The Trivialization of Macroeconomics

One of the tragedies of macro-economics is that it has been reduced to a few sound-bytes such that Anybody can become a governor, of the Reserve Bank of India, by the way. After all, it is so simple since all that you have to do is manage interest rates and inflation, as a corollary. Readers will recall that a couple of years ago a large number of people (some economists, some bankers and some corporate chiefs) were advising Dr Raghuram Rajan that the time was ripe for him to reduce interest rates. Finally, it was left to Mr Rahul Bajaj to remind everyone that it was the RBI Governor’s job to manage interest rates and he should be left alone. It is a tribute to Dr Rajan that he remained steadfast in his conviction.

The problem with macro-economics, of which interest rate is one element, is that everybody is an expert now. Unfortunately, the global business media has reduced the immensely complex macro-economics subject to a few policy matters – interest rates, taxation, inflation and FDI. Just get these right and the economy will be flourishing. Years ago when Dr C Rangarajan was RBI Governor he corrected people in their understanding of real interest rates; most people will think of it as nominal interest rate less inflation when it is to be understood as nominal interest rate less anticipated inflation. Trust me, the difference is enormous. The sustained rise in decibel levels against Dr Rajan was just this – those who were making the noise just couldn’t fathom why the good Governor couldn’t see what they could – just drop interest rates. One high profile senior editor wrote in a column how Dr Rajan was the only obstacle in the path of the prime minister’s untiring efforts to take the Indian economy to higher levels.

This particular cacophony apart, the troubling fact is that everywhere the job of a central bank governor has been reduced to just timing – when to change interest rates. Even in the midst of all the events in the word, the US Fed Chairman remains one of the most watched people in the world simply because she decides when to change the Fed funds rate. Hidden amidst all this obsessive attention is an agenda – markets or more specifically, the impact on markets (stock, currency, financial, commodity, futures, swaps and derivatives, alternatives) of a change in interest rates. Any other discussion is almost like an afterthought.

Anyone with a modicum of common sense, let alone an understanding of macro-economics, understands that interest rate changes cannot immediately influence inflation; there will be a lag for the policy effect to materialize. The impact of a change in interest rates on all markets however is invariably immediate which usually leads to portfolio managers reallocating funds among various asset classes, especially between fixed income products on one hand and all other assets. Clearly, it is this that worries all money managers the world over and not inflation. The obsessive reading of the minutes of Federal Open Markets Committee meetings testifies to this deep and single-minded interest.

After all, inflation affects common folk; it sure affects fixed income products but portfolio managers are paid to deal with this as part of their job, readjusting portfolios. Common folk, however, have to readjust their consumption.

In some quarters, the debate is taking a different direction, revisiting the link between interest rates and inflation. Lars Rohde, the governor of the central bank of Denmark has begun the debate. In an interview at the central bank’s office in Copenhagen some months ago, he said: “We’re in a territory where we don’t have very much experience, so we can’t rule out the possibility that the relationship between rates and inflation isn’t as strong as it used to be. Inflation requires demand pressure and globally there’s very little demand pressure.” (http://www.mineweb.com/news-fast-news/is-the-link-between-monetary-policy-and-inflation-broken/) Professors of economics too have begun to so wonder. Torben M. Andersen, professor of economics at Aarhus University, observed that “in the inflation policy debate there was always an assumption that it’s much easier to pull a string than to push a string. But we don’t have much experience in just how difficult it will be to succeed in what central banks around the world are now trying to do.” (Same URL as above)

At least students of my generation were taught that while monetary policy might succeed in bringing down inflation if a few other variable played their role too, it is woefully inadequate to lift an economy from a recession. The global economy has seen enough evidence of that over the last few years. The enormous stimulus that many governments of advanced economies have launched haven’t unleashed any miracle. Not so far, at least.

Perhaps, there is a deeper issue than just monetary policy – our understanding of macro-economics. It is time people stopped getting obsessed with one-to-one correspondence between two variables. An economy is a complex system inhabited by mutually interacting variables. The great economist, Charles KIndleberger, never tired of cautioning anyone about the dangers of seeing an economy through the prism of one-to-one correspondence.

However, the issue is more than this. We need to probe deeper into the link between all markets and the economy. Until we did that, we will keep prattling inanities on how to manage an economy. Is there any way to regulate these decibel levels?

Takeaways

There is too much cacophony in lay and even professional discussions on macroeconomics

An economy is a system – making one to one correspondence between any two variables is inappropriate

Common people’s lives are affected by economic policies which makes trivialization all the more serious an offence