Post-Covid economy needs intellectual re-evaluation

Pandemic has set the stage for a decade of churn. Central banks across the world are facing a great challenge

A Khashi tribal woman carries vegetables in a bamboo basket on her back in Moronga village, Friday, Oct. 8, 2021. (AP Photo/Anupam Nath)

The global financial crisis and the current pandemic are likely to reorient our thinking on conventional macroeconomics. As real world developments force intellectual re-evaluation, it also opens the space for policy innovation and experimentation. Policy becomes a function of context rather than ideology. That can only be a good thing. For example, there are now serious doubts on the long-standing wisdom that the economy functions best with an “invisible hand” and it should not be jeopardised through government “intervention”. In many countries, including in the US, industrial policy is back on the table.

Perhaps the greatest scholastic challenge is currently being faced by central banks across the world. They must deal with rising inflation. In fact, since the global financial crisis of 2008, they have been striving valiantly to push it up, and now they are struggling to bring it down. More importantly, there is now a perceptible difference in what is driving inflation: It is neither wage increases nor fiscal expansion. It is global supply shocks.

Within a span of a year, the global energy market has gone from a massive glut to a massive shortage. In theory, for central banks, bringing inflation down is easier than pushing it up since there is no ceiling on interest rates.

But, two problems confront them. One, they cannot raise interest rates because they have got everyone addicted to low or no rates. And, two, inflation caused by supply disruption is not amenable to monetary treatment. Of course, a slowdown caused by supply disruption last year did not need the monetary stimulus meant for addressing demand shortfall.

It is an irony that in the last decade, due to very minimal investments in commodities exploration due to ESG constraints, supply chains are significantly unprepared to meet the demand which is now almost equal to pre-Covid times. Regarding the much talked about semiconductor shortage, there are no closed plants to reopen. Annual inflation is running at 5.2 per cent in the US, 3.2 per cent in the UK and 3.3 per cent in the EU. These supply side issues are largely structural in nature, hence it’s correct to assume elevated inflation expectations will likely fuel a global inflation cycle. Independent research by the Federal Reserve Bank of St Louis has concluded that higher inflation in the US is a broader, not a transient phenomenon. But that is left unsaid.

So, what is new in explaining the current inflation upswing that the standard textbooks do not say? One of the important tools for understanding inflation behaviour through standard economics textbooks is the Phillips curve, which presumes that inflation is partly driven by gap variables measuring how much economic activity deviates from its potential. Gap variables can include the per cent 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 gap variable as a significant determinant of inflation.

In the modern version of the Phillips curve, inflation depends not only on gap variables but also on expected inflation. However, recent research indicates that with improved anchoring, the expected inflation term in the Phillips curve becomes more stable. Consequently, movements in the level of inflation are driven less by expected inflation and more by the output gap. Herein lies the missing link, with reference to India.

To find out what drives inflation in India, we endeavoured to conduct a similar exercise. Our results indicate that in India the link between inflation change and output gap was never strong — the gap coefficient was under plus/minus 0.40, and it has been declining overtime. Interestingly, the link is completely lost with the emergence of Covid-19.

Thus, the concept of output gap is grossly inadequate to explain the inflation behaviour in India. If the output gap is not the cause, is it inflation expectations? Well, the record of “inflation expectations” in explaining current inflation globally, including in India, is not stellar, to put it mildly.

Perhaps, it is possible to hypothesise that inflation in India reflects an economy that is supply-constrained with productivity of enterprises held back by a license-compliance-inspection (LIC) system. The good news is that it is being addressed. The not-so-good news is that much remains to be dismantled and results will take time.

There is another aspect. Developing countries are always judged differently. Take the example of the dividend transfer from the RBI to the central government. In the US, government debt held by the Federal Reserve banks increased by $3 trillion from the end of 2019 till the second quarter of 2021. As a result, the Federal Reserve earns interest on this debt which it dutifully remits to the US treasury. Of course, the privilege for America is excessive whereas the burden is exorbitant for developing countries if they seek to emulate such a fiscal transfer from the central bank to the government. Not surprisingly, in India, there has been a hue and cry after the Jalan committee recommendations on dividend transfer from the RBI.

Five decades ago, real world developments challenged the then prevailing orthodoxy. What emerged at the end of it shaped the global economy through the next four decades with more markets, greater financialisation, less government and freer trade culminating in wider inequality and higher debt burdens. The stage is set for another decade of churn. But what emerges at the end of it may be less intellectually tractable than at the end of the Seventies.

This column first appeared in the print edition on October 23, 2021 under the title ‘Wisdom after Covid’. Ghosh is group chief economic advisor, State Bank of India, and Nageswaran is member, EAC-PM. Views are personal

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