13/12/2018 10:32 AM IST | Updated 13/12/2018 10:32 AM IST

Urjit Patel’s RBI Stint Will Be Remembered For Two Flawed Policies

While demonetisation was Patel’s Nero moment, it was inflation-targeting that proved to be a watershed moment for both RBI and the Indian economy.

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Demonetisation, under Patel’s watch, inflicted a double squeeze on the poorer sections of the society.

When Urjit Patel, who succeeded Raghuram Rajan as the RBI governor in 2016, announced his exit earlier this week, he threw investors into a tizzy. The news came as a surprise, even though there had been speculation of such a move, given Patel's tiff with the government on key policy moves.

Now that his stint as RBI governor has ended, it may help to look at Patel's role at the RBI both before and during his tenure.

In my opinion, Patel will be known for two important decisions—one is controversial and the other a watershed moment in India's policymaking. The controversial one was Patel's Nero moment, when he was given the onerous job of inflicting demonetisation on the economy—this has been touted as perhaps the biggest (disastrous, for sure) macroeconomic experiment in recent times anywhere in the world. And the watershed moment was when a committee he headed in 2014 shifted the focus of the RBI from the dual objectives of employment and inflation to exclusively inflation targeting.

The problems with demonetisation

Recently, former chief economic adviser Arvind Subramanian, after years of silence, revealed what he actually thought of demonetisation—that it was a "massive, draconian, monetary shock" to an otherwise stable Indian economy.

This measure, under Patel's watch, inflicted a double squeeze on the poorer sections of the society. On the one hand, they lost jobs and incomes and at times even their lives standing in day-long queues to get their hard-earned money converted to the new currency notes. On the other hand, the significantly higher expenditure that the government resorted to in the aftermath to conceal the contractionary effects of the policy measure was funded through higher taxes on the goods they would purchase with an already diminished income.

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In the aftermath of demonetisation, many people lost jobs, incomes and at times even their lives standing in day-long queues to get their hard-earned money converted to the new currency notes.

Such an ordeal could perhaps, just perhaps, have been justified if there were substantial gains to be made from this policy. But all the three claims—controlling corruption, destroying terrorism and counterfeit currency rackets—for which it was purportedly introduced didn't hold much water, as numerous studies have shown.

Inflation targeting

While demonetisation brought Patel much criticism, his resolute stand on inflation-targeting has brought him praise from many economists and commentators, both national and international. In a nutshell, the argument is that inflation hurts because neither the incomes of the poor nor the financial wealth of the rich are indexed to it. Hence, inflation needs to be kept under check. The belief is that since money drives inflation, the role of the monetary authorities should be focused exclusively on that.

There are many problems with this argument, with implications which are far-reaching in nature. It doesn't take a genius to understand that for the RBI to control inflation, it should be able to control the factors which generate inflation in the economy. And the truth is that inflation in oil-dependent economies such as ours is to a large extent driven by the ups and downs in the crude oil market. Now it's obvious that how much ever the RBI may try, they have no control over the oil Sheikhs!

Peter Kovalev via Getty Images
Inflation in oil-dependent economies such as India's is to a large extent driven by the ups and downs in the crude oil market.

Am I being too simplistic here? Yes and no. To that part of what the economists call "cost-push" inflation, central banks have limited control but it is assumed that even there, they can mitigate it somewhat. Inflation is, after all, not just driven by cost but also the relative demand and supply of commodities in an economy.

So, even if the RBI cannot directly influence the cost side, it can surely affect the demand side and by bringing it down, it could, or so it is argued, keep inflation under check.

But even here, there's many a slip between the cup and the lip. One, inflation may not be as closely linked to demand as is often assumed. Does a sudden rise in demand for cars or toothpaste increase their price? No, the corporations respond with higher production and even in the short run, they don't increase prices because such frequent changes in prices would affect their market shares. It's true that for perishable commodities such as food, demand may play a critical role in determining their prices but food, or other such commodities, constitute a relatively smaller part of total inflation these days. Two, even if they were linked to a rise in interest costs, particularly in conditions of high profitability, this may not bring the demand down. Three, let alone bringing inflation down, a rise in interest rates increases the costs, which the corporations would more likely pass on to the consumers in the form of higher prices so as to maintain their profit margins.

The limitations

In the post-inflation targeting policy framework, there are two contrasting events which prove the larger point I am making about the limitations of this policy. Between 2009-2011 under UPA-II, inflation was very high in India, which ostensibly was one of the reasons why they lost the elections. RBI pursued targeting inflation with single-minded resolve but what did it achieve? Nothing. For almost two years, interest rates sky-rocketed—though this adversely affected demand and, hence, employment, it could not affect inflation at all. This is a perfect example of what happens when policy is driven by pre-conceived "theoretical models" and not by hard facts, and in the process inflicts avoidable hardships on the people for no fault of theirs. Eventually, inflation subsided when rising crude oil prices nosedived.

As opposed to that, under the Modi government, inflation has been quite low, simply because oil prices have hit rock-bottom levels. It's, therefore, not surprising that the government was demanding the RBI give up its strict policy stance but the matter did not end there. The government also wanted the central bank to overlook the bad debt problem and relax its policy on corporate loans to help create a credit-bubble driven growth, something which has eluded Modi despite all the claims made to the contrary. This demand of the government is akin to infusing sugar syrup in the veins of a severely diabetic patient.

Under the Modi government, inflation has been quite low, simply because oil prices have hit rock-bottom levels.

To be sure, I am not a votary for "independence" of RBI, since any public institution should ultimately be accountable to the public at large. At the same time, it's not necessary that the government of the day might necessarily have the long-term interests of the economy in mind, especially if it's looking for a magic wand to solve a deeper malaise, such as the bad debt problem facing the Indian economy today. And it won't help if the government starts meddling with the RBI by bringing in a pliant bureaucrat whose only claim to fame is his steadfast support for demonetisation.

The author is assistant professor of economics at Jawaharlal Nehru University, New Delhi.