The post-Covid economy needs an intellectual reassessment
The global financial crisis and the current pandemic are likely to reorient our thinking on conventional macroeconomics. As real-world developments force an intellectual reassessment, this also opens up space for political innovation and experimentation. Politics becomes a function of context rather than ideology. It can only be a good thing. For example, there are now serious doubts about the long-held wisdom that the economy works best with an “invisible hand” and that it should not be compromised by government “intervention”. In many countries, including the United States, industrial policy is back on the table.
Perhaps the biggest educational challenge is currently faced by central banks around the world. They have to deal with rising inflation. In fact, since the global financial crisis of 2008, they have valiantly worked to bring it up, and now they are struggling to bring it down. More importantly, there is now a noticeable difference in what drives inflation: It is neither wage increases nor budget expansion. These are global supply shocks.
Within a year, the global energy market has gone from massive glut to massive scarcity. In theory, for central banks, it is easier to lower inflation than to raise it since there is no cap on interest rates.
But, two problems confront them. First, they can’t raise interest rates because they got everyone hooked on low or zero rates. And, second, inflation caused by a supply disruption does not lend itself to monetary treatment. Of course, a slowdown caused by a supply disruption last year did not need the monetary stimulus to fill the demand gap.
It is ironic that over the past decade, due to very minimal investments in commodity exploration due to ESG constraints, supply chains have been significantly unprepared to meet the demand that is now almost equal to that before Covid. As for the much-talked-about semiconductor shortage, there are no closed factories to reopen. Annual inflation is 5.2 percent in the US, 3.2 percent in the UK and 3.3 percent in the EU. Much of these supply-side issues are structural in nature, so it’s fair to assume that high inflation expectations are likely to fuel a global inflation cycle. Independent research by the Federal Reserve Bank of St. Louis has concluded that higher inflation in the United States is a broader, not transient phenomenon. But that is not said.
So what’s new about the explanation for the current pick-up in inflation that standard textbooks don’t say? One of the important tools for understanding the behavior of inflation through standard economics textbooks is the Phillips curve, which assumes that inflation is in part driven by gap variables measuring how much the economic activity deviates from its potential. Gap variables can include the percentage deviation of real GDP from potential GDP, also known as the output gap / domestic slack. Any central bank monetary policy statement, including that of the RBI, always identifies the spread variable as an important determinant of inflation.
In the modern version of the Phillips curve, inflation depends not only on spread variables but also on expected inflation. However, recent research indicates that with a better peg, the expected inflation term in the Phillips curve becomes more stable. Consequently, movements in the level of inflation are influenced less by expected inflation than by the output gap. This is where the missing link lies, with reference to India.
To uncover the drivers of inflation in India, we set out to conduct a similar exercise. Our results indicate that in India the link between the change in inflation and the output gap has never been strong – the gap coefficient was less than plus / minus 0.40, and it decreased over time. over time. Interestingly, the link is completely lost with the emergence of Covid-19.
Thus, the concept of the output gap is largely insufficient to explain the behavior of inflation in India. If the output gap is not the cause, is it inflation expectations? Well, the record of “inflation expectations” to explain current inflation globally, including in India, is not stellar, to say the least.
Perhaps it is possible to hypothesize that inflation in India reflects an economy constrained by supply and business productivity hampered by a license compliance inspection (LIC) system. The good news is, we’re taking care of it. The less good news is that there is still a lot to dismantle and results will take time.
There is another aspect. Developing countries are always judged differently. Take the example of the transfer of dividends from the RBI to the central government. In the United States, public debt held by Federal Reserve banks increased by $ 3 trillion from the end of 2019 to the second quarter of 2021. As a result, the Federal Reserve collects interest on this debt, which it dutifully remits. to the US Treasury. Of course, the privilege for America is excessive while the burden is exorbitant for developing countries if they seek to emulate such a fiscal transfer from the central bank to the government. Unsurprisingly, in India there was an outcry over the recommendations of the Jalan committee on the RBI dividend transfer.
Five decades ago, real-world developments challenged the orthodoxy that prevailed then. What emerged in the end shaped the global economy over the next four decades with more markets, greater financialization, less government, and freer trade, resulting in greater inequality and a burden of higher debt. The stage is set for another decade of unsubscribing. But what emerges at the end is perhaps less intellectually treatable than at the end of the seventies.
This column first appeared in the paper edition on October 23, 2021 under the title “Wisdom after Covid”. Ghosh is the group’s chief economic adviser, State Bank of India, and Nageswaran is a member, EAC-PM. Views are personal