In whose interest?

Economics is a seriously inexact science. Economic phenomena are hard to predict, and harder still to govern. The instruments of economic policy are not unlike allopathic medication, in that they can have side-effects, some of which are unforeseeable and most of which are unpleasant. It therefore calls for experience, for ‘a feel for things’, for knowledge and expertise, in order to be able to judge the efficacy of policy interventions and their optimal timing. This, presumably, is why responsibility for policy-making is vested with specialized agencies and the professionals heading them. Their job is hard enough, without their having to factor in the demands and expectations of government into their decisions. Both respect for autonomy and a proper sense of their accountability to the society they serve demand that they should be allowed to function without let or hindrance within the jurisdiction of their authority and mandate.

Economists will tell you that their concern is with public good, with the welfare of a society. That’s a nice fiction to broadcast, not least when it emanates from professionals who are chosen by a government to advise and assist it with its economic policies. But it’s also a nice working assumption, and if there’s one thing at which my tribe is adept, it’s in the matter of making assumptions. (Broadcasting fiction is another.) So let’s make that assumption about economic policy being directed toward the good of the people. The trouble is that it’s almost always the case that policy that’s good for some people may not be good for other people — an instance of what is commonly referred to as conflict of interest (a lowly pun, as we shall see, in the context of today’s column). Lower commodity prices, for instance, benefit consumers but hurt producers. Raising the marginal tax rate of the ultra-rich and using the proceeds to build schools for the poor would benefit the latter but hurt the former. (If you don’t believe me, ask the ultra-rich, the poor things.)

And so it is with the rate of interest. Simple economic theory would argue along the following lines. (I must introduce the caveat here that much of what I have to say will be couched in very simple terms, since it is directed at the lay person, not the specialist. The knowledgeable are therefore persuaded to be patient, or to altogether quit reading this.) The rate of interest is simply the price of money. Price and demand, as we know, are inversely related, so that a drop in the interest rate might be expected – other things equal — to stimulate an increased borrowing of money leading, in turn, to increased levels of private spending, and therefore to increased general economic activity and increased prices of goods and services. In this simple story, a drop in the interest rate is not a good thing for inflation, while a rise is.

On the other hand, for precisely the reason that a drop in the interest rate makes borrowing money more attractive, and given that investment is financed substantially by credit, a reduction in the rate of interest might be expected to stimulate investment, raise aggregate demand, enhance incomes, and improve the prospect of employment and growth. Conversely, when the rate of interest rises, retaining money as savings in the bank is a relatively more attractive proposition than investing in capital (in general, the  rate of return on investment must be at least as high as the rate of interest, after allowing for inflation,  if investment  is to be attractive).  (For a friendly piece on the subject, see Jean Folger’s ‘What is the Relationship Between Inflation and Interest Rates?’ in ‘Investopedia’, available at Briefly, and in this simple story, a drop in the interest rate is a good thing for investment, and a rise is not. The two components of the story just outlined explain what economists call a Phillips Curve (named after the scholar A. W. Phillips) who postulated, many decades ago, the existence of a tradeoff between inflation and unemployment, as reflected in a negatively sloping curve obtained from plotting the one against the other.

How is the tradeoff to be effected? By, among other things, a reckoning of who will benefit, who will be hurt, how much, and by what.  Inflation – especially food inflation of the type and magnitude we have been witnessing in the recent past — presumably hurts the poor and the working classes a good deal more than it does the entrepreneurial classes. If the judgment is that, all things considered, it is more important to stabilize the rate of increase of prices than it is to stimulate the economy, then there would be a case in favor of not being in an all-fired rush to lower the rate of interest.  One must also ask if the relationship between interest rates and private investment levels is as strong as is sometimes automatically assumed to be the case.

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Investment depends not only on the price of money, but also on the state of aggregate demand, on the availability of infrastructure such as power and water, on a substantial easing in supply-side constraints, on the ‘general climate for investment’,  and on expectations and what Keynes called ‘animal spirits’.  The seriously disheartening performances of the agricultural and manufacturing sectors in India, combined with our arid record of jobless growth, hardly suggest a situation in which private capital is eagerly waiting for a drop in the interest rate as a signal for the lowering of the last and only barrier to investment. Indeed, a clue to the constituency that a pro-wealthy government would aim to please is offered in a fine article in the Economic and Political Weekly (‘The Interest Rate Affair’, EPW, April 04, 2015) by economist Sugata Marjit. He suggests that the principal effect of a cut in the interest rate would be not so much to stimulate investment as to directly increase corporate profit by, presumably, reducing prices and increasing the sales turnover of consumer durables.

It is a matter, as indicated earlier, of making a judgment on where and how to effect the tradeoffs. I have always understood that that is why we have an autonomous monetary institution such as the Reserve Bank of India — precisely so that it can make unbiased and un-pressured professional judgments of the type that are called for in such matters. The Governor of the RBI should be allowed to do his job, without being subjected to second-guessing and being leant on, by the Finance Ministry. I am not necessarily holding a brief for the Governor — but for his office, yes. It is unseemly, undignified, and ultimately injurious to the institutional health of a polity for its autonomous agencies to be pestered or disciplined into governmental compliance.

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