Macro and Policy: Hope and despair

Part I: Macroeconomics

Gregory Mankiw, Harvard University Economics Professor and one of the best-selling author of Macroeconomics text book writes (pg. 2, Macroeconomics, 9th edition) –

Although the job of making economic policy belongs to world leaders, the job of explaining the workings of the economy as a whole falls to macroeconomists. Toward this end, macroeconomists collect data ...They then attempt to formulate general theories to explain these data. Like astronomers studying the evolution of stars or biologists studying the evolution of species, macroeconomists cannot conduct controlled experiments in a laboratory. Instead, they must make use of the data that history gives them.

 Then he says -

To be sure, macroeconomics is an imperfect science. The macroeconomist’s ability to predict the future course of economic events is no better than the meteorologist’s ability to predict next month’s weather. But, as you will see, macroeconomists know quite a lot about how economies work. This knowledge is useful both for explaining economic events and for formulating economic policy.

In nutshell, this describes the requirement to be a good macroeconomist – data, theory, humility. The order could be reversed with ‘humility’ taking the first place followed by data and theory. What we see often is hubris – a proclamation of knowing and understanding the world with certainty. In the process, economics lost the sight of the real world – title of the article by John Kay in FT.

 Kay argues –

...a few deranged practitioners of the project (read, Economists) believe that their theory really does account for all human behavior, and that concepts such as goodness, beauty and truth are sloppy sociological constructs…. We should observe empirical regularities and – as in other applied subjects such as medicine and engineering – we will often find pragmatic solutions that work even though our understanding of why they work is incomplete.

Max Planck, the quantum theory Nobel laureate physicist once told Keynes – “that in early life he had thought of studying economics, but had found it too difficult”. Well, if not in a day, within a week, Planck could have mastered entire quantitative methods in economics. However, economics is not about method and modeling. Studying societies, individuals, markets, and numerous complexities involved in such interactions make this subject a daunting one. Applying generalized economic theory, forgetting social setting and context, is an act of bravery!

Part II: Economic Policy

 Mankiw says (pg. 533) –

 Making economic policy, however, is less like driving a car than it is like piloting a large ship. A car changes direction almost immediately after the steering wheel is turned. By contrast, a ship changes course long after the pilot adjusts the rudder, and once the ship starts to turn, it continues turning long after the rudder is set back to normal. A novice pilot is likely to oversteer and, after noticing the mistake, overreact by steering too much in the opposite direction. The ship’s path could become unstable, as the novice responds to previous mistakes by making larger and larger corrections.

How do we then pilot such a large ship called ‘Economy’? Typically, there are two types of policy lags which make it difficult to time the intervention by the policy makers.

Mankiw explains –

 The inside lag is the time between a shock to the economy and the policy action responding to that shock. This lag arises because it takes time for policymakers first to recognize that a shock has occurred and then to put appropriate policies into effect. The outside lag is the time between a policy action and its influence on the economy. This lag arises because policies do not immediately influence spending, income, and employment.

Fiscal policy has less outside lag than inside lag. For policy makers to recognize a problem and going through the maze of legislative process to act on it is a time-consuming process. Even if they announce policy measures, implementation of such measures on the ground is another challenge. However, it has less outside lag which means once they act – outcome is visible within a short-span of time.

That is why during COVID times, there is so much expectations from the fiscal side rather than from the monetary side. Monetary policy has more inside lag than outside lag. While announcing a rate cut is far easier for a central bank governor than reducing tax rate by Finance Minister, the transmission mechanism of monetary policy remains an area of concern. Sometimes the lag could be 7/8 months to more than a year! Moral suasion and Bank balance sheet are two different things.

Part III: Economic Policy and data

Dr. Duvvuri Subbarao, the 22nd Governor of Reserve Bank of India in his memoir – “Who moved my interest rate?” gives a good perspective on data challenges the policy makers face while taking policy decisions.

Let’s sample a few instances he mentioned in the book (pg. 54-55) -

Instance 1: “I have already written about how our baby-step approach to fighting inflation was in part informed by data which were telling us that recovery was still fragile. In the event, subsequent revisions to output data showed that growth in 2009–10 was, in fact, more than a full percentage point higher than the original number. It is a fair conjecture that the tightening cycle to rein in inflation would have been steeper had we known that output growth was significantly better than we knew in real time.”

Instance 2: “Another instance of data wrong-footing us was the indication of a significant drop in inflation which prompted me to cut the repo rate by 50 basis points in April 2012. But that inflation number was retrospectively revised upwards; it turned out that inflation had not declined as sharply as we were given to understand in real time.”

Instance 3: “Flawed data was also the culprit behind the ‘stagflation’ puzzle we had encountered in 2012 when growth moderated steeply from 8.9 per cent in 2010–11 to 6.9 per cent in 2011–12 even as inflation remained elevated. Many analysts had put me in the dock to explain why inflation had not softened even in the face of such a sharp decline in growth and whether the Reserve Bank’s tight monetary policy was actually pushing India down the quagmire of stagflation—a frightening combination of low growth and high inflation similar to the US experience in the late 1970s…..It now turns out that there was no puzzle, after all. Subsequent data revisions tell us that growth had not slowed as sharply as indicated by real-time data, which explains both the presence of high inflation and absence of any stagflation. If, in fact, the Reserve Bank had fallen victim to the groupthink, acquiesced in the stagflation theory and responded accordingly, the macroeconomic implications of the policy error would have been very costly.”

Then he ponders -

“The Reserve Bank, under my leadership, had come under frequent criticism for consistently getting its forecasts of growth and inflation wrong. Could we have done better? One straightforward option would have been not to make any forecast at all. Someone, it was perhaps Groucho Marx, said, never make a forecast, especially about the future! Alas, not putting out forecasts is not an option available to the Reserve Bank.”

Business Standard, in an article “GDP: The devil is in the revisions” dated 10 June 2020, has given a table which shows the rounds of revisions of GDP data. GDP data first get released as Advance estimate (a projection), followed by 2nd Advance estimate, provisional estimate, 1st revised estimate, 2nd revised estimate, 3rd revised estimate. These six rounds of release and revisions make policy making a daunting task. In FY17, the advance estimate was 7.1% released on 1st June 2017 which became finally 8.3% in the 3rd RE release on 31-January-2020 – a tad up from the 2019 release. A policy decision, knowing the inside and outside lag, has to be taken in advance to keep the economy on a long-run potential growth path as far as possible. Even if flexible inflation targeting has become integral part of RBI monetary policy framework, growth and financial stability are other important goals. With the improvisation of data collection mechanism, one could expect that such revisions are only in a few decimal points.

[Source: Business Standard, 10 June 2020]

In March 2020 National Statistical Office, Govt. of India has released a report titled “Final Report of the Committee for Sub-National Accounts”. Such an important report is no where in the discussion. The report has given valuable suggestions on how to improve the measurement of State GDP and District GDP. Mis-measurement of Macroeconomic indicators have serious consequences even for fiscal planning. 

RBI in its ‘State Finances – A Study of Budgets of 2019-20’ has highlighted the fiscal projection issues at the state level. The report states that –

 While the extent of overestimation is growing steadily in case of States’ own tax revenue (7.2 per cent in 2013-14 to 11.1 per cent in 2016-17), the over-estimation in total revenue is consistently dominated by grants from the Centre, where the extent of overestimation is about 40 per cent in same years. The large differences between Budget Estimate (BE) and Revised Estimate (RE) ratios relative to BE to actual ratios implies that, even by the end of the financial year, states remain uncertain about the amount of grants they are going to receive from the Central Government.

[Note – To calculate in percentage, deduct 1 and multiply it by 100. Source: State Finances – A Study of Budgets of 2019-20.]

Unless there is a relatively better revenue projections, how the state would plan for its expenditure?

Part IV: In Conclusion

India has taken remarkable steps in bringing data transparency, data standardization and data dissemination. Economic Survey of 2018-19 has a chapter with a title ‘Data “Of the People, By the People, For the People”. There is a wide recognition that data and welfare are intrinsically connected. Data democratization is an imperative which no one can ignore. India’s Open Data Platform is a step in the right direction. Economic Survey reflects the importance of data when it opens the chapter by saying - “Navigating in an uncertain, wobbly world requires constant monitoring of the path followed by the economy using real-time indicators. Thus, data can serve as the stones that enable one to cross the river.”

The Survey as a way forward suggests – “As data for social welfare may not be generated by the private sector in optimal quantity, government needs to view data as a public good and make the necessary investments.”

 Well, those investment would be worthy investment for a better future!