Category: Uncategorized

The following blog post is now available at Griffith Asia Institute.

The Indian economy might experience a sharp growth slowdown next year. This has to be attributed to a dramatic decision, announced personally by the Indian Prime Minister Narendra Modi, to scrap Rs 500 and Rs 1000 notes. Thus, on 8 November, at the stroke of midnight – to evoke a Nehruvian expression – these notes ceased to be legal tender. The government gave its citizens until the end of the year to exchange these notes for new ones at post offices and banks, but the extant notes were instantly rendered worthless because they were no longer legal tender beyond 8 November. The primary goals were manifold and laudable: to strike a blow against counterfeit currencies which typically targeted these notes, to come down hard on all those who held their ill-gotten, tax-avoided wealth in ‘black money’, to act as a deterrence against terrorists and criminal organisations who apparently relied heavily on these banned notes.

While the cheerleaders of the government celebrated this bold action and ‘surgical strike’ against real and perceived challenges that were allegedly endemic to the Indian economy, the ‘shock and awe strategy’ unleashed chaos as millions desperately lined up at post offices, bank branches and ATMs to exchange the banned notes for new ones. The scrapped notes, after all, accounted for 86 per cent of currency in circulation and 51 per cent of the money supply. The postal and banking system was simply unable to cope with this unprecedented ‘policy surprise’.  It might take several weeks – or even months – before the cash crunch is eased. Meanwhile, demonetisation has inflicted a great deal of hardship on the poor and the vulnerable and those of modest means. Scores of deaths have reportedly occurred. Hence, some Indians have paid the ultimate price for a policy experiment whose long-term goals may or may not be met.

The rather adverse consequences of such a major monetary shock is understandable. India is still a cash-intensive economy and its very large informal economy or unorganised sector as well as other activities, such as real estate, agriculture, the hosting of weddings are heavily dependent on cash transactions.

India’s dramatic demonetisation has attracted world-wide attention and has become the object of robust critique by many Indian and non-Indian economists. It has attracted scathing editorials in such august publications as the New York Times and the Guardian. Kaushik Basu, former World Bank Chief economist, questioned the wisdom of such a move, arguing that the costs will outweigh the benefits. Others – such as Larry Summers – were alarmed by the ‘most sweeping change in currency policy in the world in decades’. Even those – such as Kenneth Rogoff – who support the government’s long-term goals are clearly concerned about the unfolding short run costs.

Provisional estimates on the impact of  demonetisation  on GDP range from modest to major. HSBC has released estimates which suggest growth to be as much as 1 per cent lower in 2017 than the current 7 per growth rate. N.R. Bhanumurthy from the respected National Institute of Public Finance and Policy suggest similar numbers. The Ministry of Finance reportedly has a forecast of 5.5 per cent growth rate in the final quarter of 2016.

Perhaps the most pessimistic scenario is offered by Ambit Capital which has warned of growth grinding to a halt by the second half of 2017 and for growth in 2018 to be no more than 5.8 per cent. Ambit Capital points out to a permanent decline in the size of the informal economy by about 20 percentage points within the space of a year! Given the fact that the informal economy accounts for 79 per cent of employment in India, this is a staggering case of enforced structural change that will destroy the livelihood of millions unless they can find alternative sources of employment in the formal sector.

The following blog post is also available at the Griffith Asia Institute.

When Donald Trump secured a stunning victory in the US Presidential elections, Prime Minister Modi of India promptly ‘tweeted’ him congratulations and hoped that India-US relations would scale new heights. Trump himself has spoken warmly about India, most notably at an event hosted by the Republican Hindu Coalition just prior to the US Presidential elections.

One can thus expect a close relationship between the Trump and the Modi government.  Yet, the anticipated economic benefits flowing to India from such a relationship are not obvious.

India might become a victim of a global growth slowdown if Trump’s protectionist policies are fully enacted. In terms of specific sectors, the Indian pharmaceutical and IT companies are likely to be adversely affected. The former gained considerably from ‘Obamacare’ (or The Patient Protection and Affordable Care Act) as it enabled Indian pharmaceutical companies to establish themselves as competitive suppliers of generic drugs. Trump seeks to repeal Obamacare.

The Indian IT sector has gained a great deal from the outsourcing strategies of US companies. This might change as Trump has often noted that he wishes to bring back jobs home by finding ways of curtailing outsourcing. More generally, Trump’s anti-immigration stance might have a negative impact on skilled migration from India.

Paul Romer, progenitor of endogenous growth theory, caustic contrarian castigating fellow economists for succumbing to ‘mathiness’ and leading modern macroeconomics astray, commenced his role as Chief Economist of the World Bank last month.

Romer has a ‘big idea’ on development that he has been advocating for some time now from his academic perch at New York University. Welcome to the world of ‘charter cities’ that, if properly scaled up, could become an incubator of growth and innovation and transform the lives of millions in poor countries. What is needed is an uninhabited piece of land in poor countries (apparently the African continent has lots of it) – or at least sparsely inhabited land. On this template of terra nullis, one can build self-governing cities with ideas, rules and resources imported from the best of the West. Millions of people will vote with their feet and become residents of these model cities and  climb out of the deep hole of poverty. Governments in poor countries will learn from these model cities and thus try to extricate themselves from bad ideas, bad rules and poor governance that hold back development. Think of Hong Kong and Shenzhen. Let hundreds of such replicas sprout across the developing world.

Romer’s unconventional thinking has annoyed critics who rebuke him for peddling ‘neo-colonial’ ideas. Yet, his overall framework that one must have a paradigm for dealing with the challenge of urbanization in the developing world – either by focusing on existing cities or building new ones – has merit. He probably oversold his vision by suggesting the notion of charter cities in the developing world run by well-meaning and enlightened foreigners. More importantly, for someone who cares so much about empirical evidence, it is necessary to go beyond the examples of Hong Kong and Shenzhen. In any case, China did not outsource the running of Shenzhen to Canada.

Are governments in poor countries convinced by Romer’s dreams? The evidence is not promising. In 2008, the government of Madagascar was prepared to set up two charter cities along Romerian lines. Alas, the political patron of the charter cities lost office in a coup.

Honduras appeared more promising. Romer himself was deeply involved, but stepped out of the project after he recognised, perhaps belatedly, that he was consorting with unsavoury characters. The Honduras charter cities project continues despite being ruled unconstitutional by an overwhelming majority of Supreme Court judges in 2012. The current government stage-managed to reverse the 2012 ruling but the charter cities project in Honduras has been marred by the indelible stain of illegitimacy. Hence, neither Madagascar nor Honduras can be regarded as inspiring examples. By the way, charter cities can malfunction even in rich countries.

The media cheerleaders of charter cities are undeterred. The Economist, for example, is hopeful that Romer’s ‘…new platform at the World Bank will presumably give the (charter cities) idea a boost’. One hopes that Paul Romer will dedicate his undoubted brilliance and intellectual energy to many other mundane issues that are part of the development agenda rather than his pet project of charter cities. His interview with the Wall Street Journal suggests that he has moved on. He would now like to focus on higher education in developing countries, improving the resilience of financial systems and enhancing financial inclusion.

The IMF, in its October 2016 World Economic Outlook (WEO), has documented the spread and scope of global disinflation since the global recession of 2008-2009. As it notes:

By 2015, inflation rates in more than 85 percent of a broad sample of more than 120 economies were below long-term expectations, and about 20 percent were in deflation—that is, facing a fall in the aggregate price level for goods and services.

The Fund attributes this to a combination of economic slack and soft commodity prices.

Global disinflation has important implications for the inflation targeting framework (ITF) that has dominated the design and conduct of monetary policy in recent decades, at least in the advanced economies. It appears that ITF was good in taming inflation, but has so far proven to be insufficiently effective in dealing with disinflation. Yet, central bankers in the systemically important nations of the world have not given up on ITF, continuing to persist with so-called quantitative easing and forward guidance. Leading economists worry that monetary policy has run out of ammunition to deal with global disinflation despite even negative interest rate policy in the case of some countries. Larry Summers fears that there is an

Overwhelming likelihood that there will be downturns in the industrial world sometime in the next several years. Nowhere is there room to cut rates by anything like the normal 400 basis points in response to potential recession. This is the primary monetary and indeed macroeconomic policy challenge of our generation.

Yet, central bankers – or at least the most influential ones – are wedded to a framework that was the product of a specific historical period and designed to tame high inflation. One wonders whether they are like generals fighting the proverbial last war.

In 1990, the central bank of New Zealand became the first country in the world to adopt an inflation targeting (IT) regime. Two years later, the founding members of the Eurozone adopted the Maastricht Treaty that included an inflation target along with fiscal rules. Other countries – such as Australia, Canada, UK and Sweden – became IT regimes between 1991 and 1993.  Low and middle-income countries followed with a significant lag, usually about 10 years.  By 2014, the IMF calculates that there were 34 IT regimes in the world in addition to all the countries that belong to the Eurozone and fall under the European Central Bank (ECB) which practices inflation targeting. The spread of IT regimes to the developing world has been rather limited . There are only 19 out of more than 90 middle-income economies and only one out of 31 low-income that can be classified as IT regimes – even on a de facto basis.

Monetary policy in the advanced economies has emerged as the preferred tool of short-run economic stabilization, while fiscal policy has primarily been assigned to deal with debts and deficits. This is a paradigm shift from the golden age of Keynesian economics when both monetary and fiscal policy shared the responsibility of short-run economic stabilization in the pursuit of the twin goals of price stability and full employment. It was also the period in which discretion rather than rules governed the conduct of macroeconomic policy. This has evolved into a distinct preference for rules and targets rather than discretion – or at least discretion constrained by the need to observe rules and targets.

In the case of low and middle-income countries, the spread and scope of IT has been rather limited despite the formidable intellectual and political influence of both academics and practitioners preaching the virtues of IT regimes. This is not necessarily an undesirable outcome. The institutional prerequisites for the successful conduct of an IT regime are not always in place in the developing world – such as the effective transmission of monetary policy, especially in low-income countries. More importantly, following the global recession of 2008-2009, IT regimes in developed countries have faltered significantly in terms of their effectiveness. Furthermore, an ideological allegiance to a particular framework in which monetary policy is given primacy over fiscal policy has constrained the capacity of macroeconomic policy managers in the advanced economies to use fiscal initiatives to kick-start growth in the wake of the global recession of 2008-2009. This in turn has prolonged the period of slow growth in the developed world. Such lacklustre growth in the rich nations has acted as a drag on global growth.

There are thus important lessons that low and middle-income economies can learn from the experience of IT regimes in the developed world. What one learns in particular is that the objective of low inflation needs to be combined with other development objectives. If IT regimes constrain, rather than empower, central banks in low and middle-income economies to pursue growth and employment objectives that are at the core of the development process, then there is a case for re-thinking the appropriate role of central banks without sacrificing their obligations with respect to price stability.