Despite Two Mistakes, Rajan Was Probably Manmohan Singh’s Best Appointment

The world of central bankers is a very strange place.

Alan Greenspan, for all of the bubbles (the dotcom bubble, the housing bubble) he created with his ultra-low interest rates policy, was knighted. Paul Volcker, whose effigies were burnt when he was the US Fed chairperson, was the principal reason behind the sustained economic boom from 1980 to 1998. While subsequent understandings have corrected at least some of the above mistakes in US monetary history vis-a-vis public opinion, in India we continue to suffer from the delusional effects of monetary heroin.

To be sure, the US is yet to witness complete withdrawal symptoms after its “experiments with easy money” through Greenspan, Bernanke, and (now) Yellen. By the time the dollar bubble fully unwinds, the inflationary depression is going to be so bad that US citizens may well root for the return of Paul Volcker, who killed inflation by raising rates significantly.

Much in line with what has happened in the US, we still treat our past Reserve Bank Governors with undeserving respect. YV Reddy was a serial bubble man and was the principal reason behind the mess in the housing and infrastructure sectors today. As I wrote back then in October 2008, India is now paying the price with huge bad loans after the bubbles unleashed by Reddy burst. Those bubbles lay hidden during Reddy’s tenure.

Let’s now turn to the man at the centre today, Raghuram Rajan. He deserves a whole lot of praise for bringing the focus back to inflation (especially by making the consumer prices index central to decisions on rates), forcing banks to recognise bad loans, and so on. The list is long, and I will not expand on the same here as there could be many authors who may do the same. Instead, let me focus on what I think are the two main substantive mistakes that Rajan made during his tenure.

1) He was misguided by the never-in-the-offing US Fed lift-off.

Rajan assumed office under conditions of faltering growth and growing inflationary trends in India. On the international front, developing economies were concerned about a return to normal US interest rates, and Rajan made his plans around the threat of a US dollar exodus from India. But as I have written many times earlier, normalisation of interest rates - or a “lift-off”, as was referred to back then - was never on the cards as far as the US Fed was concerned. Their job was, is, and will be to pretend that every Fed meeting is a “live one” with the possibility of a rate hike while never delivering one.

Wasn’t the 25 basis points (0.25 percent) increase last year part of a lift-off? Not at all. A lift-off, by definition, implies a series of hikes in quick succession to “normal” interest rate levels. In the case of the US, even going by their claims of inflation hovering around 1-1.5 percent, this would imply an interest rate of at least 2-2.5 percent. Not only is the US Fed nowhere close to that, but even today, it is reinvesting the interest income in US treasuries, bloating its balance sheet further. Given the enormous buildup of expectations last year, the 25 bps increase was merely a face-saving measure. Current Fed chairperson Janet Yellen must have been desperately hoping that this meagre increase doesn’t prick the re-inflated housing bubble, the student loan bubble, the auto loan bubble and, most important of all, the underlying US Treasury bubble.

So without a currency crisis, the US Fed will never normalise its monetary policy. In other words, rapid increases in interest rates in the US will not happen under conditions of a strengthening economy but a rapidly deteriorating one.

So Rajan needs to ponder whether all the famed lift-off preparedness with the accumulation of high-interest-bearing dollar deposits was worth it. Sure, Rajan could claim that he never believed in the lift-off himself but was doing so as a precautionary measure, just in case the US Fed did indeed raise interest rates. Possible? Yes. But for a person who speaks his mind freely on topics not even related to monetary policy (it is a welcome change to have an RBI Governor who has the moral and intellectual courage to do that), such self-imposed reticence on monetary policy is quite unlikely. It is more likely that he believed in the normalisation speeches of Bernanke and Yellen.

2) He cut rates too soon and too fast.

The second substantive flaw in Rajan’s monetary stance was in cutting interest rates in India too soon and too fast. Ever since Rajan took over, we have witnessed a slowdown in inflation rates, i.e., from nearly double-digits to around five percent. Of course, I always see inflation as surreptitious taxation by the government so that its effects can be blamed on extraneous factors. So even five percent is bad. That, of course, is a topic for another day.

But now there are early signs that inflation is beginning to rear its ugly head again. Should Rajan have seen this coming and not been adventurous in cutting rates too soon?

Of course, yes. The Wholesale Price Index (WPI) and Consumer Price Index (CPI) are both terribly flawed (the former much more than the latter) measures for measuring inflation, as they are lagging indicators of inflation. The leading indicator is money supply growth, and that has shown no signs of flagging under Rajan. Whatever the “Rajan CPI Dip” was caused by, it’s gone, and we are looking for inflationary days ahead.

But when Rajan said “inflation is inflation” as part of his “day zero” remarks, he was entirely correct. I hope subsequent RBI Governors do not hide behind the smokescreen of a “supply side response” to do what really needs to be done – that is, increase interest rates to bring down money supply growth, which has averaged nearly 13 percent annually during 2012-16, to acceptable levels. Money supply need not grow more than 1-2 percent ahead of real GDP growth rates. Of course, given the political conditions around Rajan’s exit, none of his successors are likely to do that.

Notwithstanding the above two issues, appointing Rajan was one of the few decisions that Manmohan Singh took which actually benefited India. He has done his job with admirable competence and grace.

But the all-important question is: “Was Rajan a Karma Yogi?” No. Far from one. A Karma Yogi would have abolished the institution of RBI and put India on the classical gold standard.