The Hindu Business Line : Economic theories prove inadequate for current realities

The dollar has fallen sharply against the euro and yen with absolutely no impact on inflation. The latest addition to the fantasy world of rising Government debt and debt-GDP ratio amid falling inflation and interest rates is India.

YEARS ago, in an address to the American Economic Association, Joan Robinson, the radical Cambridge economist, spoke of a second crisis in economic theory. We are now witnessing the third and possibly the worst so far.

Consider the facts. World over, with the exception of Latin America, interest rates are at the lowest levels seen for several decades. One would expect the Third World interest rates to be much higher than in the West. Yet, China, Korea, Thailand and even Pakistan enjoy lower or only marginally higher costs of capital than the US (which itself is near zero in money market rates).

While India's short-term rates are much higher, its bond yields are barely one per cent more than those of the US. The ECB's two per cent repo is again unprecedented in recent times. As far as Japan is concerned, it seems committed to a zero rate policy for quite some time to come.

Interest rates are almost uniformly at odds with the fiscal situation and exchange rate movements in these economies. To take the US, the recent tax cuts and ballooning defence expenditure have pushed the budget into the red and it does not seem that there is much prospect of an improvement anytime soon.

Yet, the US Fed Chairman, Mr Alan Greenspan, who ought to be talking of the danger of a deteriorating fisc for interest rates, is mostly choosing to look the other way, because he cannot ignore ground realities.

The dollar has fallen sharply against the euro and yen in the last two years but with absolutely no impact on inflation. Bond yields, which should have risen to induce foreigners to hold assets in a depreciating currency, have actually dropped. The Fed has no hesitation or qualms in proclaiming the almost indefinite continuance of soft interest rates. In fact, in his latest speech, Mr Greenspan expressed the view that America's current account deficit would be financed without any difficulty.

Europe and Japan are other standing examples of the complete absence of inflation amidst their worsening budgetary position. (The Stability Pact, which restricts budget deficits of the members of the EU to three per cent, is practically on the verge of being scrapped, with two of its most vocal initial advocates — Germany and France — overshooting the limit and getting away without the mandatory fines).

The latest addition to the fantasy world of rising Government debt and debt-GDP ratio in peaceful coexistence with falling inflation and interest rates is India. (See `Why India is not sinking under huge public debt', by Harish Damodaran in Business Line on January 19, 2004).

The International Monetary Fund and the World Bank have been warning us of Armageddon not now but for years. Exactly the opposite of what was predicted has happened. (Not that this has deterred them one bit — Ms Ann Krueger, IMF's Deputy Manager Director, was here just the other day, with the same dire warnings of the consequences of our fiscal indiscipline).

Economics, despite the global economic advancement, cannot find theories to explain the most commonplace phenomena. It does not seem to have even a fraction of the precision of other sciences and has not got any of the important connects in modern economies right. This intellectually extremely interesting and challenging subject is in desperate need of reinventing itself.

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