven unconventional monetary policy post the global financial crisis (GFC) is that releasing bank reserves would encourage banks to lend. During GFC, total bank loans decreased in the US despite bank reserves increasing 170 times! Even in India, FM Pranab Mukherjee kept lamenting "Despite the loosening of the cash reserve ratio (CRR) limits, bank credit has been steadily declining." So, two key postulates that dictate monetary policy have had little effect on the real economy.
You maintain that there is no difference between monetisation of the fiscal deficit and dividend pay-out by the central bank to the government. In India, monetisation of the deficit is frowned upon.
Such incorrect perceptions stem from flawed monetary theory. We develop an equation that we call the V-S equation to comprehensively capture all the determinants of money supply, of which central bank's equity is one. Who funds this equity? It is the government. Compare two scenarios: RBI monetizing the deficit by Rs 1 trillion and RBI paying a dividend of Rs 1 trillion. As RBI lends to the government by buying G-Secs, monetizing the fiscal deficit means that RBI writes off G-Secs worth Rs 1 trillion, which reduces profits by Rs 1 trillion. As profits increase equity, equity is now lower by Rs 1 trillion compared to the scenario where the deficit is not monetized. Instead of monetizing the deficit, if RBI pays a dividend of Rs 1 trillion, retained earnings reduce by Rs 1 trillion. As retained earnings add to equity, dividend paid reduces equity by Rs 1 trillion.
In both cases, equity is impacted by Rs 1 trillion, through reduced profits when deficit is monetized and through lower retained earnings when dividend is paid. Thus, the two operations are identical. RBI's balance sheet, the government's balance sheet, and the money supply in the economy remain the same in both cases.
You have alluded to crony lending during 2009-2014 contributing to high inflation. Wasn't it a result of the post-GFC stimulus?
Of course, the post-GFC stimulus contributed to high inflation. But we also highlight the importance of sound bank lending for low inflation and high growth in an economy. Economically, crony lending is lending to dubious promoters who do not create any output because they invest in dubious projects. Thus, while such lending increases the money supply, it does not increase output. And when too much money created by such crony lending chases too little output, you get inflation. We emphasize the enormous power that banks collectively possess to drive growth and inflation. Through this book, we are hoping to play the role of the wise bear Jambavan in the epic Ramayana, where he reminds Hanuman of his enormous powers.
You have taken demonetisation period to prove that higher bank deposits do not necessarily lead to loans. But that was an aberration period when economy was undergoing a shock.
A phenomenon is an aberration only if there is no theory to explain why the phenomenon manifests. To avoid aberrations being construed as the norm, epistemology across all disciplines relies not just on what we observe in the real world but also on a theory to explain why we observe it. So, in our book, we first develop the theory to show why bank loans cause deposits and not vice-versa, as postulated by the current monetary theory.
To test this theory, we use demonetisation as a "natural experiment." Unlike in the natural sciences, where you can run a controlled experiment, in monetary economics, you cannot control the impact of other variables that can confound the effect that one wants to study. In the short two-month window of demonetization, such confounding influences were minimal. So, it represents a nice "natural experiment" not available anywhere else in the world. Demonetization increased deposits by Rs 8.5 lakh crore but loans decreased by Rs 1 lakh crore, thereby disproving what monetary theory postulates.
Do you think the current crisis and the circumstances provide a unique opportunity to India to shift to a higher growth path?
India is already undergoing this shift to a higher growth path because of the sagacious economic policy implemented in COVID, where we undertook measures to enhance both supply and demand along with structural reforms. Just as turning up the AC thermostat in a room takes a few hours to heat the room, economic outcomes today result from policies implemented 2-3 years back. That's why you see that at a time when the advanced economies are facing the twin whammy of 2.5-4 times their historical inflation and a recession, India is likely to grow at 7% with inflation lower than our historical average of 7%. I don't recall another period where India was such a positive outlier on both counts – growth and inflation.
Finally, you will recall that even when the economy was slowing down pre-Covid, I kept saying in my media interactions as CEA that there was nothing structurally wrong with the Indian economy. I am glad that the prognosis has been proven right. In this decade and beyond, India can lead the global economy.
World economy is facing new challenges as advanced economies slow. What kind of risks could India face and what kind of policy interventions would be required to shield it from those risks?
If we start from the GDP identity Y=C+I+G+(X-M), consumption (C) is mostly domestic, and it accounts for about 60% of GDP (Y). Government spending (G) is a choice variable and will continue to be robust as our fiscal space is comfortable. Net exports (X-M) will get impacted as exports will decrease due to the decrease in global demand while imports will not decline as much as exports. But the overall contribution of net exports to GDP is not very high in the Indian context. Finally, take investment (I). About three-quarters of investment is done by domestic players and only one-quarter by foreign investors. With investors becoming comfortable with the new normal of the Russian-Ukraine war, I see domestic investment picking up significantly. Foreign investment will get impacted but its overall contribution is low again. So, only net exports and foreign investment will impact GDP growth adversely. Together, their contribution would be about 0.75%-1%. Thus, India can continue to grow at about 6.5%-7% despite global uncertainty.
In your new role at the IMF you disagreed with staff analysis under Article IV consultations that India's fiscal space is at risk.
A key pillar of India's COVID economic policy was the counter-cyclical fiscal policy focusing on government capex that creates assets and thereby acts as a growth multiplier. As we had shown in the 2020-21 Economic Survey, the r-g differential, i.e., the difference between the nominal cost of borrowing and nominal GDP growth rate, is negative in India. More negative this differential, the faster the decline in the debt-to-GDP ratio. For instance, this year, 10-yr G-Sec is 7.3% and nominal growth is 15.4%. Going forward, 10-yr G-Sec will be 7% or lower and nominal growth more than 12%. So, the r-g differential will remain strongly negative, thereby driving down our debt-to-GDP ratio. As shown in the Economic Survey, only the primary deficit, which is coming down, and the r-g differential affect the debt-to-GDP ratio. So, India's fiscal space is comfortable.
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