Collateral damage ahead

A study by RBI in 2002 had estimated how much growth may need to be sacrificed to curb inflation

Investors here, there and everywhere have been busy counting their stock market losses these days. Naturally, they have been too distracted to notice another growing threat to their finances—inflation.

The rate at which prices are climbing is worrisome. Higher inflation means your money buys you less stuff than before. The official inflation rate has already broken through the Reserve Bank of India’s (RBI) comfort barrier of 5%. And economists have been busy reworking their inflation forecasts these days.

It’s now clear that the central bank had made the right call in its January policy statement, when it decided not to cut interest rates because of the growing inflationary threat. Mint has generally supported RBI’s nuanced management of capital flows and its decision to consider inflation as a major threat at this juncture.

Any central bank has to fire away at the inflation problem, because rapidly rising prices and high inflation expectations generally distort economic decisions and harm long-term growth. Disinflation is good for sustained growth, as we have seen across the world since the mid-1980s.

There will always be debate about how much of the drop in trend inflation and the jump in global growth over these past two decades was because of central banks, and how much because of technology, productivity and the entry of two billion low-wage Indians and Chinese into the world economy. However, there is little reason to doubt that central banks did have a role of play in getting down inflation all the way down to almost zero. But that’s history. Inflation is on the upswing again. It has touched a 14-year high in Europe, for example.

A central bank that increases interest rates to fight inflation inflicts inevitable collateral damage to economic growth in the near term. What could the extent of the damage be? And to what extent is a society ready to give up growth today to protect growth tomorrow?

Many economists have calculated the output losses a country will have to suffer in its battle with inflation. This is the sacrifice ratio. It broadly measures the loss of output that an economy has to deal with for every percentage point drop in the inflation rate because of central bank policies. But most of these studies have been focused on the record in the developed countries.

RBI had calculated India’s sacrifice ratio in the 2002 edition of its annual Report on Currency and Finance. It estimated that India will have to sacrifice 2 percentage points of economic growth for every 1 point drop in the inflation rate. This study was briefly commented upon and then forgotten. It was done at a time when inflation was low and many economists believed that the world was heading for a bout of deflation, or falling prices. High inflation was the last thing on their minds.

What seemed an academic exercise then could become an important policy guide now. RBI will have to take a call on whether it should wait and watch, or move fast to douse inflation right away. And it will need political support for this. In an election year, politicians will have to ask themselves what would be a bigger vote loser— higher inflation or lower growth? The current signs are that they believe higher prices in the bazaars are the bigger worry.

In a paper he wrote in 1993, Princeton economist Laurence Ball studied 65 episodes of disinflation in developed countries and examined how much output was lost each time a central bank fought to bring down inflation. He noted that the sacrifice ratio was lower when the speed of disinflation was higher. Benign neglect is a dangerous course of action. Or, as he evocatively described it, “Cold turkey is less costly than gradualism.”

There have been several other studies that chart out how the sacrifice ratio changes, depending on how open an economy is, how independent its central bank is and how flexible its labour markets are. “The size of the sacrifice ratio has been regarded as a guidepost in determining the speed of disinflation to be engineered by monetary policy action. The potential costs include lost output, higher unemployment, and related social ills… The sacrifice ratio becomes relevant not merely in assessing policy effectiveness in a one-time transition from high inflation to low inflation, but also in the context of the ongoing policy rule,” said Muneesh Kapur and Michael Patra of RBI in a 2003 paper.

Inflation is right now just a few basis points above what RBI says it is comfortable with. The research on the sacrifice ratio suggests that India may have to give up around a couple of percentage points of growth if inflation is to be brought down by a percentage point. That’s more than one standard deviation of the growth over 18 quarters since 2003-04.

It may be time to rework those uber optimistic growth forecasts as well.

One crisis, many reasons

A crisis in the real economy usually leads to deregulation. A crisis in the financial sector usually leads to increased regulation. It may be no different this time around

The wide-eyed admiration for financial innovation has been quickly replaced by sweeping doubts about the entire gamut of products that have been rolled out by financial engineers. Is this wave of scepticism strong enough to sink the ship of financial sector reform?

Don’t bet against the possibility. I had earlier pointed out in this column to an interesting policy paradox. A crisis in the real economy usually leads to deregulation. A crisis in the financial sector usually leads to increased regulation. It may be no different this time around.

The credit crunch in the West keeps getting worse, and it will be just a matter of time before pressure to impose new regulations on the financial industry builds up to an extent that governments are forced to act. There is already a perceptible change in the attitude of commentators, with financial innovation now more condemned than celebrated. From here, it is a mere hop, skip and jump to the hasty conclusion that an economy is better off without a relatively free financial system.

The jury is still out on what exactly this financial crisis is all about—and what regulatory lessons can be drawn from it. There are several ways to analytically slice and dice the credit crisis that has stalked the developed economies since the middle of 2007. Here, I focus on three popular theories on why the unstable edifice that is now close to tumbling down came to be built in the first place:

1) Blame it on the central bank. The monetary masters at the US Federal Reserve and the Bank of Japan held the price of money down to unrealistic levels, making it easy for the financial industry to borrow and invest. Low interest rates were also the reason why people went on a home buying spree in the US, sometimes to live in those homes and sometimes to flip them for a profit. In short, central banks inflated asset bubbles—especially in real estate and equities—that are now deflating.

2) The financial industry is too clever by half. It is always finding ways of convincing the world that one and one is three. Economist John Kenneth Galbraith put it in a typically succinct manner. He wrote in his book A Short History of Financial Euphoria that financial innovation through the ages is merely the quest for new ways to create more debt that is leveraged against limited assets. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version,” he wrote. The same trick gets played over and over again under a new guise.

3) Modern finance is inherently fragile. The prophecies of economist Hyman Minsky have found an enthusiastic audience in our times. He said that markets and economies inevitably go through a boom and bust cycle. Financial instability is endogenous to a modern market economy. Firms go through three styles of financing through this business cycle—hedge finance, speculative finance and ponzi finance. The last is the most dangerous. At the end of the cycle, there is a financial crisis and the economy goes back to less risky ways. And then the house of cards starts getting built all over again.

There are obvious overlaps between these three theories, but there are many unique elements as well. It is disconcerting to see these three theories carelessly criss-crossing each other in many recent analyses of the credit crunch, with comments on asset bubbles, the dodgy ways of the finance industry and the inherent instability of financial capitalism being used more or less interchangeably.

The policy lessons could be quite different in each case. If the problem is low interest rates and asset bubbles, then central banks will have to ensure that market interest rates do not fall below some undefined natural rate of interest that helps the economy achieve equilibrium. In case the problem is the tendency of investment banks to pile toxic debt, then the challenge is to regulate the incentives within the industry (bonuses, for example) that push risky behaviour. And if we buy the Minsky argument that financial instability is inherent in a modern market economy, then the financial industry is better off in tight regulatory chains at all times.

There is enough research to show that financial crises have become more common over the past few decades. One reason is undoubtedly the financial deregulation that took place after the mid-1980s. But then there are also cases such as Japan, where very conservative financial methods did not prevent a meltdown that condemned the world’s second largest economy to more than a decade of stagnation. So, financial repression has created its own crises.

In short, there is too much ambiguity right now. While there is enough reason to be wary of some of the more fancy bits of financial innovation, policymakers and regulators should also take care not to chuck the baby out with the bathwater.

Harvard on the Yangste

China is a centre for low-cost education

A doctor friend of mine tells me that the number of Indian medical students in China is growing rapidly. It is far cheaper to study medicine and surgery in places such as the Tianjin Medical University than it is to pay the high fees and capitation charges in a private medical college in India. According to a recent report by the Indo-Asian News Service, “The average tuition fee in a Chinese medical university is $2,000-3,000. Another $1,000 is needed for board and lodging. This is a fourth of what one would spend in India.”

There are already an estimated 6,000 young Indians attending college and university in China. China is a centre for low-cost education. It wants to break out and become a hub for quality education, battling the likes of Harvard and Oxford for the brightest and the best. That’s a transition — from cost to quality — which is also being attempted in many other parts of its economy.

So, a few days after the Indian government announced its decision to set up six new Indian Institutes of Management (IIMs) and four new Indian Institutes of Technology (IITs), it would be worth looking at what China is up to in its own battle to increase skill levels in the economy. And see how India compares.

The Chinese government has often said that it wants five of its universities to make it into the global top 20 list by 2020. It is investing heavily to create these world-class universities. Much of the spending is on elite universities. Peking and Tsinghua universities each received 1.8 billion renminbi — or more than Rs1,000 crore at current exchange rates — way back in 1998. The top 11 universities got more than 17.43 billion renminbi (close to Rs10,000 crore) from the government in 2004. And the money keeps flowing.

Meanwhile, the number of graduates in China has quadrupled between 1998 and 2005 as more young men and women get opportunities to attend university. A survey conducted by the Chinese Academy of Social Sciences shows that spending on education is now the biggest item in household budgets, more than even regular household expenditure. Rural households spent about one-third of their net per capita incomes on education in 2003, double the proportion in 1996.

These are some of the factoids from a new paper, The Higher Educational Transformation of China and Its Global Implications, by Yao Li, John Whalley, Shunming Zang and Xiliang Zao.

But it’s not just a question of spending money — a fact that our policymakers should perhaps learn. China is trying to do a lot more. While focusing on the elite universities, China has been busy consolidating its smaller universities into larger entities. Professors do not have tenured jobs for life. They have to perform. “It is not uncommon for an annual target of three international publications to be set for faculty member,” say the four economists in their paper. Those who do not meet this target are sacked. The results are evident, in terms of more patents and research publications.

China’s push towards building a world-class system of higher education is part of a larger plan. Economies grow out of poverty by employing more capital and labour. Later, productivity and innovation become more important. At some point, economies have to make an inevitable transition — from selling cheap labour-intensive stuff such as clothes and toys to creating new products that are rich in technology and knowledge.

The move from one stage to the other can often be painful, as many Asian companies and economies realized after the mid-1990s. The way the Samsung Group almost went bust and then reinvented itself in the past 10 years is one micro example. China is also retooling, but on a grander scale. That’s the jigsaw into which the higher education piece fits.

There will be obstacles, of course. Authoritarian and regimented societies are rarely innovative. A country that censors the Internet cannot easily become a knowledge society. Then, a sharp focus on elite universities could lead to a growing skills gap and add to China’s already unsettling levels of inequality.

How does India compare? Not too well, either in terms of the money being spent or the attempts at internal university reform. But India has been something of an Asian pioneer in setting up quality centres of research and higher education, much before the economy actually needed good engineers and technocrats. This was during the Jawaharlal Nehru era. The space programme, the atomic research programme and the stunning success in software services came much later.

So, it is not just a matter of emulating China. It is also about reinstating one of the more successful parts of the Nehruvian programme. Setting up a few more IITs and IIMs can be a first step—but far more needs to be done. That is something China seems to have understood.