Ever since Raghuram Rajan announced this Saturday that he would return to academia once his tenure as RBI governor expires in September, the media has been going, to use the scientific term, crazy.
“Why Rajan should stay”; “Why Rajan should go”; “Who will succeed Raghuram Rajan?”; someone even coined the cringe worthy term “Rexit” for the event. And in doing so, people forgot one very important thing. That we are focusing too much on the person, and too little on the system.
Sure, we should praise Dr Rajan for all his good work, and criticise him wherever he has gone wrong. But it is imperative that we understand the need for a robust system, an institution which is beyond politics. Most RBI governors have not been independent of political influence, and Raghuram Rajan is an odd man out. The RBI needs to be autonomous so that sound economic policy does not take a back seat in the face of populist pressures.
So, what do we need to ensure the autonomy of the RBI? The answer may lie in rule based policy making. This simply means that humans should have very little discretion in setting interest rates and the money supply, which should instead be based upon a rule; an ironclad mathematical equation that does not answer to any politician. This idea was first put forth many years ago by the Nobel Prize winning economist, Milton Friedman.
So how does it work exactly?
The idea is that we first set a mandate for the RBI. Should it worry only about inflation? Or should it worry about growth and job creation as well? Step two: once the mandate is set, we try to figure out how the money supply (controlled by RBI) and interest rates (partly controlled by the RBI) affect inflation, growth, job creation and anything else that might be part of the mandate.
For example, if the mandate is simply to prevent inflation, we can simply increase the money supply at a rate equal to the real GDP growth rate. If the quantity of money rises at the same rate as the quantity of goods and services, there can be no general price rise.
If the mandate includes focusing on growth as well, we can use the Taylor Rule, where we decide how much inflation we are willing to tolerate in order to stimulate growth.
Step three, we make a mathematical model (equation) out of our chosen rule. Then a government official can simply enter the desired level of inflation and growth into a computer, which will calculate and tell us what the money supply and interest rate should be to achieve that.
Sounds great! What are the hurdles to achieving this?
There are two main obstacles in the path to rule based policy making.
Data deficiency: Although the mathematical equations are made purely by using theories, those theories need to be tested against real world observations. This is done by gathering loads of data and running statistical tests on the equations to test their validity. Unfortunately, we do not have the ability to gather reliable data in large enough quantities.
A greater part of our economy is in the informal sector, from which little data gets collected, and even then with dubious reliability. The government can help in this regard by helping firms and workers transition from the informal to the formal sector where data is collected in a standardised manner.
Model building and transitioning: Even with the best economists and statisticians in India, it is doubtful that the RBI will get it’s mathematical model right on the first try. Any good policy is arrived at via trial and error. Thus in the initial phase there would be frequent, mostly small, changes to the model to reflect new insights into the workings of the economy. This might negatively affect price stability
But once the right model is discovered, our efforts will be rewarded with much needed price stability. We can enjoy the best of both worlds by way of little inflation and a high rate of economic growth.
What we can hope for
If rule based policy making is implemented, it will mean far less discretion in policy making either by politicians or the RBI governor. It will also mean policy continuity, as the government cannot easily change the rule once made, only the growth and inflation targets can be modified.
There have been concerns that another Pahlaj Nihalani, or Chetan Chauhan might be appointed RBI governor by Modi sarkar. If rule based policies become a reality, then investors, and economists like myself, can rest easy regardless of whether the government decides to appoint Dr Urjit Patel, or chooses Meghna Patel as RBI governor instead.