Subject: Economics

This article discusses the three principles which could form the basis for recreation of the economy devastated by the Covid-19. The first is adopting the economies of “scope” instead of economies of scale. The second is about governance and focus on bottom-up approach. And third is about empowering the people.

Impact of Covid-19 on the ideology of globalisation

• The history of the globalisation has turned out to be very brief.
• In 2020, the global COVID-19 pandemic has forced millions of Indians to return to their villages.
• Jetsetters have been locked in their gated communities.
• Global supply chains have been broken apart.
• People are scrambling for essentials from local suppliers.
• The ideology of globalisation has hit realities on the ground.

Recovery from COVID-19 is an opportunity to create economies that are more resilient and fair. The following three architectural principles must apply.

1. Replace economies of scale by the economies of scope

• COVID-19 has settled, for now, the debate between free-trade evangelists and advocates of industrial policy.
• The vulnerability of global supply chains: A complex global economy in which local producers obtain scale (and lower costs) by supplying products for global markets is vulnerable to shutdowns anywhere.
• The resilience of local economies: Local economies that have a variety of capabilities within them, albeit on smaller scales, are more resilient.
• Therefore, local economic webs must be strengthened, in preference to global supply-chains.
• “Make in India,” which was dismissed by free traders as a reversion to pre-1991 economic policies, has become a necessity.
• Make in India is necessary to maintain supplies of essentials and to create employment for the hundreds of millions of Indians with fragile incomes who have been badly shaken by the lock-down of the Indian economy.

2. Local systems solution to global problems

• Local systems solutions are essential for global systemic problems.
• Privatisation: Garrett Hardin had coined the expression, “The Tragedy of the Commons”, in 1968.
• The Tragedy of the Commons is a term for the proposition that a resource that belongs to everybody will not be cared for by anybody.
• This supported policies to privatise public property, ostensibly for the benefit of everybody and became the dominant school of economics from the 1970s onwards.
• A different explanation: Elinor Ostrom, who was awarded the Nobel Prize for economics in offered a different explanation for the tragedy of the commons.
• She argued that common resources are well-managed when those who benefit from such resources the most are in close proximity to them.
• For her, the tragedy occurred when external groups exerted their power (politically, economically or socially) to gain a personal advantage.
• Bottom-up approach: She was greatly supportive of the “bottom-up” approach to issues: Government intervention could not be effective unless supported by individuals and communities.
• The world is facing challenges of ecological sustainability and persistent inequalities, which seem to get worse with the prevailing paradigm of economic growth.
• These challenges are described in the 17 Sustainable Development Goals (SDGs).
• They cut across national boundaries.
• They also span several domains of expertise and institutional mandates.
• The final, 17th goal states the principle by which all the goals will be achieved — “partnerships”.

Actions theory Vs. Systems thinking

• Action theory: The prevalent action theory, used by governments, businesses and philanthropic organisations to solve complex problems, focuses on breaking complex problems into components and then tackling the components in separate silos.
• Problems caused by the actions theory: This widely prevalent theory of action has contributed greatly to causing the systemic, interconnected problems the SDGs now aim to address.
• What is systems thinking: Effective action to address multiple challenges together requires “systems thinking” — that is, a systemic vision spanning across the problems.
• Systems thinking is essential, amongst experts at the top and amongst partners on the ground.
• Several organisations are promoting collaborative action with systems thinking on the ground in India.
• Kudumbashree in Kerala has proven the power of community action.
• The Foundation for Ecological Security, guided by Elinor Ostrom’s ideas, is working in many Indian states.
• Dainik Bhaskar is promoting “SDG chaupals” in Indian villages.

3.  Empowering the people

• The third principle for the new economy is, empower the people, the fundamental requirement for genuine democracy.
• India’s Constitution seeks self-governance in India’s towns and villages.
• These are not being implemented by governments and policy experts who do not want to give up power to the people.
• India lives in its villages, Mahatma Gandhi had said. Most of India still does.
• And many, who had migrated to cities looking for jobs, are returning, shaken by the pandemic.
• Gandhi was a systems thinker. For Gandhi, the global village was an abstract concept.
• This cannot be realised until local villages and towns become harmonious communities, where people live in harmony with each other and with nature around them.

The corona crisis has laid bare some of the problems associated with globalisation. It has forced a rethink of the economic policies and model adopted by the world. Against this backdrop, a question can be asked by the UPSC that demands the analysis of problems that have surfaced and solutions. For ex. “Covid-19 pandemic has brought into a sharp focus some inherent problems associated with the globalisation. In this context suggest the ways to make the Indian economy resilient to such shocks and fair to all the sections of society”

Conclusion

COVID-19 marks the end of the economics’ paradigm of the Washington Consensus. New models of economies, and new rules of global governance, must be bottom-up, not top-down. That’s how the whole world can move from relief, to recovery, and into resilience.

Back2Basics: What was the Washington Consensus?

• The Washington Consensus refers to a set of free-market economic policies supported by prominent financial institutions such as the International Monetary Fund, the World Bank, and the U.S. Treasury.
• A British economist named John Williamson coined the term Washington Consensus in 1989.
• The ideas were intended to help developing countries that faced economic crises.
• In summary, The Washington Consensus recommended structural reforms that increased the role of market forces in exchange for immediate financial help.
• Some examples include free-floating exchange rates and free trade.

This article by Urjit Patel elaborates on the recent actions of the RBI which are likely to result in making the role of MPC redundant. Some of the moves cited are injection of liquidity by the RBI and reduction of reverse repo rate by the RBI. Implications such actions could have for the macroeconomic stability are also discussed.

Stimulus package after the 2008 financial crisis and problems created by it

• Following the global financial crisis of 2007-08, India, like many other countries, embarked on a stimulus.
• The pump-priming did not end too well.
• Inflation and bad loans: By 2013, India crossed or approached double-digit figures in inflation and the national fiscal deficit, in addition to looming bad loans.
• Taper tantrum: In summer 2013, when the Federal Reserve indicated a possible reversal of its ultra-accommodative policy, macroeconomic parameters for India were so weak that it got caught up in the “taper tantrum” and experienced external sector fragility.

Inflation targeting and the role of MPC

• While fiscal excesses and financial sector stress remain issues today, India has improved significantly on at least one dimension — namely, inflation — which has also stabilised the external sector.
• How was this beneficial progress achieved?
• Starting in September 2013, the Reserve Bank of India (RBI) initiated an effort to build credibility with domestic savers and international investors on maintaining inflation at prudent levels.
• Three years thereafter, the RBI Act was amended to put in place a flexible inflation targeting framework.
• A Monetary Policy Committee (MPC), comprising of RBI representatives and external members appointed by the Government of India, was enjoined with the legal mandate of managing the policy (repo) rate.
• MPC was mandated to keep consumer price inflation at a target level of 4 per cent, while keeping in mind economic growth.

Assessment of MPC’s performance

• By objective measures, the MPC framework until recently worked rather well.
• It lent transparency and democratic accountability to the process of interest-rate setting.
• Combined with efforts on managing food inflation, it has brought inflation closer to the target.
• It has contributed to tempering household inflation expectations.
• It has kept borrowing costs in the economy at reasonable levels in spite of the high level of government borrowing and several other distortions.
• Appreciation by the rating agencies: Indeed, rating agencies and multilateral institutions repeatedly mention the MPC and the inflation targeting framework as a landmark structural reform towards sound macroeconomic management.

Latest monetary actions by RBI that reduced MPC’s role

• Since last year, a series of monetary actions by the RBI have left the MPC’s decision on the policy rate partly redundant, diluted the accountable process of monetary decision-making.
• This has put at stake the sanctity of the MPC framework.
• With a stated intention to improve the transmission of monetary policy to households and corporations, the RBI has pumped unprecedented levels of money (close to Rs 7 trillion) into the banking system.
• It has done so mostly by purchasing government bonds but partly also by purchasing dollars.
• No desired results: Given impaired financial sector balance-sheets, transmission to economic growth has been at best muted; liquidity is no silver bullet to durably address financial sector stress.
• The primary effect of excessive liquidity has, instead, been to monetise the government’s expenditures and keep its borrowing costs low.
• With its declared aim not being met satisfactorily, the RBI has doubled down on liquidity supply, with the same outcome.
• An important casualty has been the MPC framework.
• Contradictory actions: At times, even when the MPC has kept the policy rate unchanged, the RBI has injected yet more liquidity to move medium-term interest rates down.
• The two actions have been noted to be in direct contradiction of each other.
• If the objective is to move medium-term rates, why not build consensus within the MPC to cut the policy rate more aggressively and communicate the rationale?
• Change in reverse repo by the RBI: Further, given the enormous liquidity glut, every night banks park liquidity with the RBI at a (reverse repo) rate lower than the policy rate and which is not set by the MPC; nevertheless, this rate used to be changed only as part of the MPC Resolution.
• Lately, the RBI has moved reverse repo rate progressively lower than the policy rate; recently.
• It has done so outside of the MPC meeting cycle and not as part of the MPC Resolution.
• There are straightforward tools in liquidity management to ensure that in surplus conditions also, the central bank transacts with banks at the policy rate — technically, by switching from “deficit” to “floor” system of liquidity management.
• Such a switch is routinely adopted by central banks when they provide excess liquidity; the RBI has chosen not to do so.

What are the implications?

• The net effect is that market interest rates are being increasingly controlled by the RBI rather than the MPC.
• Indeed, there is a proposal that the rate at which the RBI absorbs liquidity be still lower, likely divorced from the policy rate set by the MPC.
• The spirit of the MPC framework enshrined in the RBI Act is being violated.
• It is unclear how the MPC can be expected to satisfy its legal mandate if what it seeks to achieve via the setting of the policy rate is in conflict with, or compromised by, the RBI’s liquidity management.
• These developments have the potential to pose risks for India’s macroeconomic stability going forward.
• The implicit monetisation of fiscal expenditures through government bond purchases by the RBI in the secondary market has postponed the recognition of the untenable fiscal reality.
• The delay has meant the government has had limited policy space since the onset of COVID.
• Supply-chain disruptions due to measures taken to contain the pandemic raise the possibility of cost-push inflationary pressures, especially given the excessively easy fiscal and monetary conditions.
• This can abruptly raise economy-wide borrowing rates, inflict losses on banks, and imperil financial stability.
• If the gains in inflation credibility built by the MPC framework are dissipated by ineffective policies and operations, both household and investor expectations for inflation in India could unhinge.
• Worse, it could instigate turmoil in the external sector.
• Excessively low bank deposit rates may induce some non-resident deposits to exit the country.

A question based on the issue of RBI’s action and its implication for MPC and overall economy can be asked by the UPSC, for ex- “The MPC framework has performed well in delivering on its mandate. Yet, there were some actions by the RBI recently which could be perceived as inimical to the functions of the MPC. Discuss.”

Conclusion

In a highly unpredictable time such as this, the RBI should preserve its inflation credibility. The decision on monetary policy actions based on voting by committee members, provision of inflation and growth forecasts in the resolution statement, and coordination of rate-setting and liquidity management, need to be adhered to.

Back2Basics: What is MPC?

• The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016,  to provide for a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth.
• The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to contain inflation within the specified target level.
• The meetings of the Monetary Policy Committee are held at least 4 times a year and it publishes its decisions after each such meeting.
• As per the provisions of the RBI Act, out of the six Members of Monetary Policy Committee, three Members are from the RBI and the other three Members of MPC are appointed by the Central Government.
• Governor of the RBI is ex officio Chairman of the committee.