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.
ou 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.
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.
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 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.
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.
