Duvvuri Subbarao: Economic crisis and crisis in economics - some
reflections
M Ct M Chidambaram Chettyar Memorial Lecture by Dr Duvvuri Subbarao, Governor of the
Reserve Bank of India, at the Indian Institute of Science, Bangalore, 27 August 2010.
* * *
M. Ct. M. Chidambaram
1. Thank you for this kind invitation. It is a pleasure and privilege to deliver the
M. Ct. M. Chidambaram Chettyar Memorial Lecture honouring one of the most eminent
entrepreneurs and financiers of the early twentieth century.
2. The Chettyar community of Tamil Nadu has made impressive contributions to our
national life. The stereotype view is that the Chettyar community is conservative. But Shri
M. Ct. M. Chidambaram broke that stereotype. His is the story of a visionary, ahead of his
time who, through his thought and action, contributed to laying the foundations for
transforming India from an agrarian society to an industrializing nation.
3. M Ct, as he was popularly known, was a true pioneer who did not let the restrictive
economic environment of his time restrain his abounding spirit of enterprise. He started the
United India Life Insurance, the first national level life insurance company; ventured into
general insurance through the United India Fire and General Insurance Company,
established a bank - the Indian Overseas Bank, and set up a large manufacturing unit -
Travancore Rayon. M Ct thought big. The LIC building on Anna Salai in Chennai that he built
remains iconic even today never mind that taller skyscrapers have since come up. I can go
on with the list. What is impressive about this remarkable man is that he accomplished all
this in an era of controls and regulations, and that too in a tragically short life span of just
46 years. That all these institutions survive to date is a tribute to M Ct's enduring legacy.
4. M Ct was quite the Renaissance man who let his life and work be influenced by
learning from across disciplines as well as from listening to a wide range of people. But as
with any successful entrepreneur, in the end, he depended on his intuition and judgement -
some may call it plain common sense - to determine his course of action. In that sense, M Ct
had unwittingly set a role model for policy makers. Good policy makers should get all the
technical inputs and advice, but ultimately need to superimpose their judgement on that
analysis to reach policy decisions. This is something that M Ct mastered. The best way
perhaps to pay tribute to M Ct is to convey to you how we struggle with making judgement
calls on top of technical analysis in order to reach policy decisions.
5. For good economic policy, you need good economics. But you also need good
judgement because no economic theory can capture the complexity and capriciousness of
the real world. And this is what I want to focus on in this lecture. In particular, I want to
address two issues. In the first part of the lecture, I will address the question, has economics
failed us. And in the second part, I will try to convey to you the dilemmas and the
complexities that policy makers confront in making judgement calls.
The Queen at LSE
6. A few months into the crisis, the Queen happened to be at the London School of
Economics and asked a perfectly sensible question: "how come none of the economists saw
the crisis coming". The Queen's question resonated with people around the world who felt
that they had been let down by economics and economists. As economists saw their
profession discredited and their reputations dented, the economic crisis soon turned into a
crisis in economics.
Crisis in economics
7. This was a particularly hard landing for the profession. The years before the crisis, in
fact, saw economics as a subject gain impressively in clout and popularity. The price stability
and macroeconomic stability that prevailed over an extended period - the Great Moderation -
enhanced the standing of economics and gave economists an enviable halo; the increasing
sophistication of financial markets where risk could seemingly be measured with precision of
up to five decimal points gave economics the clout of prophesy; and the way economists
were able to raise obscure questions such as why drug dealers continue to live with their
mothers, what school teachers and sumo wrestlers have in common, and answered those
questions with impressive insights, awed common folk. Economists were being sought out to
pronounce on an ever growing number of issues and their opinions were being heard with
regard and trust. And then the financial crisis came and crashed all this.
8. The sharp reversal in fortunes raises two questions: what went wrong and what can
be done about it. Both questions are complex; the first because it has too many answers and
the second because it has too few. What I propose to do in this first part of this lecture is to
address these two questions.
What went wrong with economics?
9. Let me turn to the first question. What went wrong with economics? I am not an
economist, only a practitioner of economics. I will, therefore, restrict myself to just the bigger
maladies that, I think, afflict the discipline.
10. With the benefit of hindsight and by wide agreement, it now seems that by far the
most egregious fault of economics, one that led it astray, has been to project it like an exact
science. The charge is that economists suffered from "physics envy" which led them to
formulate elegant theories and models - using sophisticated mathematics with impressive
quantitative finesse - deluding themselves and the world at large that their models have
more exactitude than they actually did.
Is economics like physics?
11. As I started thinking about this charge, I realized that there are indeed quite a few
parallels between economics and physics. Let me explore these parallels briefly.
(i) The theory of rational expectations says that wages and prices adjust
instantaneously to new conditions because of perfect information just as Newtonian
physics says that the gravitational configuration of the universe will change
instantaneously in response to any infinitesimal change in the system, an inference
that Einstein found troubling because it conflicted with his special theory of relativity.
(ii) The centerpiece of Keynes' theory is the existence of inescapable uncertainty about
the future which implies that risk cannot be measured precisely beyond a point, and
that taking uncertainty seriously has profound implications for how one applies
economics. Look at the parallel in physics. The foundation of quantum mechanics is
Heisenberg's Uncertainty Principle which puts an irreducible limit on our ability to
simultaneously determine the position and momentum of a particle.
(iii) Physicists know of "singularities", or black holes if you will, where the laws of
physics break down. In economics, the analogy would be Depression Economics.
There is currently a fierce debate, especially in the US, about the quantum of fiscal
stimulus and the timing of its withdrawal. Some economists, notably Krugman, have
argued that the size of the stimulus should be much larger than what the models
suggest simply because "in Depression Economics, the usual laws of economics do
not apply".
Why economics cannot be like physics
12. Striking as these comparisons are, I am sure, you have noticed an obvious flaw in
this line of thinking. Similarity in a few laws does not mean similarity in the basic nature of the
academic discipline. The fundamental difference between physics and economics is that
physics deals with the physical universe which is governed by immutable laws, beyond the
pale of human behaviour. Economics, in contrast, is a social science whose laws are
influenced by human behaviour. Simply put, I cannot change the mass of an electron no
matter how I behave but I can change the price of a derivative by my behaviour.
13. The laws of physics are universal in space and time. The laws of economics are
very much a function of the context. Going back to the earlier example, the mass of an
electron does not change whether we are in the world of Newton or of Einstein. But in the
world of economics, how firms, households and governments behave is altered by the
reigning economic ideology of the time. To give another example, there is nothing absolute,
for example, about savings being equal to investment or supply equaling demand as
maintained by classical economics but there is something absolute about energy lost being
equal to energy gained as enunciated by classical physics.
14. In natural sciences, progress is a two way street. It can run from empirical findings
to theory or the other way round. The famous Michelson-Morley experiment that found that
the velocity of light is constant led to the theory of relativity - an example of progression from
practice to theory. In the reverse direction, the ferocious search now under way for the Higgs
Boson - the God particle - which has been predicted by quantum theory is an example of
traversing from theory to practice. In economics, on the other hand, where the human
dimension is paramount, the progression has necessarily to be one way, from empirical
finding to theory. There is a joke that if something works in practice, economists run to see if
it works in theory. Actually, I don't see the joke; that is indeed the way it should be.
15. Karl Popper, by far the most influential philosopher of science of the twentieth
century, propounded that a good theory is one that gives rise to falsifiable hypotheses. By
this measure, Einstein's General Theory was a good theory as it led to the hypothesis about
the curvature of space under the force of gravity which indeed was verified by scientists from
observations made during a solar eclipse from the West African islands of Sao Tome and
Principe. Economics on the other hand cannot stand the scrutiny of the falsifiable hypothesis
test since empirical results in economics are a function of the context.
16. The short point is that economics cannot lay claim to the immutability, universality,
precision and exactitude of physics. Economics is a social science and its predictive power is
at a fundamental level influenced by human behaviour and actions. Let me now illustrate how
real world behaves in capricious and unpredictable ways posing complex challenges for
economic prediction.
(i) Take the recent financial crisis. It is not as if no one saw the pressures building up.
There were a respectable number of economists who warned of the perilous
consequences of the build-up of global imbalances, said that this was simply
unsustainable and predicted a currency collapse. In the event, we did have the
system imploding but not as a currency collapse but as a melt down of the financial
system.
(ii) Again, there was widespread apprehension that the financial crisis would be
followed by a sovereign debt crisis under the weight of unprecedented government
borrowing to finance the fiscal stimulus. We did get a sovereign debt crisis but not
because of stimulus led debt burden but because of fiscal profligacy in some
European countries, notably Greece, made possible by the umbrella cover of a
monetary union.
Economic models
17. Moving on with what went wrong with economics, another flaw, actually one related
to "physics envy", is the obsession of economists with models so much so that they
convinced themselves that if something cannot be modeled, it is not fit enough for academic
pursuit. Indeed, with the benefit of hindsight, it is now possible to see that one of the basic
causes of the crisis was that the models used by central banks, such as even the
sophisticated Dynamic Stochastic General Equilibrium (DSGE) models, remained confined to
the real sectors of the economy and did not capture the complexities of the financial markets.
It is not surprising that economists missed seeing the crisis brewing in the underbelly of the
financial sector.
18. Yes, it is possible to construct beautifully precise models but only if you assume that
rational economic agents with perfect information are operating in free markets that always
return to equilibrium. But none of these assumptions holds true in the real world; models of
economists are mere abstractions of reality that are useful for understanding but woefully
inadequate for prediction. That is why good economists are those who superimpose
judgement on the predictions thrown up by models, a subject to which I will return in the
second part of my lecture.
19. Of all the economic theories that came under attack after the crisis, the one that got
the most grilling was the efficient market hypothesis put forward by Eugene Fama of the
Chicago School. Its central tenet is that the price of a financial product captures all available
information about it. The efficient market hypothesis did away with the unrealistic assumption
of perfect information but it assumed perfect information about risk. An obvious inference of
the theory is that risk is perfectly measureable, and if it can be measured perfectly it makes
eminent sense to use that measurement in economic decisions.
20. Not surprisingly, the efficient market hypothesis spurred furious model building
based on the assumption that the distribution of risk is captured by the Gaussian bell curve.
The spectacularly, albeit briefly, successful Black-Scholes model for option pricing too was
based on the normal distribution of risk and ignored the possibility of extreme events.
21. With the benefits of hindsight, it is now clear that the models used by governments,
central banks and economic agents were flawed in many ways. First, the models assumed
that the real world exhibits stability over time, and by extension that the future can be
predicted from an extrapolation of the past and present trends. Students of physics will notice
that this is akin to the Newtonian world view that God is, in fact, a clock-maker and the
universe is nothing more than clockwork. Knowing the initial conditions, it is possible to
predict the precise configuration of the universe for any point of time into eternity.
22. The second flaw was to believe that risk follows a normal distribution - a flaw that
became evident by a series of failures, most prominently by the spectacular collapse of the
hedge fund Long Term Capital Management (LTCM) based on the Black-Scholes model. As
the much celebrated author Nassim Taleb argues, conventional models used by financial
economists not only didn't capture, but even refused to acknowledge, the possibility of black
swans - low probability, high impact events.
23. The third major flaw of financial models was that instead of fitting the models to the
real world, they tried to fit the real world to the models. In the process, they assumed away
the models' limitations and caveats. Convenience, and not conviction, dictated the choices
that economists made. As the Economist magazine put it so well, economists got seduced by
their models, fooling themselves that what the models leave out does not matter. This
penchant of economists to build models determined more by what they can rather than what
they should is best illustrated by the joke that I am sure most of you heard - about a
drunkard who lost his keys and was searching for them under a lamp post not because he
lost the keys there but because that is where light was.
What can be done about it?
24. I realize I have straddled economics and physics somewhat erratically to convey to
you what went wrong with economics. Now let me turn, if only briefly, to the follow on
question about what can be done about it.
25. The first thing is for economics to give up the pretence of being an exact science
and striving for false precision. While there is value to models for furthering understanding of
economic phenomena, economists should, however, be sensitive to the limitations of their
models and use judgement in interpreting model results. And we clearly need to get back to
emphasizing the importance of economists "getting their hands dirty" with empirical work.
26. Then there is the crucial aspect of economic history. Much of economic thinking has
been handicapped by economists not having a sense of economic history. In their
Time is Different: Eight Centuries of Financial
painstakingly researched book, "This Folly",
Kenneth Rogoff and Carmen Reinhart show how over eight hundred years, all financial
crises can be traced to the same fundamental causes as if we learnt nothing from one crisis
to the next. Each time, experts have chimed that "this time is different" claiming that the old
rules do not apply and the new situation is dissimilar to the previous one. If only training in
economics had included a study of economic history, perhaps we could have avoided
repeating history, never mind as a farce or as a tragedy.
27. Finally, economics, perhaps more than other social sciences, has suffered from
"group think". Group think is best illustrated by the simulated game of a beauty contest where
prizes are awarded if your choice matches the aggregate choice of the group. Under this
rule, you get rewarded not for original thinking but for mastering the art of thinking like others.
Keynes made the point a long time ago, comparing market psychology to a beauty contest:
"It is not the case of choosing those which, to the best of one's judgement, are really the
prettiest, nor even those which average opinion genuinely thinks are the prettiest ... we
devote our intelligences to anticipating what average opinion expects the average opinion to
be. " Might it be the case that economics is suffering from too much inbreeding? Economists
all read the same books, browse the same journals and use the same data because that is
what gets professionally rewarded. And that inevitable leads to "group think" and all the
associated follies.
Applying economics to real world policy
28.
While I have spoken about the follies of economics, I am hardly suggesting that we
can do away with economics. Indeed economics needs to be pursued as an academic
discipline even more vigorously but we need to be more intelligent and aware in translating
textbook economics to practical policy making. In applying economics to practical policy, a
sound economic background is necessary. Models too are needed to capture the
complexities of the real world. But these are not sufficient. In making economic decisions,
practical policy makers need to superimpose judgement on the inferences thrown up by
analysis and models. I want to illustrate this by presenting to you the rationale behind the
Reserve Bank's calibrated exit from the expansionary monetary stance of the crisis and the
policy dilemmas that we confront.
Calibrated exit from expansionary monetary stance
29. Not unsurprisingly, emerging market economies (EMEs) recovered from the global
crisis sooner than advanced economies - an outcome attributable in part to the relatively
limited exposure of their banking systems to tainted assets and in part to the self-insurance
they had built up through foreign exchange reserves.
India's recovery
30. On the recovery trail, India has been an outlier even compared to other EMEs. Our
recovery has been swifter reinforcing the fact that the drivers of our growth are largely
domestic. We have been an outlier on the inflation front as well. Even as most advanced
economies were flirting with deflation, price pressures caught up with us and headline
inflation started inching up.
31. Sensing our unique growth-inflation dynamics, the Reserve Bank began managing
market expectations by signalling the need to exit from the crisis triggered expansionary
stance even as the rest of the world was still struggling with crisis management. Ironically,
we had to begin this messaging about exit as early as August 2009, when our headline
inflation was still in the negative territory and some analysts were even talking about a risk of
deflation.
October-December 2009
32. Sure enough, WPI inflation surfaced into positive territory by September 2009, and
soon started increasing. Even as the reversal owed partly to the base effect, inflationary
pressures were also fuelled by supply shocks arising from a deficient monsoon. The
challenge for the Reserve Bank during the October-December quarter of 2009 was to
respond to a hardening inflation situation even as recovery was still fragile.
33. The arguments for not yet reversing the policy stance were clear enough: recovery
had yet to take firm root and also that monetary policy is not an effective tool against inflation
emanating from supply constraints. There was an equally persuasive case to the contrary -
of tightening the monetary stance to combat inflation. Given that monetary policy acts with a
lag - a lag that can be as long as 12-18 months - the argument was that the Reserve Bank
needed to look ahead and curb incipient inflationary pressures. The Reserve Bank, it was
contended, also had to keep a watch on inflation expectations since the inflation outlook will
be shaped by what people expect will happen to inflation as much as by the actual inflation
itself.
34. Balancing these arguments for and against reversal was the crux of the judgement
call that the Reserve Bank had to make in the October 2009 policy review. If we were to
begin the reversal of the accommodative stance, we had to be credible. And this is where
real life policy differs from physics. Once a central bank credibly commits to a reversal of an
expansionary stance, firms and households change their behaviour. How this behaviour
changes also needs to be factored in by the central bank. In the event, we reversed the
expansionary stance by raising the SLR requirement to the pre-crisis level of 25 per cent of
net demand and time liabilities (NDTL) of scheduled commercial banks. This was admittedly
a modest step but helped us in signalling the beginning of the reversal of our monetary
stance.
January-March 2010
35. By the time of our January 2010 policy review, it was clear that we had to take more
substantive steps towards rolling back the stimulus. Our main dilemma was that premature
exit could derail the as yet fragile growth, but delayed exit could potentially engender inflation
expectations. The task was about the precise calibration of the policy action. Increase in
policy interest rates cannot be effective if there is a large systemic liquidity. We determined
therefore that the right sequencing would be to withdraw the excess liquidity before raising
policy rates. Accordingly, we raised the cash reserve ratio (CRR) by 75 basis points from
5 per cent to 5.75 per cent of NDTL.
36. The growth-inflation dynamics changed markedly after the January 2010 policy
review. Economic recovery was taking firm hold as evidenced by expanding exports,
improvement in industrial production and sustained increase in financing from banks and
non-banks. On the other hand, there were distinct signs of the inflation process getting more
generalized. Information then available indicated that the contribution of non-food to WPI
inflation (excluding food articles and food products) which was zero in November 2009
surged to nearly 50 per cent by February 2010. Also, year-on-year non-food manufacturing
products inflation, with a weight of 52 per cent in the WPI basket, which was (-) 0.4 per cent
in November 2009 rose sharply to 4.5 per cent by February 2010 evidencing incipient
demand side pressures. We determined that we had to act quickly before inflation
expectations get further entrenched. Accordingly, in an unscheduled and mid-quarter policy
action, we raised the policy interest rates by 25 basis points raising the reverse repo rate to
3.5 per cent and the repo rate to 5.0 per cent.
April 2010 and beyond
37. Monetary theory tells us that if prices come under pressure because of
strengthening demand, monetary tightening has to take place. But monetary policy does not
offer a template for when to tighten, how to tighten and how much to tighten. This remains a
judgement call. We face this dilemma all the time but did so most acutely during the Annual
Policy Review in April 2010. Year-on-year WPI non-food manufactured products inflation had
moved up further from 4.5 per cent in February 2010 to 5.4 per cent in March 2010
evidencing clearly that demand side pressures on inflation were strengthening.
38. To understand the demand side pressures in perspective, we need to go back two
years to August 2008, a month before the global crisis struck. At that time inflation in the
country was raging well above double digits. Some of it was due to the unprecedented rise in
global crude and commodity prices, but a significant portion of it was also due to sizzling
growth in an economy that was structurally capacity constrained across the entire spectrum -
infrastructure, agriculture, industry and services. Then came the crisis and the monetary and
fiscal stimuli in response. A part of the stimulus was aimed at supporting investment, and
public and private infrastructure investment did indeed increase, but much of the stimulus
ended up supporting consumption. This helped the economy weather the crisis but the
supply constraints remained. As a result, when recovery started and demand pressures
started building up, capacity constraints started becoming increasingly evident.
39. So, at the time of the April 2010 policy review, we had to balance the by now
wellknown arguments in managing the growth-inflation dynamics. Some analysts had argued
that we were already behind the curve and that unless we tightened substantively, the
economy ran the risk of a hard landing - which is to say that we were boxing ourselves into a
corner, that delayed response would mean much sharper increase in interest rates later on
and that will severely impair growth.
40. Even as we were managing the macroeconomic situation at home, we had to be
mindful of global developments. The Great Recession in the advanced economies appeared
to have reversed course by mid-September 2009 and some calm seemed to return to the
global markets. It was widely expected that the recovery would be sluggish; but subsequent
developments belied even these modest expectations. While recovery prospects in Europe
remain clouded by sovereign debt concerns, recovery in US appears constrained by
consumer spending and private investment not picking up sufficiently to offset the impact of
the waning stimulus. We had to factor in these developments too in calibrating our exit path.
41. Keeping these domestic and external developments in view, in our April 2010 Policy
review, we raised the CRR by a further 25 basis points to 6 per cent and the policy rates too
by 25 basis points each. We followed that up with two policy actions in July 2010 further
raising the policy interest rates.
42. To summarize, as part of crisis management starting October 2008, we reduced the
CRR by 400 basis points, the repo rate by 425 basis points and the reverse repo rate
275 basis points. As part of the calibrated exit starting October 2009, we raised CRR by
100 basis points, the repo rate by 100 basis points and the reverse repo by 125 basis points.
It must be noted that on top of this, there has been some autonomous tightening of 150 basis
points because of the tightened liquidity and the consequent shift of the operative policy rate
from the bottom of the LAF corridor (absorption mode) to the top of the corridor (injection
mode).
43. Some critics contend that the Reserve Bank is "behind the curve". Others put it
differently saying that we are yet a distance away from the "neutral rates". This criticism
obviously presumes a notion of the shape of the curve or the neutral rates. This is a complex
debate to pursue in the Indian context. Technically, the "neutral rate of interest" is an
important concept in monetary policy and a potentially useful guide to monetary policy
stance. The neutral rate is defined as a rate that is consistent with the economy's potential
growth and low and stable inflation. The actual policy rate will, therefore, differ from the
theoretical neutral rate if the underlying parameters - actual growth and inflation - are away
from their respective potential or target rates. The neutral rate evidently varies over time as
the potential growth rate of the economy changes - which in turn is typically a function of the
demographic profile, the fiscal stance of the government and technological changes. In a
rapidly growing economy like that of India, the structural changes make the potential growth
rate even more variable. That makes the neutral rate even more difficult to estimate and a
less useful policy guide.
Policy Rates - During and After Crisis
September 2008-August 2010
Crisis Management Calibrated Exit
Reduction as Increase as
Rates in part of crisis part of
Variable
September management Rates in calibrated exit
Rates in
2008 (Oct. 2008- September (Oct. 2009-
August 2010
(before Sept. 2009) 2009 Aug. 2010)
crisis) (basis (basis
points) points)
CRR 9% 400 5% 100 6%
Repo 9% 425 4.75% 100 5.75%
Reverse Repo 6% 275 3.25% 125 4.50%
Outlook
44. What is the outlook? There is evidence that growth is getting more broad based.
Inflationary pressures too are easing because of improved supply position as also the impact
of monetary tightening effected by the Reserve Bank. Going forward, the Reserve Bank will
calibrate policy action to the evolving growth-inflation dynamics. Given the uncertainty in the
world and the lags in monetary transmission, it is not possible to offer more precise
festina lente
guidance. All I can say is that our guide post is - as the Romans used to say -
make haste slowly.
45. One final point as I close this issue. The Reserve Bank has to balance between the
intersé
objectives of growth, price stability and financial stability with the prioritization
determined by the macroeconomic context. Determining this prioritization is the judgement
call of the Reserve Bank. People who apprehend that monetary tightening will hurt growth
must remember that even if there is some sacrifice of output in the near-term, we are better
off curbing inflation since inflation can be inimical to sustainable and equitable growth in the
medium term.
Conclusion
46. Let me now conclude. I started with the Queen's query to economists about the
shortcomings of their trade, went on to sketch the perils of economics positioning itself as an
exact science and argued that economic thinking has to be conditioned by human behaviour.
I then explained how, in economic policy formulation, we need to use judgement over the
results of analysis and modeling to decide among policy choices.
47. Since so much of my talk has been shaped by comparing economics to physics, let
me also conclude with a parallel between the two disciplines. Physics, an exact science,
explores known unknowns. Economics, a social science, deals with unknown unknowns. We
all know that all through his life, Einstein remained skeptical about quantum mechanics. In
particular, he could not reconcile to the probabilistic nature of the physical world implied by
quantum physics and famously said that "God does not play dice". Less well known perhaps
is the retort of Neils Bohr who told Einstein, "Albert, stop telling God what he can or cannot
do". Economists have a much humbler remit. They cannot even tell man, let alone God, what
he can or cannot do. They just have to take human behaviour as given and pursue their
trade on that fundamental premise.