India and the Mundell-Laffer policy mix

It was a pleasure again this past week to participate in the annual Santa Colomba Conference, convened and chaired, as it has been since its inception, by the Nobel economist, and my own guru, Robert Mundell.

This year’s theme was “The World Economy In Motion: Past, Present, Future”, as the world digests the rise of populism in America and Europe and continued economic pressures in the global economy. Hosted, as always, at Mundell’s palazzo in the rolling hills near Monteriggioni in the Tuscan province of Siena, by “Bob” and his family, the conference is a perfect venue to discuss ideas about the global political economy in a convivial yet intellectually charged setting.

Masterful overviews of the global situation were presented by, inter alia, the former International Monetary Fund (IMF) chief economist and former governor of the Bank of Israel, Jacob Frenkel, and the former IMF chief and Spain’s former economy minister, Rodrigo de Rato, among other notable members of the group. My Canadian co-author, James Dean, spoke about the populist challenges to the principles of globalization, drawing in part on our joint research.

For my part, with the privilege of speaking in the final session of the conference weekend, I gave an update on the Indian economic situation, touching on demonetization, among other topics, given the keen interest from those around the table. However, the organizing principle of my remarks was the concept of the Mundell-Laffer policy mix, drawing on seminal work in the 1970s by Mundell and his former student, Arthur Laffer (made famous by the eponymous “curve” describing the relationship between tax revenue and tax rate.)

Briefly put, from the perspective of the “supply side”, one can view economic policy (and reforms) in the context of three broad buckets—tax and spending policy, monetary policy, and regulatory policy. On the first, the goods and services tax (GST) is, of course, assuming good implementation, a major efficiency-enhancing tax policy reform—in other words, it offers the prospect of reduced distortion cost per unit of tax revenue raised—or smaller “Harberger triangles” in the parlance of classic Chicago School economics.

On monetary policy, the monetary policy framework agreement, which instantiates inflation targeting as the official policy regime under the aegis of a monetary policy committee headed by governor Urjit Patel, now brings India up to global standards. Whether one likes it or not, in a world of flexible exchange rates, inflation targeting remains the gold standard (if you will pardon the mischievous analogy).

Alas, many breathless critics of the Reserve Bank of India (RBI) on the Indian commentary scene understand neither inflation targeting nor the concept of lags in the effects of monetary policy, which are crucial to understanding that the success or failure of an inflation targeting policy regime must be judged once a sufficient span of time has elapsed, and the economy has settled into a steady state equilibrium. Passing judgement on last month’s rate decision based on this month’s realized inflation rate is hilariously bad economics, yet this was the tenor of much ill-informed commentary on social media in the past few days.

Fortunately, of course, I do not have to teach school at Santa Colomba on how inflation targeting works, as many of the members of the group were instrumental in developing and perfecting it. Frenkel, in particular, was most appreciative of India adopting inflation targeting, and commended the Indian government’s decision to do this.

On regulatory policy, I spent the bulk of my presentation delving into the various initiatives of the government in improving the “doing business” regulatory environment, which, too, will take time to bear fruit. As I put it to the group, Prime Minister Narendra Modi understands that rapid growth, and sustained job creation, can only be sustained with high and sustained growth in labour productivity, and this in turn will only occur if entrepreneurs and firms are unshackled from burdensome and growth-retarding rules and regulations, which have allowed the now defunct “licence raj” to morph into an almost as pernicious “inspector raj”.

Other promising economic policy initiatives of the Modi government to which I drew attention include the heroic work being done by governor Patel and his team at RBI to deal with the spectre of non-performing assets on the books of banks, and the equally commendable work of vice-chair Arvind Panagariya and his team at NITI Aayog to push forward the disinvestment agenda.

India could well take a leaf from the US of the 1980s, the period in which Mundell’s ideas, and those of his disciple Laffer, took root, during the administration of president Ronald Reagan. It is customary to give credit to Mundell’s former Chicago colleague, the late Nobel economist Milton Friedman, for pushing deregulation, and such credit is deserved, but few laypersons understand the profounder impact of Mundell on bringing about the combination of tax cuts, sound money, and deregulation.

India could do no better than look to inspiration from the ideas of Mundell as we continue our journey from socialism to the market. If we succeed, India, like Mundell himself will then be able to say that we did it “our way”