A Response to RBI Governor Raghuram Rajan's Question
Recently while appearing at Frankfurt’s Goethe University to accept the Deutsche Bank prize in financial economics, RBI's new governor Raghuram Rajan asked an important question to the monetary authorities around the world. He questioned the merit of the unconventional monetary policy of ultra low interest rates to spur economic growth. Rajan said: We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don't know. He also said:
Now, Dr. Rajan doesn't know the answer of his question, that whether low interest rate policy is a solution or in fact part of the problem, but the answer of his question is very much available. He only needs to look at that answer, understand it and put it in practice. The Austrian School of Economics has the answer of Dr. Rajan's question. Dr. Rajan is hailed by the mainstream media as someone who predicted the on-going financial crisis, but Austrian Economists were, before Dr. Rajan, warning about the impending financial and economic crisis of 2007, and for right reasons. (see here for evidences). The Austrian Business Cycle theory (ABCT) provides the answer of Dr. Rajan's question. And the answer is, not only the low interest rate policy is part of the problem, but it is THE root cause of all the economic problems being faced by the Indian and world economy at present. I discuss ABCT in very brief below. For a detailed analysis please refer to, (Hayek, 1967; Mises, 2009; Rothbard, 2000; Soto, 2006).
First, we have to understand that the market rate of interest is not just one monetary variable which RBI governor can arbitrarily determine at his own whims. Interest rate is one of the most important price phenomena. It is a price of time. It is determined by the societal time preference - the ratio of consumption to saving - at a given point of time. It guides entrepreneurs in determining whether they should allocate more resources in producing present consumption goods i.e., consumer goods sector or in future consumption goods i.e., in capital goods sector (for more see, Herbener, 2011). The money interest rate is determined by the market forces of demand for loanable funds and supply of those funds. This demand and supply in turn are determined by consumption and saving preferences - satisfaction in present or future - of societal members i.e., societal time preference rate. Any interference by the monetary authority, i.e., the central bank, in this market process will create distortions in the consumption and production goods industries e.g., if the central bankers keep the market interest rate lower - by creating artificial credit via money printing - than its natural level as determined by societal time preference rate, then, it will generate a boom mostly in the capital goods industry. This boom will be unsustainable because it is not backed by genuine real savings. It is a product of central bank's cheap phony credit. As the boom progresses, it generates price inflation. Because consumer goods production is taking place slowly due to more resource allocation in the capital goods industry, increased income and demand for consumer goods by workers will lift prices. This price inflation will accelerate as the central bank pumps more money to keep the artificial boom going. When the price inflation goes out of hand and becomes unbearable for people and government, central bankers will have to stop their money spigot. Central bank will start raising the money interest rates to arrest the rising prices, and the moment they will start raising interest rates, it will bust the prior artificial boom; economy enters recession. Recession starts to liquidate prior malinvestments. As it liquidates the malinvestments, formerly employed people in the capital goods industry will lose their jobs temporarily when the economy is adjusting. We have to understand, that recession is the cure of prior artificial boom, and not a problem as mainstream economists tell us. If there is no further intervention by the monetary authorities, then, recession will end soon and the economy will resume its normal path of progress again.
So, as we have seen above, low interest rate policy is the root cause which generates inflation, boom-bust cycles, unemployment etc. Dr. Rajan's skepticism about the low interest rate policy is certainly valid. But only skepticism is not enough. Dr. Rajan must digest the teachings of the Austrian School and act accordingly. His diagnosis of the bubble activities is right, but he must see the root cause of those bubble activities in RBI, the institution which he is heading right now!
His assertion that fiscal policy, may be, can better spur economic growth is also wrong. Neither monetary policy nor fiscal policy can spur economic growth. Economic growth comes from real savings and investment neither of which can be stimulated by monetary or fiscal policy. In fact, both monetary and fiscal policy adversely affect savings and investment. Both of them lower economic growth! Only real free market capitalist system can ensure economic progress. Any interference with free market will create troubles.
In the end I will request Dr. Rajan to leave the free market alone and stop his monetary policy juggling with the interest rate. Dismantle RBI, Dr. Rajan, and then you resign. And if you can't do that, then, at least don't lower the interest rates further. And please don't print even one paisa of new currency as long as you are the governor.
"We seem to be in a situation where we are doomed to inflate bubbles elsewhere"Before I go onto discuss this whole matter, I must, at least, congratulate Dr. Rajan for asking this important fundamental question. Compared to Rajan, other central bankers are not even bothering to entertain this question of efficacy of their lunatic monetary policies. Notwithstanding his questioning of low interest rate policy, RBI governor remains ignorant and confused about the whole matter as reflected in his short answer: I say I don't know! His ignorance and confusion coupled with fault lines in his economic reasoning are dangerous for the health of the Indian economy. If he is not sure about the role of monetary policy in spurring economic growth, then, he should immediately resign from his governor's post. To design monetary policy in the state of ignorance is fatal; fatal not for him, but for common man who will face the full force of these wrongheaded policies.
"In general, central bank stimulus risks letting governments off the hook...warning against central bankers seeing themselves as the ones who can solve all economic problems"
"We need to think of the dangers of over stimulation. We need to think of the sustainability of growth created by stimulus measures"
"It (interest rate tool) is very, very blunt ... targeted fiscal policy may be better"
Now, Dr. Rajan doesn't know the answer of his question, that whether low interest rate policy is a solution or in fact part of the problem, but the answer of his question is very much available. He only needs to look at that answer, understand it and put it in practice. The Austrian School of Economics has the answer of Dr. Rajan's question. Dr. Rajan is hailed by the mainstream media as someone who predicted the on-going financial crisis, but Austrian Economists were, before Dr. Rajan, warning about the impending financial and economic crisis of 2007, and for right reasons. (see here for evidences). The Austrian Business Cycle theory (ABCT) provides the answer of Dr. Rajan's question. And the answer is, not only the low interest rate policy is part of the problem, but it is THE root cause of all the economic problems being faced by the Indian and world economy at present. I discuss ABCT in very brief below. For a detailed analysis please refer to, (Hayek, 1967; Mises, 2009; Rothbard, 2000; Soto, 2006).
First, we have to understand that the market rate of interest is not just one monetary variable which RBI governor can arbitrarily determine at his own whims. Interest rate is one of the most important price phenomena. It is a price of time. It is determined by the societal time preference - the ratio of consumption to saving - at a given point of time. It guides entrepreneurs in determining whether they should allocate more resources in producing present consumption goods i.e., consumer goods sector or in future consumption goods i.e., in capital goods sector (for more see, Herbener, 2011). The money interest rate is determined by the market forces of demand for loanable funds and supply of those funds. This demand and supply in turn are determined by consumption and saving preferences - satisfaction in present or future - of societal members i.e., societal time preference rate. Any interference by the monetary authority, i.e., the central bank, in this market process will create distortions in the consumption and production goods industries e.g., if the central bankers keep the market interest rate lower - by creating artificial credit via money printing - than its natural level as determined by societal time preference rate, then, it will generate a boom mostly in the capital goods industry. This boom will be unsustainable because it is not backed by genuine real savings. It is a product of central bank's cheap phony credit. As the boom progresses, it generates price inflation. Because consumer goods production is taking place slowly due to more resource allocation in the capital goods industry, increased income and demand for consumer goods by workers will lift prices. This price inflation will accelerate as the central bank pumps more money to keep the artificial boom going. When the price inflation goes out of hand and becomes unbearable for people and government, central bankers will have to stop their money spigot. Central bank will start raising the money interest rates to arrest the rising prices, and the moment they will start raising interest rates, it will bust the prior artificial boom; economy enters recession. Recession starts to liquidate prior malinvestments. As it liquidates the malinvestments, formerly employed people in the capital goods industry will lose their jobs temporarily when the economy is adjusting. We have to understand, that recession is the cure of prior artificial boom, and not a problem as mainstream economists tell us. If there is no further intervention by the monetary authorities, then, recession will end soon and the economy will resume its normal path of progress again.
So, as we have seen above, low interest rate policy is the root cause which generates inflation, boom-bust cycles, unemployment etc. Dr. Rajan's skepticism about the low interest rate policy is certainly valid. But only skepticism is not enough. Dr. Rajan must digest the teachings of the Austrian School and act accordingly. His diagnosis of the bubble activities is right, but he must see the root cause of those bubble activities in RBI, the institution which he is heading right now!
His assertion that fiscal policy, may be, can better spur economic growth is also wrong. Neither monetary policy nor fiscal policy can spur economic growth. Economic growth comes from real savings and investment neither of which can be stimulated by monetary or fiscal policy. In fact, both monetary and fiscal policy adversely affect savings and investment. Both of them lower economic growth! Only real free market capitalist system can ensure economic progress. Any interference with free market will create troubles.
In the end I will request Dr. Rajan to leave the free market alone and stop his monetary policy juggling with the interest rate. Dismantle RBI, Dr. Rajan, and then you resign. And if you can't do that, then, at least don't lower the interest rates further. And please don't print even one paisa of new currency as long as you are the governor.
Interesting analysis but there's another flip side to this Rajan effect as well. Do have a look at it http://greatgameindia.wordpress.com/2013/09/08/raghuram-rajan-and-other-piped-pipers-of-the-new-world-order/
ReplyDelete