Former central banker Raghuram Rajan speaks to ProMarket about how sources and remedies for inflation differ from the US in developing countries such as India and Brazil. He also suggests governmental reforms for business growth, unemployment, and international sanctions.

While the world still grapples with the Covid-19 pandemic, new challenges have surfaced in the last few months: Russia’s invasion of Ukraine has exacerbated a global post-Covid-19  cost-of-living crisis, leaving the poor in both the developed and developing worlds struggling to access food and fuel. 

In an interview with ProMarket, economist Raghuram Rajan speaks about the different challenges facing the developed and developing worlds. Dr. Rajan is a professor of finance at Chicago Booth. He was the governor of the Reserve Bank of India (RBI), the Indian central bank, between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist at the International Monetary Fund.

In this interview, which has been condensed for length and clarity, Dr. Rajan speaks about the long-term economic and political consequences of inflation, the risks of sovereign bankruptcies in South Asia and developments in the world of central banking that one must be wary of.

Q: Id like to start with the question of inflation. Youve written and spoken about the causes and effects of inflation in the US and the developed world, but much of the developing world is also facing inflationary shocks. Do you think the origins for this are different in emerging economies, and so should the solutions? Alternatively, with central banks like Indias reluctance until recently to address price rise, are we looking at higher tolerance for inflation now?

I don’t talk about monetary policy in India but I can speak about inflation’s implications for the developing world. Clearly, what’s happening in the developed world is that there is genuine excess demand relative to available supply. You can see this in the tight labor markets. Chairman Powell keeps referring to the 1.9 available jobs for every unemployed worker: that’s a suggestion of how tight the labor market is.

One reason this is so tight, especially at the lower end, is that older workers—64 years and above—have stayed away from the labor market. Another is that there is a regional mismatch between where the jobs and workers are. But particularly important is that immigration has been low in the last two years, with fewer people coming in to fill jobs at the lower end, so the market for relatively unskilled workers is tight. This has created some wage pressure there.

Since anybody who wants a job now can get one with a reasonable income, spending has been strong. Firms have been able to pass through price increases without seeing a significant fall in demand. That’s the traditional inflation happening now in industrial countries.

In emerging markets, it’s a little different. I would say there is some element of supply constraints, partly because of global supply chains being snagged, partly because of commodity prices rising, but partly also because, in countries like India and Brazil, the upper-middle class has a lot of spending power while the lower middle class hasn’t done very well during the pandemic. So there you might see some elements of inflation skewed towards the things the upper-middle-class spends on.

The big problem is that this kind of inflation, even if it originates from supply constraints, remains high, it becomes more generalized inflation and then you get problems with wage-price spirals and so on. Already you see high wage growth in certain sectors of the Indian economy, in tech for example, though this is driven more by global demand than local. I think in general the fear in the emerging world is that this is not classic demand-push inflation, it has some elements of it and the added supply constraints mean that you have to make demand correspond more to supply.

“We may need slower growth if you want reasonable levels of inflation.”

Q: What do you think central banks in emerging markets should be doing in response? Are they reducing the money supply fast enough?

Countries like Brazil have been raising interest rates for some time to slow down demand and make it balance better with supply. That is the general reaction across the emerging world. These are not countries necessarily with very high growth and they may want more growth.

Q: Isn’t that where the tension is, though? Between balancing recessionary trends post-Covid-19 with runaway inflation?

I don’t think there’s a post-Covid-19 recession in South Asia; the recovery is far slower than expected compared to how far and how quickly it went down during Covid-19. In general, the problem is that the economy can only grow as fast as it is capable of growing, and to the extent that the supply side is damaged either within the country or globally, demand has to adjust. We may need slower growth if you want reasonable levels of inflation.

Q: Do you see governments in emerging economies willing to accept this trade-off? 

Unless they can significantly ramp up the rate of reforms to energize growth in other ways. On the fiscal side, many governments are stretched by past debt. But perhaps on the reform side, they can create changes that can energize growth more.

Q: What kind of reforms are necessary?

Typically, reducing some of the constraints on business creation. In the US, you’ve seen a lot of business creation during the pandemic, people are getting more entrepreneurial. Finding ways that credit can expand without creating non-performing bank assets, improving the credit delivery process, and reducing some of the red tape that surrounds labor hiring; there are a bunch of reforms one can think of, you have to do it carefully and negotiate with the relevant stakeholders to make it happen. If done, this could increase the pace of growth and may be the only option left for a number of emerging markets because you can’t press the monetary accelerator and you certainly don’t have much fiscal room left.

Q: I think what we’re seeing instead is that countries are becoming more insular post-Covid-19, battening down the hatches so to speak, imposing trade tariffs, etc. 

I think you are right and they are becoming more insular, usually because of bad economics. It’s always simplistic to think “I can raise my tariffs and I create growth.” Well, in reality, I don’t create growth, just rents for my existing industrialists, and I don’t increase the pace of growth significantly over time. You create the illusion of protecting national champions and creating national champions, but if you look at the growth picture, not much changes.

You’re offering big subsidies and tariff protections to industrialists, at the expense of the local consumer. But all this is disguised as patriotic nationalist economics—imagery, which, I think we’ve seen happen before in the world and it’s happening again now in too many countries.

Q: Another cause for worry is the high rates of unemployment in India, especially among the youth. This joblessness leads to discontent and a breakdown of communities. 

That is a real danger: that unemployment rates stay high, especially for the lower middle class and that creates more inequality and divisions, and (room for) entrepreneurial politicians who cater to these divisions. (Perhaps they say) “let’s focus on recovering these former Hindu temples which now have mosques (standing there)” rather than focusing on actually enhancing jobs.

I do think what India needs is a program of strong, sustainable and equitable growth, that brings together all minorities, including women and Muslims, into the fold and takes them along. Otherwise, these tensions will just grow.

If we focus on just the Indian growth number right now, we’re not doing too badly apart from the dramatic plunge during the pandemic but if you add in that the women’s labor force participation is worse than in Saudi Arabia—people don’t believe me when I say this—these are pressing issues that need to be solved.

Q: Economically, South Asia seems to be dealing with a lot of volatility. Sri Lanka is bankrupt, and Pakistan is on the precipice. What ripple effects do you expect in the Indian economy or the subcontinent? Does India have a moral imperative to send more aid to its neighbors?

I don’t think the direct ripple effects (for India) will be that large or obvious, apart from the possibility of economic refugees. I do think that unstable societies on your borders, with neighbors who are hungry or don’t have fuel to heat their homes or to cook their food, makes for a very volatile neighborhood. We already have enough problems of our own without having a neighborhood that’s going to become more radicalized. Unfortunately, the consequence of normal systems failing is a radicalization of the politics and of societies. People who are cold or hungry have very little to lose. When I was at the RBI, we made emergency loans to Sri Lanka. It was an attempt to be a friend in need, but of course, they were not as indebted then as they are now.

Vis-a-vis Sri Lanka, India is definitely making some loans to buy fuel, send food, and so on. I think the worry from India’s perspective on the debt side is that Sri Lanka has an enormous amount of debt and if we are treated pari passu with everybody else, then we will only get a fraction back of the money we are lending now for humanitarian reasons. So there has to be some kind of guarantee provided by international organizations or other creditors that this money will not be treated on par with existing debt. But other kinds of aid—like sending food—are things we should do with the aim that it is necessary for goodwill in the neighborhood. As the biggest economy (in the subcontinent), if we want their friendship, we should be a friend in need.

Q: As a former central banker, I’m curious what you think about these global conversations, particularly in Europe and the US, about seizing central bank assets, in the context of the Russian invasion of Ukraine. Isn’t this worrying?

Anything that creates uncertainty about property rights is problematic. What I would like, however, is for there to be a process, as structured and clear as possible, for when something like this could happen.

The problem is when you don’t have such a process and it is based on a few countries or their legal systems deciding on this, that leaves countries that have to accumulate reserves in order to protect their own economies vulnerable. It also leads to a lot of gaming within the international economy, for example: “how do I invite your prized banks into my system so I can use them as hostage if you use my financial assets as hostage?” That becomes a spiral downwards.

I would prefer that we think of the consensus that is needed for something like this to happen and what legal hurdles it has to pass, so that countries have some confidence that this will not happen when they simply differ politically from countries that hold their reserves. It can’t be done on a whim.

I think it would be in the interest of developed countries also that they build these safeguards. Otherwise, people are going to be reluctant to hold their bonds as reserves.

Q: And you hold a similar view on allowing bond repayments during sanctions?   

That’s a slightly different level. I think the whole process of sanctioning should have some checks and balances on it. Typically, you want some oversight so that these things aren’t done in a moment of passion. We do know that not every US administration is methodical or careful in its actions. I would hate to hold reserves if some angry president can essentially sanction them at a moment’s notice. I would think it’s in everybody’s interest to develop some rules of the game.

That doesn’t mean that you cannot act when somebody does something egregious, but it should be actions that are bound by a minimum consensus. You can’t seize a poor country’s assets just because they are ruled by a government you don’t like while its children are starving. I’m, of course, talking about Afghanistan.

Q: Do you think these decisions will hasten the creation of alternatives in global finance outside the western world? China is already developing substitutes for the SWIFT payment system. They will try their best to do it. It will take time but China is the second-largest economy in the world and if it has a will, it will find a way. There are plenty of countries that want an alternative to SWIFT, even if they don’t trust China that much. China has often said they don’t care about the quality of other governments, but there are other things that China cares about – for example, another country’s relationship with Taiwan. If you are an independent emerging market, you probably will want to have one foot in both payment systems so that you are not overly exposed to any one of them. My guess is that if China develops a reasonable system, it will find a fair number of takers simply because no country wants to be overly exposed to any one political side.

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