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The Macroeconomic Case for Central Bank Independence – I

The Long Run Phillips Curve shows that any policy that tries to increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and lower GDP growth rate in the long run.

In a pioneering paper titled “The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957”, engineer turned economist E.W Phillips noticed a statistical correlation between two macroeconomic variables that would define economic policies in the decades to come. He noticed an inverse relationship between unemployment and inflation, i.e. when unemployment was low, inflation was high and vice-versa. Graphically, this is a downward sloping curve as shown below.

Figure 1: The original Phillips curve for the period 1948 to 1957, showing the inverse relationship between inflation and unemployment.

Figure 1: The original Phillips curve for the period 1948 to 1957, which shows the inverse relationship between inflation and unemployment.

This particular statistical relationship had huge implications for fiscal and monetary policy. The correlation between the two macro variables was now seen as a trade-off – an economy can lower unemployment if it tolerates a bit of inflation. Noted economists Solow and Samuelson used this relationship to advocate large governmental (deficit) spending and lower interest rates. The rationale behind this was that as long as you can lower unemployment rate, through increased GDP growth, a slightly higher level of inflation can be tolerated. It was believed that the welfare gain through higher growth and lower unemployment would offset the welfare loss due to a higher rate of inflation.

This line of reasoning was employed in the US in the 1960s – the decade of previously unprecedented economic growth – to reduce unemployment to record lows while inflation went up only slightly. Democratic President Lyndon B Johnson initiated “The Great Society”, which involved huge government expenditure to boost growth and lower unemployment. In the 1969 Economic Report of the President to the Congress, the Phillips Curve was again used to justify the large deficit spending in infrastructure, war expenditure (Vietnam), education, Medicare and Medicaid and finally, welfare benefits. Notice that the unemployment rate was reduced from 7% in 1961 to less than 4% in 1968, with inflation increasing from about 1% to 4% in the same period.


Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Figure 2: The Phillips Curve used in the Economic Report of the President, 1969.

Then came the great stagflation. The first part of 1970s saw the US and UK economy go through something unusual that could not be explained by the Phillips Curve. Inflation and unemployment both increased simultaneously. This peculiar phenomenon was called as stagflation (a term coined by British Chancellor of the Exchequer, Iain McLeod to denote stagnation plus inflation). The US stagflation is wrongly attributed, even today in most economic textbooks, to the infamous oil price shocks in the early 1970s. However, that is simplistic and flawed reasoning. The real cause of the episode of stagflation in the US is the buildup of inflation momentum. By the time of the OPEC oil shock, inflation in the US had doubled from 3% to 6% due to the expansionary fiscal and monetary policy followed in the 1960s. The high US inflation caused the dollar to depreciate in the world markets and since oil was invoiced in dollars, the OPEC was forced to increase their prices.

The Long Run Phillips Curve

The US stagflationary episode is better explained by the Expectations Augmented Phillips Curve (EAPC). The Chicago School monetarists led by Milton Friedman deconstructed the inflation-unemployment tradeoff suggested by the Phillips Curve.  The EAPC demonstrated that the Phillips curve tradeoff holds true only in the short run and it turns vertical in the long run. The policy implication of the long run Phillips Curve is that though lower levels of unemployment can be achieved in the short run by compromising on inflation, in the long run, both inflation and unemployment will end up being higher. This is shown in the graph below. Taking 1981 as the end period (before Paul Volcker’s war on inflation in the 1980s), it can be seen that unemployment has increased by half a percentage point, while inflation has increased by about 8 percentage points from 1961.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Figure 3: The long run vertical Phillips Curve noticed in the US, where both unemployment and inflation increased.

Theoretically, in a long enough period, there can be several short run Phillips curves where high GDP growth rates can be achieved with small increases in inflation. In the long run, however, the Phillips curve will be vertical, denoting that there is no tradeoff between the two variables.

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

The Long Run Phillips Curve shows that any policy that tries to reduce unemployment/increase GDP growth rate at the cost of higher inflation will end up with both a higher inflation rate and higher unemployment (lower GDP growth) rate in the long run. (Image source: bized.co.uk)

Relevance Today:

Due to the inherent nature of democratic cycles, most policy makers in developing countries still try to trade off high GDP growth rate with inflation. Since the political term is for five years, there is a tendency to ride on the short run Phillips Curve. Furthermore, the level of economic activity (GDP) reacts much quicker than inflation – it takes time for the population to adjust their inflation expectations and renegotiate their contracts. Thus, it is always tempting for policy makers to push through policies that increases GDP growth rate immediately (especially, if the elections are around the corner) and worry about inflation in the next term or leave it as a parting gift for the next government.

India saw incredible growth rate between 2004 and 2009 mainly because of policies (both monetary and fiscal) that pushed the GDP growth rate above its potential GDP (See post on Potential GDP). Expansionary fiscal policy through increased welfare spending (MGNREGA, MSP, etc) along with interest rate cuts by the RBI (through sustained pressure by the Finance Ministry) saw GDP growth rates touch 9% for three years. The long run Phillips curve took effect after 2010 where India underwent a stagflationary period of increased inflation and lower growth.

Much of India’s fiscal policy still aims to take advantage of the short run Phillips curve, despite the knowledge of the consequences it entails. This is precisely the reason why leaving monetary policy in the hands of the government will have disastrous effects. The inherent growth bias in politicians will naturally opt for lower interest rates to push up growth. An independent central bank is not prone to time bound election pressures and will thereby maintain price stability in the long run, which, by itself is conducive to sustainable growth.

Anupam Manur is a Policy Analyst at the Takshashila Institution. He tweets @anupammanur

Read Part II Here

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Problems with Movement of Goods Within India

The quality of the road network infrastructure in India is in need of drastic improvement and better coordination among regulatory authorities can reduce the delays in travel times.

The biggest markets in the world, i.e., the largest concentration of people in a geographic entity, are China, India, US and the EU. With such large markets, internal trade should account for a significant portion of overall economic output. However, internal trade in India accounts to less than 15% of GDP, which is one of the lowest in the world. The Eurozone does slightly better with internal trade accounting for 20% of GDP, in China it hovers around 35% of GDP and in the US, internal trade forms 40% of GDP.

The low share of internal trade in India can be explained by many factors. Complex, varied and multiple tax structures in different states. Laws and regulations also differ from state to state which increases transaction and compliance costs, which are then passed on to the consumers. Agricultural commodities and manufactured commodities have their own set of problems. However, a very practical and big constraint in the movement of goods within India is the state of road infrastructure, which this post shall try to highlight.

India has the second highest road network in the world, spanning over 4.7 million kilometers, which easily makes it the most important mode of transportation in the country. It carries over 60% of the country’s total freight traffic and about 85% of the passenger traffic. While this is impressive in its own right, the state of roads in India actually falls behind the requirements. One way to measure this is to calculate the volume of road freight growth in India and the corresponding growth in expansion of the road network. While road freight volume and the number of road vehicles have been growing at a compounded annual growth rate of 9.1% and 10.8% respectively, the growth rate of length of roads lags behind at 4%.

Further, most of the road network in India is rural roads that do not allow the smooth transit of heavy vehicles meant to transport goods across states. The share of motorways/expressways and national highways in the total road network is abysmal when compared to many developing and developed countries. India has only 1.7% of its total road network in the form of expressways and highways, whereas the corresponding figure for the US is 5.7%, UK – 12.6%, South Korea – 16.9% and China 2.6%.

This results in lower truck speeds and delays in transportation of goods across the states. India has one of the lowest average speeds for trucks. This table below, taken from a report by Ernst Young and Retailers Association of India (2013), shows different parameters to gauge the efficiency of the transportation system in India.

Different indicators of efficiency in road transportation

Different indicators of efficiency in road transportation

Apart from the lack of good physical infrastructure, the regulatory structure in India causes many more delays in road transportation. India’s trucks spend only about 40% of their time moving on the road. The rest of the time is taken up at checkpoints and tollgates. A McKinsey report and a EY summit with FICCI confirms that India spends nearly 13% of its GDP on logistics.

A sample of the different checkpoints and detentions for trucks on national highways.

A sample of the different checkpoints and detentions for trucks on national highways.

A World Economic Forum Report observes that “a truck carrying goods from Gurgaon to Mumbai has to pass through 36 checkpoints and takes up to 10 days to reach its destination.”

“Vehicles are frequently detained for checking essential documents, like sales tax, payment of market fee, octroi, entry permits, law and order concerns, protection of environment and the endangered species etc. Besides, there are numerous other reasons under different legal provisions that can detain a vehicle, like check on the movement of essential commodities, food adulteration and hazardous chemicals etc. These checks are generally conducted by respective agencies at separate points, resulting in more than one detention. There exist flying squads or surprise checking teams other than normal checkpoints, who are empowered to stop and check the vehicle at any point within their jurisdictional limits and detain it for any violation” notes a Ministry of Agriculture Report on Removal of restrictions on internal trade in agricultural commodities.

Better coordination between the various agencies involved in checking for regulatory compliance can reduce the number of stoppages and improvement in travel times.

In order to develop inter-state trade within India and make India a manufacturing hub, it is imperative to fix the structural infrastructure issues, both in terms of the quality of roads and the number of stoppages due to regulatory checking.

 Anupam Manur is a Policy Analyst at Takshashila Institution and tweets @anupammanur

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Divergence between Wholesale and Retail Inflation

The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently.

There are two measures of inflation in India: the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). As the name indicates the WPI measures prices at the wholesale level and CPI at the consumer level. Beyond the basics, the number and types of items included in the WPI and CPI basket differ and so does the weights given to these items. Primary articles, consisting of food articles such as cereals, meat, fish and vegetables; and non-food articles such as cotton, cooking oil, jute and minerals, etc are given a weight of about 20% in WPI. The second sub-group is fuel and power, which is given a weightage of 15% and finally manufactured items consists of 65%. In the CPI basket, there are five main sub-categories, which are Food and beverages (35.8%), Fuel and Light (8.4%), Housing (22.5%), Clothing, Bedding, and Footwear (3.9%), and Miscellaneous group which includes services (28%).

Given that the CPI measures retail prices, it is bound to be higher than the WPI, which measures wholesale prices. This has been the case for a long time now and is not a cause for concern as long as both the indices are moving in the same direction. The central bank can gauge the general trend of inflation. However, the latest WPI data available for June was at -2.4% and CPI inflation was at 5.4%, a whopping 7.8% difference. There has been significant divergence between the two indices since November 2014, with the WPI steadily dropping and the CPI inflation crawling upwards, as this graph indicates.

The WPI and CPI have been moving in diametrically opposite directions recently.

The WPI and CPI have been moving in diametrically opposite directions recently.

The exact reasons for such a sharp divergence remain unknown. Mr. Subbarao, former Governor of RBI admitted that “We do not yet have a full understanding of the process by which wholesale price changes are transmitted to retail prices or of the magnitude of the associated pass-through and lags.”

The divergence between the wholesale and retail prices could indicate that there is an increasing inefficiency in the supply chain between the farmers, producers and the end consumer. The middle man might be making gains. Another reason could be that one of the indices is seriously wrong or is not capturing what it should.

Another cause is the structure of the different baskets. As nearly 65% of WPI is made of manufactured goods, reduced global oil and energy prices would have played a big role in lowering costs. Also, there is a general slack in the manufacturing sector in India at present, which is corroborated by low and falling IIP numbers. For the CPI, prices of food, housing and services, the three big components, have not shown any indications of easing.

It is also important to note that WPI index is usually the lead index and CPI lags behind. It takes time for the wholesale prices to pass through to retail. Historical data indicates that CPI usually converges with WPI after a considerable lag.

Regardless of the cause for the divergence, it has serious implications for monetary policy decisions. While the RBI solely focussed on the WPI before the current Governor, Raghuram Rajan took office in 2013, it now focuses unilaterally on the CPI as the leading indicator of inflation in India. Arvind Subramaniam, the Chief Economic Advisor to the PM commented on this, asking the RBI to consider both WPI and CPI while making a decision on interest rates.

Both wholesale prices and consumer prices are important, but to different agents. Consumer behaviour is usually a response to the trajectory of retail inflation but companies decide based on wholesale price movements. The large magnitude of the divergence between the two indices makes it difficult to assess the inflation dynamics in India presently and makes it harder to take a decision based on contradicting data.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Distortionary Public Policy

Bad public policy creates severe distortions in the economy, can lead to macroeconomic imbalances, and often has large societal costs.

Badly designed public policy can cause a lot of harm. It can cause severe distortion in the economy, misalign incentives, and finally produce bad outcomes in the economy and society at large. Take one example of a large US federal scheme that is worsening the drought conditions in the West coast.

The US states of California and Arizona are facing one of the worst droughts in recent history. It has received sparse rainfall in the past four years, less than 34% of expected rainfall, and there is a severe water shortage in the desert land. With experts claiming that the drought like situation could last for a few more years to come, this has already been termed as a ‘megadrought’.

California Drought: Before and After

California Drought: Before and After

Exacerbating the natural crisis is the pattern of agricultural land use. The preference of most farmers in the region is to grow cotton, which is one of the thirstiest crops, in a desert landscape. Each acre of cotton planted here demands six times as much water as lettuce and sixty percent more than wheat. That precious liquid is pulled from a nearby federal reservoir, siphoned from beleaguered underground aquifers and pumped in from the Colorado River hundreds of miles away. Ironically, billions of dollars have been spent on building reservoirs, aqueducts, and power stations to push water from the Colorado river to the dry states of Arizona and California. Similarly in California, production of almonds, another exceedingly thirsty crop, is expanding and it now accounts for nearly 80% of global production. However, it also consumes more than 10% of the state’s annual agricultural water use – or more than what the entire population of Los Angeles and San Francisco use in a year.

The reason that farmers are growing water thirsty crops in the middle of the desert during a harsh drought like situation is basically misdirected government policy. A relict from the dust bowl era in the 1930s, the US Farm Bill, provides misdirected incentives to farmers to grow certain crops, though it may not be in the societal interest at large. No American law has more influence on what, where and when farmers decide to plant. And by extension, no federal policy has a greater ability to directly influence how water resources are consumed in the American West.

The Bill offers monetary incentives to farmers planting cotton seeds in the ground; it also provides heavily discounted loans, which they do not have to repay in case the crop fails. Further, the government provides insurance cover on the entire cotton crop, guaranteeing that the farmers will be financially protected even when natural disasters like drought prevents a good harvest. In total, farmers in Arizona and California have received $4.1 billion in cotton aid.

The subsidies are bad enough in creating a fiscal strain and in creating incentives that draw farmers away from growing other crops. Also, due to the implicit government guarantee on the crops, banks are more willing to lend to farmers growing cotton than any other crop. However, the bigger damage it does is in distorting water usage and providing incentives to use more water than would be used in an open market. The final push comes in the form of providing water all the way from the Colorado River, a distance of 230 miles, for a minimal price. The government is also considering building a billion dollar desalination plant to purify ocean water and feed the crops.

If farmers were charged for the water, as well as for the cost of transporting water (using generators to pump the water, cost of building the infrastructure, etc), no farmer would even consider planting a water intensive crop.

In their textbook, Tyler and Alex Tabarrok dwell on this subject:

Farmers use the subsidized water to transform desert into prime agricultural land. But turning a California desert into cropland makes about as much sense as building greenhouses in Alaska! America already has plenty of land on which cotton can be grown cheaply.  Spending billions of dollars to dam rivers and transport water hundreds of miles to grow a crop which can be grown more cheaply in Georgia is a waste of resources, a deadweight loss. The water used to grow California cotton, for example, has much higher value producing silicon chips in San Jose or as drinking water in Los Angeles than it does as irrigation water.

Closer to home, there are several governmental agricultural policies in India that have similarly changed the incentive structure for crop choice. The Minimum Support Price, the minimum price paid by the government to the farmers for their produce, has introduced severe economic distortions. Rice and wheat have a higher MSP than most other crops, which naturally tilt the preference of farmers towards them; rice is a fairly water intensive crop and despite this, it is grown in arid areas across India. Pulses, which do not get much support from the government, are not grown in adequate quantities. There is a chronic shortage of pulses on the Indian market, prices have risen and it has to be imported in large quantities.

As the example of Farm Bill and MSP show, bad public policy and unnecessary government intervention creates severe distortions in the economy, which leads to macroeconomic imbalances and often has large societal costs.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Snippets from the Greek Crisis

The Greeks are holding a referendum and the consequences from the vote is an event horizon

It is alarmingly close to a Greece exit from the Euro as the deadline for Greece repaying the €6.74 billion to the Troika is approaching. The Syriza government refuses to accept the bailout package with the conditionality of excessive austerity measures and the Troika is unwilling to back down and extend the deadline or give fresh bailout money without imposing conditions. This post last week explained the exact conundrum that Europe finds itself in.

As predicted, stock markets across Europe have plummeted. Capital controls have been imposed in Greece. A bank run is on the way, with hundreds of people queuing outside ATM kiosks across Greece. In order to counter the bank run, all commercial banks will be shut for a week and there is a cap of €60 withdrawal.

As discussions between the Greek government and the Troika have broken down, the choice of accepting the austerity measures lies with the people of Greece.

Greece calls for referendum (Greferendum):

Prime Minister Alexis Tsirpas, in a surprising move, decided to hold a referendum to ask the Greek people if they should accept the bailout money with the conditions of further austerity. He claims that it is the “sovereign democratic right of the Greek people, necessary to ensure ownership over the financial assistance programme that will be eventually agreed with the institutions”. Needless to say, the EU, ECB, IMF and the private creditors did not take to the idea.

Wording of the Greek Referendum Ballots:

The exact wording of the referendum is highly unclear and it would make Greek voters more confused than they already are.


This is what it translates to (supposedly in English):

Should the plan of agreement be accepted, which was submitted by the European Commission, the European Central Bank, and the International Monetary Fund in the Eurogroup of 25.06.2015 and comprises of two parts, which constitute their unified proposal? The first document is entitled ‘Reforms for the completion of the current program and beyond’ and the second ‘Preliminary debt sustainability analysis’.”

Not Accepted/NO


One can readily imagine that the two documents outlined in the ballot are not any clearer than the wordings of the ballot.

Positioning the choices – Government nudge?: There has been quite a bit of criticism against the positioning of the choices in the ballot paper. The format for the ballot paper is quite unusual as the government has decided to present the ‘No’ choice, which is what the present Syriza government wants, above the ‘Yes’ choice.

Logistical Issues: In a slightly ironic development, the Greek government may not have the money to conduct the bailout. The referendum will cost around 110 million Euros, which the Greek government cannot afford. Further, the Athens Chamber of Commerce added there is no paper to print some 20 million required ballots!

Significance of the Yes/No Vote: The Troika and the Greek opposition party are emphasising that a No vote would essentially result in Grexit. The European Commission Chief Jean-Claude Juncker passionately pleaded for the Greeks to vote ‘Yes’, so that Greece need not exit the Euro.

However, Mr. Tsirpas clearly believes that a No vote does not imply that Greece has to exit. He is calling the Troika’s bluff on the basis that a Greek exit would be too costly for them and thus, they have no choice but to relent on the push for austerity measures.

Ultimately, the events after the 30th of June, 2015 remain an event horizon.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Deadly Taxes

The high ‘sin tax’ on liquor drives people to look for cheaper and unfortunately, fatal alternatives

It is that time of the year again where another hooch tragedy has occurred, the dead are counted, state compensation is given to the kin, few are arrested, political blame game ensues with no real consequences, and we move on till the next time the cycle repeats itself. The death toll this time has gone up to 97 and the opposition is demanding Maharastra Chief Minister Mr. Fadnavis’ resignation. An inquiry has been set up, the police claim that they have caught the main culprits and that justice will be meted out. Those caught will be tried and prisoned and within no time, others will take their place. The makers of hooch are suppliers of a commodity that is high in demand. This high demand for the illicit liquor makes it a profitable venture to produce the commodity. So long as the demand is high, the supply will exist.

The real question to ask then is regarding the cause behind the high demand for illicit liquor. One of the main reasons why the poor decide to drink illicit liquor is because they cannot afford to buy packaged, manufactured and regulated alcohol. There are different categories of alcohol available in India: the most expensive are the imported ones, which attract heavy import duty and other taxes, then, there is the Indian Made Foreign Liquor (IMFL), country liquor and finally, illicit liquor.

The customary police raid and destruction of illicit liquor bottles after the tragedy.

The customary police raid and destruction of illicit liquor bottles after the tragedy.

While the imported liquor and IMFL are firmly out of reach of the daily labourer’s budget, he often cannot afford even country liquor and it might not be easily available. Country liquor is produced in cottage industry type of setting and was recently brought into the regulatory fold. Many southern states have completely banned country liquor and others are beginning to impose strict regulation and taxing it heavily.

Like a typical patronizing welfare state, heavy taxes are levied on alcohol to prevent people from over-consuming the substance and thereby, prevent health hazards and societal evils. While the intention might be good, the outcome, as is the case more often than not, has not been desirable. A look at the Maharastra tax structure on liquor reveals the extremely high rate of tax levied on regulated alcohol. The excise duty on IMFL is 300% of manufacturing cost and on country liquor, the excise duty is upto 250% of manufacturing costs. It is these high tax rates that explains why large factories which enjoy significant economies of scale produce liquor which is more expensive than home-made liquor produced in small quantities.

The high rates of tax is levied by the government in order to make the relative price of alcohol higher than other products, which, in theoretical economics, should reduce the product’s demand. However, it is a known fact that high taxation on alcohol and tobacco products does not deter people from its consumption. Instead, they move to cheaper alternatives. Of course, the other reason for high taxation is that it continues to be a strong revenue earner for the various state governments. Nearly 10-15% of state government revenue comes from excise duty on liquor and another huge chunk from the tax on tobacco products.

While the government might feel that it is its moral obligation to levy a ‘sin tax’ on harmful products to prevent its use, it might not realize that its morality is driving people to illicit liquor and consequently, death.

P.S: For an excellent discussion regarding the ineffectiveness of using taxation to influence public consumption behaviour, read Catalyst’s post on “Taxing our way to better health“.

Anupam Manur is a Policy Analyst at Takshashila Institution. He sporadically tweets @anupammanur

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The Economic Consequences of Debt Repayment

If either the troika or the Greek government does not blink, a Greek default on its loans and exit from the Euro (Grexit) is a very real possibility.

With about €320 billion involved, the standoff between the left wing Syriza Government in Greece on one side and the IMF, ECB and the European Union (collectively known as the Troika) on the other makes it the most glorified and high risk game of chicken played. Monday, the 22nd June, presents one of the last opportunities for a deal to be brokered between the two sides and neither side is willing to back down and give in to the other’s requests.

In short, the situation reads thus: Greece has an outstanding debt of about €320 billion to various creditors. Recognising its inability to pay the amount, in 2010 and again in 2012, the IMF, the EU and the ECB decided to formulate a bailout package totally amounting to €240 billion. However, this money would be given to Greece only on the condition that it makes wide sweeping reforms and introduces a severe austerity drive. Further, 9 out 10 Euros from this bailout package will be used to pay back the creditors and not for Greek citizens. In June, Greece owes about €6.74 billion as part of its monthly debt repayment schedule (about €1.5bn to the IMF) and it does not have the resources to pay for that, while the last tranche of the bailout package worth €7.2 billion is also due to be given to Greece. While this situation is complicated enough, throw in a bit of political economy to the mix and there exists a true conundrum for everyone involved. The present government came into power in the last election in 2014 on a strict anti-austerity platform. It refused to prioritize repaying the creditors by cutting back on government expenses towards citizens’ welfare.

The IMF refuses to hand out the last €7.2 billion of the bailout package unless Greece undertakes severe austerity measures and also pays back the €6.74 billion that is due by the end of the month. The Greek government, with tremendous support from the citizens, refuses to take either action.

If one of the sides does not blink – the IMF extending the deadline for Greece to pursue fiscal consolidation and debt repayment or the Greek government undertaking reforms and paying part of the bailout money to its creditors – a Greek default on its loans and exit from the Euro (Grexit) is a very real possibility.

The IMF and Germany would do well to revisit Keynes’ classic work “The Economic Consequences of Peace” (1919), where he hinted at the possible consequences of the Allied countries extracting huge sums of money as reparations for the war (WWI) damages from Germany. He had rightfully explained that Germany will have no means to pay back the sums demanded by the Allied countries, especially given the economic downturn they were facing, except by resorting to the printing press. The predictions came true later on as Germany printed large sums of money in an expansionary monetary policy, which later resulted in hyperinflation, political upheaval, economic chaos, etc. The consequences of this are well known.

In this game of who blinks first, if neither of them blink by the looming deadline, everybody loses.


There is a chilling parallel here. If Greece defaults and exits the Euro, there will firstly be a bank run, where depositors will rush to withdraw their savings from the banks. This will result in a loss of liquidity. In the past few days, hundreds of Greeks are queuing up outside the cash points, in order to withdraw their money, in anticipation of a financial crisis. This will only worsen as the deadline approaches. Further, there will be a new, deep and prolonged recession. It would also be forced to go back to printing its own currency, the Drachma, or some other variant of it. Its financial system will collapse in the wake of a liquidity crunch and loss of access to the ECB. The Independent explains: “To prevent these institutions collapsing Athens would have impose controls on the movement of money out of the country. The international value of the new Greek currency would inevitably be much lower than the euro. That would mean an instant drop in living standards for Greeks as import prices spike. And if Greeks have foreign debts which they have to pay back in euros they will also be instantly worse off. There could be a cascade of defaults”.

This will obviously have a contagion effect, where banks, financial institutions and governments who are over exposed to Greek debt will lose their principal amount. The Euro currency and Euro stocks will crash, which can have renewed negative consequences for a world economy just recovering from the previous recession.

Thus, in this game of who blinks first, there is a unique scenario, where if neither of them blink by the looming deadline, everybody loses.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur


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Demonetising a currency

Adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by massive corrections in the macroeconomic fundamentals.

 The Central Bank of Zimbabwe announced that it would officially demonetise the Zimbabwean dollar with effect from 15th June 2015. Any bank account in the country which holds between zero and 175 quadrillion Zimbabwean dollars will get a flat amount of US $5. This, in effect sets the exchange rate at US$1 = Z$ 35,000,000,000,000,000

Demonetisation is the process whereby a currency of a country officially loses its status as legal tender. The Zimbabwean dollar’s usage was effectively abandoned in April 2009 itself, but was still recognised as legal tender. Legal tender or fiat money is the official status given to a currency by the central bank, whereby all citizens of that country are obliged to accept it as a means of exchange.

Demonetisation has often happened in the past. Germany has demonetised at least thrice in recent history – from Papiermark to RentenMark; from Reichsmark to Deutchemark to finally from Deutchemark to the Euro.

The process of demonetisation was seen when several European countries abandoned their national currencies to be replaced by the Euro. The other big event of demonetisation process happened with regard to gold, when the US officially closed the gold window in 1973, thereby ending the decades long gold exchange standard/Bretton Woods system.

Apart from these one-off occurrences, the process of demonetisation usually happens after a country goes through a process of hyperinflation and the currency becomes worthless. Zimbabwe’s episode of hyperinflation in 2008, where inflation rates were as high as 231 million percent, caused the Zimbabwean dollar to collapse in value. It was impossible for normal trade to occur with the national currency, as a loaf of bread cost Z$1.6 trillion at one point. As a result, currencies such as the US dollar, the South African rand and the euro were widely circulated and used in Zimbabwe.


A hundred trillion Zimbabwean dollar note


Demonetistion is usually the last step in the fight against hyperinflation. It is the official acceptance from the central bank and the government that its currency is of little or no value and acknowledgements of its failure. Thus, demonetisation is undertaken only at severely extenuating circumstances. Countries usually try to redenominate the currency first. Redenomination is the fixing of a new value for the existing currency. Operationally, it is the equivalent of knocking of a few zeroes from the value of the currency. For example, Zimbabwe tried redenomination four times since 2006. In the first redenomination Zimbabwe removed three zeroes from the value, 13 zeroes in the second redenomination and a further 12 zeroes in the third redenomination. However, bad macroeconomic fundamentals and a bad fiscal and monetary policy framework ensured Zimbabwe’s journey further into hyperinflation.

Once a currency is demonetized, the country has two options left: 1) Dollarization/Adoption of a foreign currency – This is when the country adopts the currency of another country as its own, which effectively translates into abandoning independence in monetary policy. The monetary policy of the adopted currency become applicable and binding on the country adopting it. Usually, the dollar is adopted, but not necessarily so always. 2) Introduction of a new currency – Eventually, the country might choose to introduce another of its own currency and have a preset exchange rate with the old currency/dollars. This is done to regain independence in monetary policy.

In the final analysis, adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by large scale corrections in the macroeconomic fundamentals.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Narendra Modi’s One Year – A review of reviews

By Anupam Manur and Devika Kher

In one year, the PM has made incremental changes to the economy, government structure, and foreign policy but the lack of the game-changing reforms expected of him renders the year marginally above average.

One year on, Prime Minister Narendra Modi’s performance has been under severe scrutiny and though the assessment has been mostly positive and hopeful of the coming four years, there is an underlying recognition that much more needs to be done in order to justify the overwhelming mandate.

Economic Performance under Modi

As per New York Times’s article by Ellen Barry, “India is now seen as a bright spot, expected to pass China this year to become the world’s fastest-growing large economy.” Prime Minister Modi entered the office at one of the most exciting time that the Indian economy has seen till date.

To begin with, almost all the dailies commonly acknowledged Prime Minister’s ‘luck’ with the oil price fall and discounted his contribution to the financial condition of the country. The Live Mint’s editorial article remarked on lower commodity prices bringing down inflation, fiscal deficit and the current account deficit. However, Raghuram Rajan is quoted by Barry as appreciating the government’s steps to create an environment for investment.

India also saw liberalisation of sectors untouched for a long time; limits on foreign investment in defence and insurance were both raised to 49 percent. The PM also deregulated the prices for diesel, petroleum and cooking gas. Live Mint also appreciated the PM’s move to avoid lavish increases in minimum support prices and the successful auction of coal blocks and telecom spectrums.

The improvement in economic performance has largely been attributed to positive global factors rather than the present government’s interventions. There have been no revolutionary game-changing reforms and the government is struggling to implement its Goods and Services Tax and Land Acquisition Bill, even in a diluted form. Surjit Bhalla, in his Financial Express column, is particularly critical of the confused tax policy. The retrospective Minimum Alternate Tax (MAT) has led to Foreign Institutional Investment outflow and a loss of confidence in the Indian economy. The data on FDI for the popular ‘Make in India’ campaign does not match the brouhaha. The Urbanization agenda also scores rather poorly, with no real activity on the ‘100 smart cities’ project. The government’s track record on education and health is not impressive either, as argued by Tavleen Singh. Another article in the Hindustan Times also severely attacked the government for reducing the budget in areas like food subsidies, health, education, etc.

Social Policies

Subir Gokarn’s one year report card in Business Standard positively assessed the progress on three critical structural challenges: food, infrastructure and employment.

The PM has, however, been applauded for the announcement of various social schemes such as the Pradhan Mantri Jan-Dhan Yojana and the Atal Pension Yojana that will improve the financial inclusion of the people. However, G. Sampath has dubbed these financial inclusion schemes as Modi’s war on welfare as they have come at the cost of poverty alleviating ones. While the MGNREGA and the Food Security Act were rights-based social provisions, the Pradhan Mantri Yojanas “put the onus of social security on those who lack it the most — the poor themselves”.

PM Narendra Modi and President Obama

Foreign Policy 

An Open magazine article by Brahma Chellaney commented that pragmatism, zeal and showmanship were the trademarks of the PM’s foreign policy. He describes the PM as a ‘a realist who loves to play on the grand chessboard of geopolitics’ and postulates that the foreign policy strategy is to revitalise India’s economic and military security. He does appreciate the PM’s “non-doctrinaire foreign-policy approach powered by ideas”. In a Hindu article, Chellaney states that “for a politician who came to office with virtually no foreign-policy experience, Mr. Modi has demonstrated impressive diplomatic acumen”.

The Diplomat’s two part review of the PM’s one year by Rohan Joshi complimented the PM on his efforts ‘to correct the faltering trajectory of India’s relationship’ with the United States and China and described them as “a positive departure from the past”. Joshi also acknowledged the PM’s attempt to strengthen relations with “Asian Sates that share India’s anxieties over China’s aggressiveness in its neighbourhood.” He goes on to commend the PM’s indifference to Pakistan and his work to build relations with Bangladesh.

It is generally agreed that Narendra Modi has been the most active PM in India’s recent history with regard to foreign policy. However, critics have questioned the timing and number of Modi’s foreign visits as it has left Modi with little time for domestic affairs. Chellaney points out that the Sri Lanka visit could have been extended till after their domestic elections and that his visit to China within 8 months of Xi’s visit to India can be considered too soon.

The Autocratic ruler

The PM’s micro-managerial style has come under intense scrutiny. The Economist ran a cover story on “India’s one man band” where the PM was appreciated for his move to devolve powers to the states. According to The Economist, this would help in creating a manufacturing boom in the country. However, the magazine contends that Modi’s biggest mistake is to believe that he alone can transform India.

The PM is however, having an impact on the bureaucratic culture in India. One of his first reforms was to push for the self attestation of documents. The fastidious whip of the PM has made the bureaucratic staff more efficient and punctual. According to the New York Times article, the PM has ensured that all business deals by ministries are routed through his office to remove the “informal meetings that business leaders used to hold with ministry officials.” This opinion was also backed by Mint, which dubbed the PM an effective administrator.

Brahma Chellany also supported this view by pointing out that the PM has realised the negative impact that corruption would have on internal security and foreign- policy options, and is seeking to bring it under control.

However, not everyone is happy with Modi’s style of governance. The biggest criticism against Modi and his government is that it is hard to distinguish between the two. Santosh Tiwari, in his Financial Express column, contends that the fallout from PM Modi projecting himself as the sole panacea to all of India’s woes is that there is a genuine lack of second rung leadership in the party and the government. The result is that the PM is the final authority on all matters, which hampers the ability of other ministers/leaders to act competently and independently.

Mihir S Sharma, in his acutely critical article “Wasting 282” in the Business Standard, argues that Modi has wasted the enormous mandate presented to him in his first year and attributes this to the lack of direction of top officials.  Ministers and bureaucrats are confused and pulled in different directions because there are no clear set of guiding principles from the PM. The PM insists that “hands-on, case-by-case action such as he delivered in Gujarat, is enough”. This explains the piece meal reforms and lack of big sweeping reforms.

The final word:

Given the nature and enormity of expectations, PM Modi’s government was bound to fall short. As Rajiv Kumar puts it “surprisingly, thus, at the end of one year, Modi finds himself facing disquietude and impatience from the middle, neo-middle and business classes who were his star supporters during the campaign”.  In one year, the PM has made incremental changes to the economy, government structure, and foreign policy but the lack of the game-changing reforms expected of him renders the year marginally above average.

Anupam Manur is a policy analyst at Takshashila Institute and tweets @anupammanur

Devika Kher is a Research Associate at Takshashila Institution. Her twitter handle is @DevikaKher

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Potential Output – Importance and Estimation

Potential output is of vital importance in macroeconomic policy making, despite imperfections in its estimation.

In order to have an effective monetary and fiscal policy, policy makers need to gauge the level of economic activity in the economy and whether this level is consistent with the potential level. In economic terms, policy makers look at the real output and its deviation from potential output, called the output gap. Potential output – the trend growth in the productive capacity of an economy – is an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use.  This is not a technical ceiling on the maximum level of output attainable. Rather, it is an estimate of maximum sustainable output – output that can be sustained in the long run without leading to macroeconomic instability.

While this may seem like a purely academic and statistical exercise, in reality, understanding and proper estimation of potential output has grave consequences for the economy. If actual output is lower than potential output, that is, if the output gap is negative, then the economy is performing below its potential – resources and capacity are underutilized and unemployment is higher than what it should be. On the other hand if the output gap is positive (actual output is higher than potential output), the economy is overheated, demand exceeds supply and inflationary pressures on the economy is high. As is self-evident, neither state is desirable. The manifestation of the output gap is usually through inflation in the economy. A positive output gap results in higher inflation and a negative output gap results in deflation.

For policy makers, therefore, understanding potential output and the output gap is of crucial importance. Negative output gap should ideally be followed by an expansionary fiscal and monetary policy, so as to increase spending and demand in the economy, which will result in actual output converging towards potential output. A contractionary monetary and fiscal policy is required in the case of a positive output gap to reduce the demand in the economy and to provide liquidity to the suppliers to increase their production.

Many central bankers around the world indeed use the concept of potential output in determining the rate of interest. In deciding the policy rate, central bankers use a popular rule of thumb called the Taylor rule, which reduces the complexities in choosing the interest rate to a formula that incorporates the difference between the actual and targeted inflation rate and the difference between the actual and potential GDP[1].

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

As can be seen from the graph, real GDP has exceeded potential GDP during the boom years in the late 1990s and has significantly fallen below the potential GDP after the recession off 2007. It can also be seen that inflation reacts to the output gap. Inflation is above the targeted rate of 2% when output gap is positive and vice versa.

Estimating Potential Output

Despite its overwhelming importance to policy making, there seems to be no consensus amongst economists regarding the best method to estimate potential output. Different countries and organizations use different methods based on country specific circumstances. However, no method has been able to provide consistently robust estimates and each method has its own set of lacunae.

The various methods of estimating potential GDP can be broadly classified into two categories: the production function approach and the statistical approach. The first approach, followed by the Congressional Budget Office, USA, relates the level of output to level of technology and factor inputs, namely capital and labour. Potential Output, thus, would be the output if both labour and capital are fully utilized in an efficient manner. This manner would also require certain assumptions regarding the specific form of the production to be made. Usually, a constant returns to scale production function, such as the Cobb-Douglas production function, is used.

However, for emerging market economies, where reliable data on labour and capital is unavailable, time-series statistical techniques have become quite popular. A widely used approach in the Indian context is the Hodrick-Prescott filter, which decomposes the actual real GDP into two components – a trend and a cyclical component – and potential output is proxied by the trend component.  In other words, the GDP growth rate has an underlying structural component (trend) and another component that is seemingly random due to natural variations in the business cycles and external demand and supply shocks (cyclical). The purpose of the statistical tools is to remove the cyclical part and project the long run potential GDP based on the trend growth rate.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

The graph below shows the estimates of output gap for India using various statistical techniques. While there are differences between the different techniques, broad generalizations can be derived: the economy was overheated for a prolonged period between 2005 and 2012 and has been in slack ever since.

Irrespective of which method is used, it is important to understand the shortcomings in these approaches. However, the presence of short-comings should not be a reason to undermine the immense importance of the concept of potential output in determining macroeconomic policies.

Anupam Manur is a policy analyst at Takshashila Institution. He can be found on twitter @anupammanur


[1] Specifically, it is: it = i* + α (πt – π*) + β (yt – y*), where it is the policy rate; πt and π* are the actual and targeted inflation rates, respectively; yt and yt* are actual and potential output, respectively; and i* is the federal funds rate consistent with on-target inflation and output.



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