The Impossible Trinity and Last Law of Lickonomics

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The RBI’s fuzzy approach to this famous trilemma of economics could challenge anyone’s sanity

‘Even the A, B, C of it is baffling,’ observed Mark Twain more than a century ago, referring to a holy trinity he had close encounters with on a trip to India. If an American economist or humourist were to visit now, s/he might want to say the same of India’s take on the ‘Impossible Trinity’ of economics.

Such a visitor would, of course, have been forewarned that little of global origin survives contact with Incredible India. Dunkin’ Donuts is set to rival McDonald’s on aaloo-tikki appeal, Starbucks has grabbed the awestruck instead of the down-on-luck, and KFC has been turning into a tandoori chicken joint—on the scholarly advice, one assumes, of KFC’s ‘Indian School of Lickonomics’.

What makes an Indian drool, who knows, but economics is a Nobel-worthy field of academia full of propositions that aspire to universal validity, not saleability. Consider the Trinity. In a speech at London’s European Economics and Financial Centre on 17 July, Reserve Bank of India Governor D Subbarao cited its textbook formulation thus: “This trilemma asserts that a country cannot simultaneously maintain all three policy goals of free capital flows, a fixed exchange rate and an independent monetary policy.”

Simply put, one can go for only two of those three goals at a time. If a country keeps its cash gates open and suffers a wave of capital outflows, it would mean local currency converted to dollars with such fury that the dollar’s local price spikes; now, if it also wants to peg the dollar down to a specific rate, its central bank would have to sell a chunk of its dollar reserves, thus slurping up the local currency and leaving it so scarce that lending rates spiral out of control: upwards, that is, since interest rates are prices too and market demand for money in excess of supply pushes them up.

Undoing that spiral, by spewing out cash (buying bonds), would throw the central bank’s longer-term rate policy out of gear. The market economies of the West have binary on-off settings to meet two of those three goals. They keep capital completely ‘open’ and monetary policy ‘independent’ but leave exchange rates ‘unfixed’.

In splendid contrast, India prefers a fuzzy policy framework, with each of those three knobs turned only partially the way Washington would have it (the now- battered Consensus, that is, not the US administration per se).

New Delhi has its cash gates only half-open: foreigners can buy Indian equity and some debt assets, but resident citizens may not convert all their money into dollars and send it overseas, at least not legally. The RBI intervenes in the currency market too: occasionally, not to peg the rupee, but contain volatility. And if these two policies mean some monetary policy freedom is forfeited, so be it.

Subbarao may not admit that yanking out an already-loose rupee peg after the fall of 2008 was a premature move, but in a couple of radical moves on 15 July and 23 July, India’s central bank has squeezed overnight cash availability to glare speculators down and aid the currency up. Longer-term lending rates have also risen—undesirably.

It’s fuzzy, but Subbarao says that India’s policy framework is aligned with its macroprudential strategy. The idea is to give up “some flexibility on each of the variables to maximise overall macroeconomic advantage” as he said in London. What this implies is that India must watch all three variables, he added, and shift ‘relative emphasis’ in real-time response to varied scenarios.

Ah, now that demystifies what the RBI does, doesn’t it?

Okay, never mind. How it really works puzzles everyone except perhaps the governor himself.

No wonder the RBI has such confused critics. Some scream the fuzzy settings grant it too much discretion. Others argue that India is way too globalised and capital flows way too large for this defiance of an impossibility to go on. Given how manipulative all of it sounds, a few simply fear the wrath of Uncle Sam (‘I Want YOU to Globalize!’) The dull reality, however, is that so long as India’s imports and exports stay inelastic—and unresponsive to price changes—trade just cannot be balanced the usual textbook way. Couple this fact with the risk of ‘hot money’ overwhelming all capital flows, and the case for a fuzzy framework presents itself: at this stage, it would be foolhardy to expose India’s external sector to the brunt of global market forces.

Fuzzy isn’t exactly crazy, even if working out its tugs and contradictions is a job that could threaten anyone’s sanity. Still, somebody’s gotta do it, na? Try hard enough, and some synthesis may emerge from each thesis and antithesis as one goes along. Like so many other naive idealisations, the Trinity is impossible. No doubt, sir, on that. But the ultimate truth? Like the Last Law of Licknomics, nobody knows.