Opinion The most difficult job

When the eminent economist Raghuram Rajan was in India recently,yours truly asked him: why is the economy taking so long to respond to the stimulus? With his characteristic candour,he admitted that economists simply did not know why! What he does know and has brilliantly catalogued in his new book is that the unintended consequence of a prolonged low interest rate environment is that the financial sector indulges in excessive risk-taking and asset bubbles get created. Last time round,the bubbles were in the US with residential real estate becoming a particularly exuberant one. This time round,Ben Bernanke has taken interest rates virtually down to zero and he has kept them there so long that collectively markets may have forgotten that there is any time value for money at all! The US economy is as anaemic as ever and the unemployment rate is almost in double digits. This never happened in the ’70s and ’80s. Poor Bernanke — does he just have a bad horoscope? He has for sure precipitated another unintended consequence.

The low dollar interest rates are not creating bubbles in the US — but in China,Brazil,India and elsewhere. We clearly have a bubble in Indian real estate and marked over-exuberance in our stock markets. D. Subbarao is trying to figure out how to insulate his fellow Indians from the ominous future consequences of these bubbles. What is worse is that Bernanke keeps worrying about deflation — he is threatening to get even more aggressively easy with the Fed’s monetary policy in order to pre-empt this anticipated deflation. At the same time,Subbarao has to worry about inflation. Low interest rates are driving up prices of foodgrains and similar commodities which have a large weight in the consumption basket of Indians. As these prices rise,we are hurt; our poor are hurt disproportionately. In a democracy,these inflationary pressures just cannot be ignored. But Subbarao’s degrees of freedom are limited. If he raises interest rates to combat inflation in India,more money comes in fleeing the zero interest rates of the US dollar,exacerbating the bubbles in the Indian stock and real estate markets.

A terrible situation with no easy answers. Bernanke cannot afford not to go with an ever-easier monetary policy even though it is taking so long to work. He can take a tiny measure of comfort that US markets are so badly mauled that he is not creating any bubble there. But he sure has the central bankers of Brazil and India worried — worried about both bubbles and inflation in the short term.

In the medium term,there is another worry that all of them share and indeed one that all of us should share. Is it possible that Bernanke’s medicine of endless low interest rates just may not work? What if US unemployment levels do not come down for 10 years? Can the US polity with its own democratic compulsions handle this? In the meantime,what is going to be the fallout of bubbles and commodity inflation in countries like ours? Could we be heading for a catastrophe worse than the ’30s — one whose contours we are unable to chart,a veritable Rumsfeldian “unknown unknown”? The US is divided between those who look for fiscal stimulus through government expenditure (Democrats) and those who look for it through tax cuts (Republicans). But the real spoiler in the world of aggressive fiscal policy is the looming fear that while till now the assumption has held that the US can be fiscally profligate and not pay the price (unlike Greece,Ireland or Britain),will this assumption be valid over the medium term? What if this debt pile-up and deficit build-up becomes the next nightmare? Meanwhile anti-free-traders gain in strength — Ohio wants to ban outsourcing and the US Congress wants China to revalue the yuan. These are outright protectionist measures,similar to the Smoot-Hawley tariffs of the ’30s and they could trigger the Great Depression we are trying to avoid.

As we lurch from one question to another,one thing is clear — economists do not understand business cycles and looking to them for so-called policy prescriptions to control or reduce the amplitudes of the swings simply leads us from one problem to another. The recipes of the past do not work now — a tragic reconfirmation of the Rational Expectations hypothesis. As an optimist and a believer in astrology,I,for one,am betting that Obama has a good horoscope and so irrespective of what he or Bernanke or others do or do not do,by 2012,this wretched business cycle will end. US unemployment will be down and Obama will be re-elected!

The writer divides his time between Mumbai,Lonavala and Bangalore jerry.rao@expressindia.com