Viral Acharya on Fiscal Dominance—A Theory of Everything

In this episode, Shruti spoke with Viral Acharya about his new book, Quest for Restoring Financial Stability in India. Acharya is the C. V. Starr Professor of Economics in the Department of Finance at New York University Stern School of Business. He is also an academic adviser to the Federal Reserve Banks of New York and Philadelphia. He served as a deputy governor of the Reserve Bank of India from January 2017 to July 2019. His primary research interest is theoretical and empirical analysis of systemic risk of the financial sector. This transcript has been slightly edited for clarity.

 SHRUTI RAJAGOPALAN: Viral, thank you so much, and welcome to the show.

VIRAL ACHARYA: Thank you, Shruti. It’s my pleasure to be on your podcast.

On Fiscal Dominance

RAJAGOPALAN: Your book outlines your theory of fiscal dominance. When I started reading it, I thought, in one sense, it’s a continuation of some of the past work. In the Indian context, for instance, Urjit Patel and Willem Buiter have done their work on fiscal dominance over monetary policy. Of course, there is Urjit Patel’s book, Overdraft, which is much more focused on the impact of fiscal dominance on banking regulation, a function of the RBI [Reserve Bank of India].

I initially thought your argument is along similar lines. As I read more carefully and got to the end, to me, it seemed that you are a little more radical than your colleagues. Because you’re not just talking about fiscal dominance over monetary policy, or even specifically about banking regulation.

The kinds of impact that fiscal dominance has on India’s economic growth or the current growth slump, or on its public finance and central and state relations, on private sector crowding out, even the nature of government spending and welfare entitlements. And by the end of it, I felt like your argument is a radical case made by a central banker to severely limit most of India’s government spending and not just narrowly about fiscal dominance.

ACHARYA: Absolutely, Shruti, that’s very well put. What I would say is that when the size of the state in terms of its borrowings and deficit becomes so large as it is in case of India, where even pre-COVID, the fiscal deficit numbers on a true consolidated basis were already in the range of 8% to 10% of GDP with demands increasing by the day—of course, post-COVID, these numbers are projected to be as high as 14% to 15% of GDP.

Now, when the government borrowing programs become so large, what I’m trying to highlight in the introductory chapter of the book is that it has a tendency to permeate every single aspect of financial sector policy, and you are spot on, which is that it is this everything aspect.

From the vantage point that I had, I found that the Reserve Bank of India is, of course, in charge of supervision and bank regulation as you mentioned. It is the debt manager for the government of India. It regulates the debt markets, so it sets the rules under which the debt markets are going to be governed. These rules can also get skewed in favor of government borrowing compared to borrowings by the private sector for example. It’s in charge of the external sector, so what kind of external debt the government issues can also be a pressure point between the central bank and the government interactions.

Other financial regulators, such as the Securities and Exchange Board, are in charge of disclosure notes should publicly listed companies disclose if they have missed a payment on a bank loan. Now, in developed economies, you would think that any materially relevant information should be disclosed by the firm to its public investors, such as bondholders or shareholders, for efficient allocation of capital, for ensuring that minority investors are not taken advantage of by those who are privy to this insider information, and so on.

Yet, in India, whether you disclose defaults by publicly listed companies in a timely manner to the markets or not is driven by, what will that do to the credit rating of the company? How will that lead to capital requirements for public sector banks? What will that mean for the annual budget allocation? How much of a compromise would that lead to on the government’s desire to spend, say, on populist subsidy programs?

The reason why I point out this example is because it shows that something that looks so distant from the government budgets, which is the quality of disclosure of information on a stock exchange, is also actually intimately compromised by the end budgetary recalculations and the desire of what the budget should be in the minds of the government.

I think this is the main thesis. I want to actually make it clear that just fixing one aspect of this problem, which is you go narrowly in the direction of supervision or regulation of bond markets, this is not going to fix it because then it’s like a whack-a-mole problem. You kind of whack-a-mole and it springs up somewhere else because the fiscal is so deeply permeating the rest of the system. It’s always trying to get everything in the rest of the system to its advantage.

I think even as an economic framework, we need to do more along these lines in our conceptual thinking, in our theoretical models, and in teasing out how the interactions between the government and different parts of the economy work. It has its own conflicted objectives of being popular, for example, or running certain kinds of programs that will bring it the votes from a particular constituency that it’s trying to swing over in its favor. I think I wanted to offer an organizing framework, a set of principles that would help us think through. I think the sum total of it is that the fiscal stability and financial stability in India are now intimately linked.

This is a theme that I've been developing in my research over a period of time, that there is a nexus between the sovereign and the financial sector through its choice of the rules of the game, through its compromise of the central bank and other financial sector regulators, through its crowding out of the private sector, a form of financial repression basically. The governments get deeply intertwined with the bank balance sheets.

They want banks and others in the financial sector in one way or the other to make it easy for the governments to borrow. What that leads to is that when the governments doesn't continue on a path of stable debt finances or there's an external shock or there's a shock like the pandemic that actually completely knocks off you from your steady-state path, then you have a serious problem. Because not only will the government face these problems, now it will impose a huge collateral damage to the financial sector in the process.

This nexus then starts creating what some people have called a doom loop or forward-backward linkages or a diabolical loop. There’s all kinds of fancy terms that economists have come up with. In some of my work, notably with Raghuram Rajan in a series of papers—first, a joint paper with him, then in a separate paper with him and one of my PhD students, Jack Shim—what we are trying to argue that by creating this nexus, governments actually first increase their debt capacity because you create a clientele in the economy that is repressively required to buy the government bonds in one way or the other.

Privatizing Government Banks in India

RAJAGOPALAN: You have a recent paper that you’ve written with Dr. Raghuram Rajan. The question you asked about Indian banks is, is it a time to reform? What do you and Dr. Rajan know and are willing to share about government resistance to completely privatizing public sector banks that you went in a slightly different direction of a more gradualist set of reforms, especially in terms of the reforms you’ve suggested for management and control of these banks?

Eventually, you suggest that the government does need to dilute the stakes. Given everything that you’ve laid out, I’m curious why the prescription is not – “the government needs to privatize all banks,” and that will really cut the nexus or the conduit, which is public sector banks, that the government has for extending its spending problem and kicking the can down the road.

ACHARYA: Yes. I think the idea is that, eventually, we want the system to embrace a fair bit of reprivatization from the current space. In fact, we would be even happy if the system is fully reprivatized down the line. I think what we know that is leading us to— I wouldn’t call it gradualism. I think I would say that we are pushing for a more calibrated, well-thought-out path—a blueprint or a framework—that’s going to be used over a three-to-five-year period to complete this process.

First, presently, the market-to-book valuations are very low. Public sector banks’ market-to-book ratios are in the range of 0.3 to 0.6, something along those lines. There are many reasons for it. One, they have not recorded all the losses that have economically manifested yet. This is the classic D rate recognition of losses, which is a feature of Indian banking system almost by design.

Second, their growth potential is extremely weak. Some of these banks used to have price-to-book ratios even above one just three or four years back. Steadily, their franchise, their ability to make good loans, collect on them, their relationships, their ability to grow deposits, all of these are now gradually evaporating because the private system is actually able to do many of these things much better.

Third, and fundamentally, is the lack of adequate governance and management practices at these banks. I think this last point is crucial. For an entity to be allowed to operate as a private bank there, the government backing is not as strong as it is for a public sector bank.

Right now, the way the public sector banks work is that, essentially, there is sort of a common business model that gets thrust upon them from the finance ministry or the Department of Financial Services. They are required to meet certain kinds of targets, depending upon the electoral cycle, sometimes the economic cycle. They are specifically told that you must go and lend more to this sector. Of course, we know there has also been behest lending in the past, which is that they’re being told specifically to lend to specific borrowers as well. Whatever it is, basically, that’s their mode of function.

The government needs to be at arm’s length. The Narasimham Committee in the ’90s [1991 and 1998], the P. J. Nayak [Committee Report] in 2014, they’ve all recommended repeatedly over the last three decades that we need to actually get the ownership of the shares of these entities into what looks like an investment arm of the government. I wouldn’t use the word “sovereign wealth fund,” but it’s something like an investment arm.

It should be professionally managed as just like an investment manager role. They would hire someone to manage these assets from the industry presumably. Simultaneously, you would need to empower the boards and put in place processes so that these banks gradually, without the interference and the intervention of the government, start actually figuring out what it is that’s their business strategy, what it is that they would like to do with their bank, and so on.

Once these things are done, then I think the likelihood that other competent banks, other technologically or financially equipped investors, will come and want to turn these banks around would be far greater.

Let me give an example here, Shruti, which will make this very concrete. This is not an Indian example, but I’m going to give the example of government-sponsored enterprises in the United States, Fannie Mae and Freddie Mac, which provide the massive guarantees to the mortgages, residential mortgage defaults, in the United States.

When Fannie Mae was privatized in late ’60s and then Freddie Mac was eventually set up and also became a private, publicly listed entity, they have always kept serving two masters. On the one hand, they are serving their private shareholders. On the other hand, they’re always meeting the government requirements. The government continues to give them different treatment on taxes in terms of the eligibility of Fannie Mae and Freddie Mac’s bonds at the central bank in order to get liquidity. It’s eligible collateral for dealing with the central bank, etc.

Now, all of these have created a perception that even though Fannie Mae and Freddie Mac are private in a shared ownership sense, they are actually not at a distance from the government. We are trying to avoid that, that this should not become a vehicle for private shareholders and management to essentially do even bigger transfers out of the taxpayer money because now what they do on the balance sheet is at arm’s length from the government, but it is always continuing to be the government’s backing and the government’s interference because that leads to really, really toxic outcomes as far as the underwriting and eventual losses is concerned.

RAJAGOPALAN: The one area where I think we disagree is the moment of opportunity. I think, post-COVID, the opportunities have changed a little bit in the following sense. The current government is extremely strapped for cash because of the extreme disruption in economic activity and the contraction in the economy. The government is already in constitutional default of its commitment to the states on GST compensation.

I thought that this might be a very good time to raise money. One way of doing that is to exit its positions in public sector banks. That has multiple consequences. One, it obviously binds its own hands in the future in terms of not using public sector banks as a conduit for spending off balance sheet. It’s a way to discipline the entire banking system because now there won’t be a difference between public sector and private sector regulation, which has been a source of great problem for the RBI.

It also avoids this constant confrontation with the RBI, which has multiple roles. The conflicting roles now are managing the government’s debt as well as managing public sector banks. I thought this is one smooth or radical move, which will actually kill multiple birds at the same time.

ACHARYA: In fact, we don’t disagree at all. Indeed, I absolutely think that COVID has given a window of opportunity to do something decisive on the financial sector front. All of these things can be done together. In principle, the divestments and the governance changes can happen right away. That would pave the way for reprivatization. Of course, we have to realize that there’s a large number of entities that we are talking about here.

We’re talking about a lot of capital that would have to come in internationally or from the domestic capital surplus players. Most likely, a combination of both might be required. If a decisive reprivatization has to take place, all of them will engage in due diligence. All of them will engage in figuring out what the valuations are. All of them will want some clarity on what the government sees its role in these banks as the stakes are getting unwound.

I think my sense is that the point A to point B is clear, which is that we ideally want to be in a system where most of the financial sector has been reprivatized substantially. I think the point of my piece with Dr. Rajan is that the steps along the way are important. Now, whether you go from A to B in one year or whether you go in three years is, to us, less crucial. Therefore, I’m not calling it a gradualist approach.

RAJAGOPALAN: Fair enough. My personal preference for doing it in a radical swoop is some of the reforms that happened in the past through the various committees that RBI had set up are in one sense causing the current problem. What I mean by that is, earlier, RBI would automatically monetize the government’s debt, and then restrictions were placed on that.

From the time Mrs. Gandhi nationalized banks in 1969 until liberalization, the SLR [statutory liquidity ratio] used to be close to 40% almost, and then it was gradually dialed down. In one sense, taking away these two weapons that the government had for its various jugglery tricks with its large deficit is causing this new problem of trying to use public sector banks to conduct some of its spending and to hide some of its deficits off balance sheet.

In one sense, it feels like each reform might shift the pressure in a slightly different direction. Like whack-a-mole, it pops up in a different spot. The only real way out of this is to solve the problem in one radical swoop and say that the government has no business in directly banking when it comes to the financial sector, so that was sort of the point of view with which I was asking about this more.

ACHARYA: Yes, my sense is, frankly, if they announce a reprivatization package, which is combined with giving a time path for over what period it will be achieved and what will be the governance mechanisms to be put in place to be at an arm’s length from the government, I think it would be a very radical package, given the last 50 years of complete inaction on this front. In fact, I would say not only inaction, we’ve actually gone in the other direction.

The interference in the last 10 years has been far greater than what it used to be. I think we were on a somewhat better path for a point of time, post-liberalization, that public sector banks were gradually getting stabilized, and then we seem to have lost the plot again in the last 10, 12 years.

I want to touch upon one of your themes, Shruti, which I think to me is the crucial one. Even though during my term as a deputy governor I focused a lot on taking care of the bank losses, resolving the underlying distressed assets, reprivatizing them, stabilizing the banks, putting some of them in prompt corrective action, etc., to me, the real root cause of much of the economic malaise right now is the fact that the state is becoming too large.

Its presence in the economy, its presence in the financial balance sheet of the nation as a whole, and therefore, by implication, its desire to actually skew the terms of the financial sector regulation and markets towards its own advantage . . . these forces are now so powerful. So my sense is the fiscal now really needs to take hold.

Global Problem of Fiscal Dominance

ACHARYA: If I could give an explanation that’s provided in one of the recent academic papers, in the traditional notion of fiscal dominance, Thomas Sargent and Neil Wallace, they explained that, yes, there is this arithmetic in which the central bank will have to figure out that the sovereign has debt refinancing problems, and then it will start actually facilitating that. They almost tantalizingly suggested that, what if this was like a game of chicken?

Now, one of my coauthors, Guillaume Plantin of Sciences Po along with some other colleagues of his in France, Banque de France in particular, they’ve actually modeled this game of chicken between the government and the central bank, playing this game where the government is setting its fiscal; the central bank is determining the rates and the liquidity policy.

What they show is that, essentially, if there is no fiscal constraint on the government . . . Now, of course in India, there are fiscal constraints, but they are very easy to violate because of poor fiscal institutions, poor disclosures, and the ability to do all these off-balance-sheet contingent liabilities in different parts of the economy. What they show is that if the fiscal has no ability to commit to be on a particular fiscal path, the game of chicken unravels, and the central bank ultimately just ends up monetizing it. Now, they have a very interesting conclusion that maybe this is what quantitative easing and large-scale asset purchases have been.

Essentially, this idea that the national balance sheets of the governments in developed economies that have become bloated and it’s no surprise that the central bank balance sheets have grown in parallel by absorbing this paper. In a way what they are suggesting is that this could be thought of as a form of fiscal dominance. Thankfully, inflation and other outcomes, including financial stability in some of the developed countries, are more benign than in case of India.

I think what we have to worry about, exactly as you said, is that suppose the government’s debt path and fiscal deficit path is essentially unchecked, and we reform parts of the financial system so that they are not going to be repressed anymore. The question is, will that then just lead to a dominance of the central bank? And then you get more perverse outcomes because we have much higher inflation than in the rest of the world. If central bank, which is supposed to guard against the runaway inflation, itself gets dominated and repressed, then you lose a very important institution and tool in the process to actually retain macroeconomic stability.

RAJAGOPALAN: In the post-COVID world, the United States Federal Reserve has made some extraordinary moves. It is now lending not just to nonfinancial corporations, but also to state and local governments. This is squarely in the area of fiscal policy.

One fear is not just fiscalizing the apex global monetary policy institution or authority in the world, but it’s also politicizing the monetary policy institution within the US, right? Now we’re going to be in a situation where different states might be going to the Fed and asking the Fed to bail them out or something along those lines. What you mentioned, I feel like it’s already playing itself out slowly as the governments increase spending to counter the COVID disruption, and I feel like this is going to happen more and more. What do you see happening from this point on with an institution like the US Federal Reserve?

ACHARYA: I think we have to wait and see. I definitely think that this is a slippery slope. I think the central bank should not get into what looks like an outright fiscal action, as you said, supporting the states and very risky borrowers. It’s better if it is a policy of the government and the central bank is just essentially executing the policy, but the contours and who gets bought, etc. is actually determined by the elected officials given that, in the end, it looks like a fiscal policy.

The question, because the mission creep happens very, very quickly as you said, there is also this view sometimes among central bankers. They fight every crisis as though this is the worst point. What we have seen is that things do get worse no matter how worse the present situation is because, paradoxically, uncertainty is actually very, very high at a time when you think you have reached the rock bottom.

It suggests that actually you have not reached the rock bottom. There is a scenario that’s possible that’s even worse, and then the question is, at that point, will the pressures on the central bank rise even further? I think there is an important point to be learned from this game-of-chicken view of fiscal dominance. I’ve witnessed it in particular during my term, which is that what you think is a compromise today and you think it’s a ceasefire in this game, but it’s not. It’s the beginning of the game. It’s the initial point of the game starting tomorrow.

There is a very steady, period-by-period erosion of the operational autonomy that arises. Then a central bank basically starts giving in because once you have given in, the fiscal remains unchecked. Now the initial point is such that it makes fiscal dominance even more likely the outcome because it becomes important to support the government in order to meet its goal or earnings.

What does this mean for the central banks? I think the key question that we have to ask is that all these inflation credibility that developed economies’ central banks have built, that India has built with the option of flexible inflation-targeting regime, I think, ideally, this needs to be preserved because when we are coming out of COVID, the private sector demand for credit will grow.

The governments would be trying to roll over the large share of public debts that they have accumulated. And then the question is, will the central banks be able to stick to their inflation-targeting mandates or will the investor expectations get unhinged? Because maybe the dialogue between the government and the central banks and the tango that they have got into right now is such that you think they are getting too close and will try to manage the government debts rather than actually deal with inflation.

Of course, as you know, if governments don’t want to restructure debts, don’t want to default, nor do they want to get onto a consolidation path, one way out is for them to impose an inflation tax on the savers. If they do that in real terms, they are not paying much to the investors. That could be a form of debt liquidation effectively. What is very interesting, Shruti, is that I had written the fiscal dominance chapter pre-COVID.

I never thought that in the context of developed economies that the term “fiscal dominance” will get talked about so much as it has in the last six months. It’s hard now to go into a seminar or a webinar or a discussion on developed economy central bank inflation outlooks without a talk about the rise in inflation expectations, without a talk about inflation running away down the line—fiscal dominance. I think we are in a very interesting territory in a way, where a very old theme of fiscal dominance that was pushed aside from macro for a while is rearing up its ugly head all over again.

Mundellian Trilemma

RAJAGOPALAN: I want to bring up another old lovely macro theory, which I think is rearing its ugly head in the context of India. I’m, of course, referring to the in Mundellian trilemma international finance, where an economy or rather a central banker must choose between free capital mobility, fixing the exchange rate, or autonomy over monetary policy. The way Mundell set it up was that only two of these three are possible.

Of course, the way it plays out in emerging markets like India is not picking two out of the three but trying to prioritize one or two out of the three while managing all three. Now, countries like the United States have been very clear on this. They choose free capital mobility and autonomy of monetary policy. Consequently, the dollar value is set in the international market freely. Now, it’s never been clear to me how India manages this trilemma because it seems like at different points in time, different things are a priority.

Rajeswari Sengupta has tried to explain this in the history of, say, the last 20 years in India. But the only trend that I am able to discern is that the foreign exchange has always prioritized. It is carefully managed in a way that it benefits exporters in India, who are also a big lobby with the government. It seems like in India, we neither seem to have free capital mobility nor autonomy in monetary policy. So where do you place India in this Mundellian trilemma, given your experience as a central banker?

ACHARYA: I would say that this idea that the exchange rate is being managed to help the exporters, etc., I’m not so convinced about it. I think RBI’s stated policy for a while has been that it manages volatility of the rupee rather than the level. The rupee is now a much deeper market than what it used to be in the ’90s. That is, I would say, $30 to $60 billion in trading floors taking place. To be able to set the price on a persistent basis when you have this kind of liquidity in the market would require massive scales of intervention by the central bank.

Second, this idea that weak currency is boosting exports doesn’t work as well for India as it does for the manufacturing hub of the world like China. A lot of what India supplies to the world is value-added on top of intermediate goods being imported. Research by Prachi Mishra of Goldman Sachs and formerly RBI and IMF [and Sajjid Chinoy and Siddhartha Nath] has shown that, actually, this export transference of the exchange rate has reduced over time because the intermediate goods need to be imported. Of course, that kills some of the direct export benefit that you get.

In fact, the studies that we did at the central bank showed very clearly that, if at all there is any impact on exports, it’s very lagged. It doesn’t happen up to a year. Therefore, it’s statistically actually very hard to establish with great confidence that there is, in fact, a possibility. Nevertheless, other analysts have found slightly different results. They do believe that exports actually benefit substantially from the exchange rate policy.

I would make two points on the trilemma in the Indian context. One, I would encourage the readers to actually read the excellent work of Professor Hélène Rey of London Business School on this. She has explained that if more or less you assume that the global interest rates are set by the systemically important central banks such as the Federal Reserve, then it essentially becomes a dilemma problem rather than a trilemma problem.

Then she explains that really then if you want to have a flexible exchange rate, the only way out is to actually have capital controls. I think this is what is the main policy of the Reserve Bank of India in my view. Contrast India to Indonesia. Indonesia has allowed almost 30% to 40% of its domestic government bond market to have a presence of the FPIs [Foreign Portfolio Investments]. In contrast, India is now at less than 10%. India is on a much slower, very gradual path of liberalization of capital flows so that when you get a situation, such as a taper tantrum or a COVID, the debt market flows are not as strong.

There’s a big difference between taper tantrum and now, which is that at the time of taper tantrum, India had actually allowed presence in commercial paper. India had allowed presence in the T-bills issued by the government from these foreign portfolio investors. Post-taper tantrum, realizing that these flows are very fickle and hot money flows, maturity restrictions were put in place.

So not only is the ownership of the government stock of debt low, it is required that at the time it comes in, it’s beyond three years of maturity, which was then relaxed to one year, but it’s still not as short term as it is in many countries, and I’ve seen this in the last few years. Whenever external sector stressors have arisen, debt flows out of Indonesia, for example, have been far stronger than they have been out of India.

As a consequence, the volatility of Indonesian rupiah has been far greater than it has been in the case of the Indian rupee. The point I’m trying to make is that prudential controls are actually the most important tool that the Reserve Bank of India uses. In fact, there’s a very nice, very thoughtful Rangarajan - Reddy committee report in the ’90s when they were liberalizing, which lays out a whole pecking order of how you should liberalize your flow, starting with FPI being the most desired flow and a foreign-denominated sovereign debt being the least desired flow.

What I show in a paper with Arvind Krishnamurthy at Stanford GSB, it’s called Capital Flow Management with Multiple Instruments. What we show is that suppose the central bank is building reserves, but it’s built entirely on top of short-term debt inflows. It has achieved nothing because at the time of a sudden stock, all the short-term debt flows will go out, and all that you have done is actually backstopped them with the reserves that you have in your balance sheet. In the process of that sudden stop, most likely now we have created a greater stock of vulnerability because some firms will be scrambling for dollars, liquidating their assets, etc.

Large reserves work in reducing the volatility of a currency only if these reserves are in part built with long-term flows because you want the stock of reserves to grow at a faster pace than the stock of your short-term external liabilities. This is one important point on the capital controls front, which I think doesn’t get as much attention as the size of the reserves or the trilemma itself. I think India in its own ways has actually dealt with the trilemma or the dilemma, as  Hélène Rey puts it.

The second important point I would put here is that what is not discussed yet, and I’ve always wanted to do some theoretical research on this, is that you take the trilemma of the international setting and now you throw in a fiscal dominance into that. You throw in a government that is running very large deficits. It’s not generating growth on a sustained basis. It has a relatively close relationship with the central bank, so fiscal dominance pressures could arise quickly.

Recently, Dr. Sajjid Chinoy from JP Morgan has a nice report where he calls it a quadrilemma rather than a trilemma, saying that now when you have to worry about the government financing and its rollovers, now you have an additional constraint that is getting imposed on a variety of these factors.

Usually, the conclusions reached are that you optimize a little bit on each of these margins exactly the way you’ve described. It is that you do a little bit here, little bit there, and you keep changing it based on the state of the world. My own view is that, as far as the quadrilemma is concerned, we really need to deal with the fiscal situation because it’s hard to deal with the trinity.

RAJAGOPALAN: The dissaving by the government is so high that it takes up almost the entire chunk of household savings in India, which means the private sector and the corporates are really looking towards external sources for borrowing. As the deficits get larger, I feel like there is already a pressure on trying to control inflows and outflows, given that the entire private sector debt or the private sector resources now depend on it.

The more the RBI tries to control that element, in some sense, the more it can shortchange the private sector or at least that’s where the pressure is from all sides in terms of managing stability.

ACHARYA: Absolutely. I think that is the concern. The concern is that if the fiscal doesn’t figure out a part to consolidate itself, do you do pressures on the crowding out of the private sector? They will have to start allowing them to borrow more and more outside. So far, this is a dog that hasn’t barked. The corporate sector, even during the, I would say taper tantrum, was not a complete source of vulnerability.

It was this relatively short-term debt flows, even though the correction in the currency was so much that the corporates also had to start scrambling for dollars at some point. I think Turkey is a case in point. Much worse fiscal situation, a very compromised central bank. Lack of any inflation credibility, very heavy borrowings by Turkish corporations in the foreign currency denominated markets, and therefore, an extremely volatile external sector as far as the Turkish Lira is concerned.

On Inflation Targeting in India

I would add here that one of the less appreciated points is how much value the inflation-targeting framework and the movement towards it has added since 2014, [2013-14] because we have one of the best frameworks in my view, as far as monetary policy framework is concerned because it’s a very specific target, a very specified tool. The target is the consumer price inflation at 4% with a band of 2% above and below.

The policy people rate is the instrument, and there’s democratic accountability. If you can’t meet this, you have to explain to the Parliament. Every member of the Monetary Policy Committee explains through minutes why they voted the way they did. This transparency is actually not available in any central bank where each member writes their own minutes and explains their stand on the situation.

Of course, there is the caveat that you have to pay attention to growth, but the primacy of the objective is price stability. This is a contract with investors, especially the external sector investors and the domestic investors that, “Listen, the central bank is tying its hands down to maintaining price stability.”

Now, think about that game of chicken analogy that I was mentioning to you. My coauthor Guillaume Plantin  and his coauthor, they have focused on the lack of a fiscal rule. My question is -- now what if the central bank ties itself to the mast and says, “I won’t give into the calls of the sirens when the fiscal pressures rise.” Now, of course, ideal would be if there were both fiscal rules and an inflation-targeting regime in place, but it seems to me that their framework helps understand the value of commitment in this dynamic game between the government and the central bank that an inflation-targeting regime can provide.

Last point here shortly is that therefore in my view, the capital controls and the inflation-targeting regime are actually the underappreciated, understated virtues of India’s management of the external sector. The focus is always on the reserves and their size, but actually what enables the reserves to remain effective is the fact that they are not being undone with a set of hot money flows. Second, that the investors have the expectation that most likely India is not going to need to deploy these reserves in the first place because the central bank has adopted a commitment to keeping inflation in check.

RAJAGOPALAN: I am a little worried about MPC in India and its ability to stick to the plan given COVID. It suddenly seems like there is enormous pressure towards announcing some big fiscal stimulus because as you know real incomes have dropped, unemployment was at an all-time high and is now slowly going back to trend. There is a huge worry that India has been kicked off its steady state of 6-6.5% growth.

There seems to be a lot of pressure even amongst traditionally conservative economists who would have said stick to an inflation target and keep government spending low, given the COVID scenario. I have two questions on this. One is, of course, the fear that they may just abandon this target because we are in an exceptional, once-in-a-century pandemic situation, which is quite easily imaginable.

The other is that in these circumstances, if the MPC does tie its hands to the mast, there is a greater and greater tendency towards packing the committee with those who are more likely to favor the government and vote in that direction.

ACHARYA: I don’t see it happening as dramatically as is being feared by some, in the following sense, which is that if you think about the two reforms of the present government that have— I mean, not the most recent ones but reforms from the previous term that I think have been the game-changers. I think they’ve been the insolvency and bankruptcy code, even though it does work in fits and starts, presently remain suspended for fresh cases, but hopefully it will come back up soon.

The inflation-targeting framework. I actually give the government a lot of credit for actually relinquishing control of the monetary policy with what, as I described, looks like a very highly strong and democratically accountable institutional framework for the Monetary Policy Committee. Just compare to outcomes such as in Argentina or Turkey, where inflation can run away very quickly when fiscal pressures rise. I don’t think they will give up on such an important structural reform, that they have themselves put in place less than five years back, so quickly.

Second, I think because they don’t want to give up on this reform most likely, I don’t think that they will necessarily compromise the committee member choices either. I think they would have a tough time defending a reversal of such an important structural reform of the financial sector that they themselves put in place. Listen, this reform came about in a very planned manner. Dr. Rajan, when he took over, already announced a shift towards a flexible inflation targeting. There is a recent paper by Shekhar Tomar and coauthors at Indian School of Business that shows that starting in 2014-15, the focus on inflation in the discussions of monetary policy of the central bank has actually risen very dramatically compared to what it was before.

There was a Dr. Urjit Patel committee report that actually explained why India should move and how it should move to a flexible inflation targeting framework. Then the legislative reform was undertaken to amend the RBI act to have this inflation-targeting framework in place. It was a very well-thought-out reform. I think by all objective measures, the inflation targeting has been achieved reasonably well over the last four years, and I think most likely the system will persevere with it, even though there are pressures to actually tinker with it. Why would you try to fix what ain’t broke?

RAJAGOPALAN: Well, I didn’t see it as much as fixing what isn’t broke as much as tinkering with the constraints of which we saw a little bit with the bankruptcy code also—that there is a bankruptcy code, and then the RBI issues a procedure or a protocol on how books need to be marked and how loans need to be marked to their current valuation, how we need to recognize nonperforming assets correctly and actually bring defaulters to check.

Then the moment that process starts, the government wavers a little bit and then the Supreme Court wavers a lot. The whole thing, I won’t say crumbles, but it definitely loses some of its legitimacy. Those are some of the fears that I have.

RBI as an All-Purpose bank

I want to go in a slightly different direction and ask you more generally about the Reserve Bank of India. The way I think of the Reserve Bank, as you already mentioned, it’s an all-purpose bank.

On the one hand, it must manage the monetary policy, rate setting, liquidity, inflation, targeting, etc. Another function is to manage the external sector and make sure it’s managing the foreign exchange and the capital flows. Then there is, of course, the supervision and regulation of public sector banks, which is slightly different from the supervision and regulation of the private sector banks. There’s also the task of guarding savings and managing deposit insurance, of course in this case, through the wholly owned subsidiary of DICGC. In addition to that, it’s the debt manager for the government and placing government of India securities, and finally, the issuer of currency, which tends to be the simplest task, except in a situation like demonetization.

How much of the problem is fiscal dominance, which I recognize is a huge problem? How much of the problems that the central bank is currently facing are that it is an all-purpose central bank without cleanly separating these functions and handing them over to different institutions?

ACHARYA: I would say that the views on this since the global financial crisis have reversed. Earlier, there was a perception that separation of regulatory functions would create lesser conflicts of interest, create greater specialization, and so on, but what you saw, including in countries with relatively stronger regulatory expertise such as United States and United Kingdom, was that the fragmented regulation was actually what made the system weaker.

Banks and financial firms started exploiting the regulatory fragmentation by creating loopholes and doing “within-country jurisdictional arbitrage,” so to speak. In case of United Kingdom, the separation between the supervisory and the lender of last resort functions actually became quite a big problem in dealing with actually the first phase of the global financial crisis.

I think broadly there is a recognition that the monetary policy, the lender of last resort policy, and at least the supervision-regulation functions need to be under the same house. Perhaps deposit insurance corporation could be separate as it is in the United States. I think the key point to some has been the debt management. Can you really have on the one hand a flexible inflation-targeting framework that’s trying to distance the central bank from the short-term fiscal pressures of the government and remain focused on inflation, and yet, by making it the debt manager, you create an impression that it has to be bothered about the government’s borrowing costs?

Now, in my view, there’s a misinterpretation of the function of debt management. I think debt management should be just about running the auctions. It should not be about the prices that come about in these auctions. Unfortunately, both outside as well as inside the central bank, there’s a perception that we also have to worry about the price.

A lot of the former RBI governors and deputy governors, they are not in favor of separating the debt management function. Many others are conceptually in favor of separating it out. I have somewhat mixed feelings about it. I think that if RBI interprets debt management narrowly, it can actually not remain bothered about the government yield curve and the prices at which the auctions are taking place. I think if it is going to be bothered about it, then it could be that transferring it over to the government is the right thing to do.

Of course, the government has to demonstrate that it will do a good job of this. I’ll just mention here that one of the reasons why some are worried about transferring this function to the government is that they think that it will lead to an even bigger nexus with public sector banks and public sector financial institutions, than in a setting that RBI, which is a bit removed from this public sector institutions, is running these entities.

Now, having said that, if you read Dr. Y. V. Reddy’s foreword in my book, which I think is a masterful historical commentary on fiscal dominance in India, he makes two points. In the ’70s and ’80s, the central bank, the government and the public sector banks were what he calls “the Hindu undivided family,” that no one kept anyone’s accounts. He also explicitly mentions that there were times when the central bank called banks to buy the state government’s paper.

Such things can also happen at the central bank, but the perception of some is that if it is with the government, then the distance between the nexus of the balance sheets would be completely removed. The nexus would be very, very strong between public sector entities and the government. The one point I would mention here though is that the reason why I gave the example of the disclosure of losses being compromised by fiscal dominance is that I wanted to clarify that while the pressures on the central bank are first and foremost, there are fiscal dominance pressures on other financial sector regulators too.

It’s not at all clear to me that if you divide up the functions of the central bank into individual silos and you have several weaker regulators in the system, to start with, they will be weaker. They will not have the technological expertise right away. This was one of the big problems with the financial supervisory authority in the UK. The central bank is able to attract a certain kind of human capital that other regulators in the system are not able to attract.

Now, if you have weaker regulators, will it be easier to fiscally dominate them or is it easier to fiscally dominate an all-purpose central bank? I think it’s a conceptual question. I lean a little bit in the direction of keeping the efficiency of the central banking by keeping it an all-purpose central bank. I would be happy with deposit insurance to be even farmed out completely.

I would prefer if debt management is interpreted narrowly so that the central bank is not into yield management on a perennial basis. Other than that, I think what we really need to do to deal with fiscal dominance is to put in place better fiscal rules.

Fiscal Federalism

RAJAGOPALAN: In terms of fiscal rules, one is of course the aspect of how we manage the debt. The other is the aspect of how one manages the spending, and very uniquely, unlike most other central bankers, you have also expressed an opinion on the nature of government spending and how most of it is not capital spending. Most of it is revenue spending, and it’s in fact just giving away welfare entitlements now, increasingly so in the form of private goods, not public goods.

I wanted to switch gears a little bit to talk about public finance. In one sense in India, public finance is extremely centripetal in terms of raising revenue, in terms of controlling credit policy, in terms of fiscal spending, and also borrowing in the bond market. Now, how much of the fiscal dominance problem will be resolved if India becomes more fiscally federal and relies less on intergovernmental transfers and more on states raising their own revenue?

Do you think this will compound the problem in the sense that instead of managing one union government pressure, now the RBI has multiple state governments lobbying for all sorts of benefits and to borrow money and for loosening constraints? Or do you think it will actually check the fiscal problem by federalizing both raising revenues and spending?

ACHARYA: I would say it’s more of a cooperative federalism in a sense. I think you do want to leave some market borrowing in place for these state governments because then they’ll document their records to explain to people how much they are borrowing, where the revenues are coming from.

You can see that a loose fiscal arrangement of the type of European Union doesn’t work either. A strong federal arrangement of the type of United States works, that they can do the fiscal transfers. A lot of the fiscal transfers that happened post the global financial crisis were actually to provide unemployment insurance in the states.

But nevertheless, the local municipalities in the United States borrow on their own. I stress here that this debt is not eligible for the central bank’s open market operations. Central bank in the United Federal Reserve doesn’t provide emergency lending in a normal situation against this debt. Of course, as you mentioned in the post-COVID situation, it is providing some support to the states.

In India, by contrast, what we have done is we have moved towards a US-style arrangement by allowing states to borrow and requiring that they borrow within some contours. The Goods and Services Tax has, I would say, federalized a big part of the tax collection, with some commitments for transfers, which are under discussion and dispute to an extent, as you mentioned.

What has not happened is that the state government paper is not yet trading in the markets as much as one would like, and there are many problems with it. I would prefer if it was not actually a part of the open market collateral. What that would do is that it would create a greater perception in the market that this is the state’s own risk, like with the municipalities in the United States, and that would actually create a little bit of an yield movement between safer states and the weaker states.

Then that would have the feedback and the disciplining mechanism. Now, of course, the current situation may not be the right time to implement some of these things, but I think in a more normal time situation, such as what was like maybe three or four years back, I think something like this could have been planned so that gradually you are either weaning the states off the central bank guarantee or you are getting the state’s paper to be rated.

Then the collateral haircuts or margins that the central bank is charging is linked to the rating of the states. And then gradually over time, you could actually create some sort of complete weaning from the central bank facility, etc. We are in a little bit of a hybrid situation compared to US and Europe.

Now, having said all of this, to be brutally frank, as you said, I’ve been very open in my views on the government spending and fiscal. I think the discipline is not great in many of the states themselves. The discipline has not been that great at the center. At both levels there has been great reliance on off-balance-sheet transactions, accounting fudges, moving stuff over into public sector enterprises.

What needs to be done in India, fundamentally, first is that we need to have better accounting and accountability of government numbers. There’s this famous Goodhart’s Law, named after Charles Goodhart for his work on monetary policy, where he said that, if you have a measure that you are trying to control, say a public entity on the basis of, and that public entity can manipulate this measure, then it will have no economic content because once you start using it for the purpose of control, they will game it completely.

In my view, India’s fiscal outcomes are like a textbook recipe outcome of Goodhart’s Law. He put rules in place, the Fiscal Responsibility and Budget Management Act, that gave a deficit path, a debt path, but we didn’t appoint an independent bipartisan or nonpartisan fiscal council. We don’t vet government’s budgets; we don’t vet the programs. We don’t have a discussion before the budget is announced as to whether the growth assumptions and the budget projections are reasonable or not.

We don’t hold a mirror to the government’s accounts on whether they made the disinvestment targets by doing musical chairs, as I call it, between public sector enterprises, or was it genuine disinvestments, government balance sheet as a whole, relinquishing its stakes to the rest of the economy.

So I think we need this sort of an independent fiscal council. It would be something along the lines of the Congressional Budget Office in the United States, which since 1974 has been vetting various programs and the assumptions. I think in India, even the finance commission chaired by Dr. Y. V. Reddy explained this, that it should be what is called as a comply or explain approach.

If the government wants to deviate from the assumptions of the council, then the government has to explain at the time of budget that we were told to make these assumptions but these are the reasons why we have chosen these assumptions. It could certainly throw some sand in the wheels of making heroic assumptions at the time of every single budget that’s presented.

Second, India needs to calculate accurately a public sector borrowing requirement, a PSBR, as it’s called. What will this do? This means that if you try to optically manage your deficit numbers by shifting the borrowing into off-balance-sheet makers, the public sector borrowing requirement won’t change. The public sector borrowing requirement will include not just the borrowings of the center and the states, but also of these off-balance-sheet entities.

I think the CAG, the Comptroller and Auditor General of India, I think that office is best placed to actually calculate this number and provide it on a twice a year or once a year basis. They can even make the individual pieces available. In fact, over a period of time, they can even factor in contingent liabilities. Professor Debbie Lucas at MIT has been doing these calculations for different countries to show how large the contingent liabilities are in some cases relative to the on-balance-sheet liabilities. I think these fiscal institutions are very crucial.

Regulating Private Sector Banks

RAJAGOPALAN: I wanted to talk a little bit about regulating the private sector banks. We know that RBI has recently more so than ever before had some serious skirmishes with the government on regulating public sector banks. Anytime it tries to rationalize the books, actually mark the books and recognize bad loans, and streamline and discipline public sector bank lending, there is a lot of pushback from the Ministry of Finance and so on and so forth.

On the other hand, though, a lot of these pressures don’t exist for the private sector. The Reserve Bank of India has not been a very tough regulator when it comes to the private sector either. It seems to be quite frequently caught by surprise. Of course, the most recent example of this is Yes Bank and all the issues that happen with the Yes Bank, and finally, the ultimate situation where the RBI has to limit withdrawals fearing a run.

What is your view on the failures of the Indian central bank in regulating private sector banks better? I think this is a really important piece of the puzzle. Most people are recommending that public sector banks eventually be privatized.

ACHARYA: I’ll make three points, Shruti. In my view, one of the reasons why overall regulatory standards of the banking sector in India are weak is because they constantly have to be kept low for the public sector banks. And to the extent possible, the central bank doesn’t want to make its regulations ownership-specific, that a separate set of rules apply for private banks and those for public sector banks.

The presence of public sector banks their weak governance, their weak balance sheets, the lack of recapitalization, fiscal dominance of regulation coming through that first and foremost has meant that we have overall adopted somewhat weaker standards for the system as a whole. You can just imagine if you have to design a forbearance package. If you are not going to recognize the losses and say, “Okay, these restructured assets are actually fine,” then it relaxes the pedal on the supervision function because you are actually calling an asset that has defaulted a standard asset.

What is the need for the supervisor to actually bent backwards to figure out whether these assets in a particular category were paying in a timely manner or not. This is one point. Second point I would stress in favor of the central bank, RBI in particular, is that at least when the problems have been discovered, actions have been taken. Management at the top has not been allowed to be renewed in some cases. In one case, the case that you mentioned, it has been explicitly asked to take care of that management.

I think even if it is with a lag, as long as some disciplinary actions of this type are taken, it has a huge deterrent effect up front. I think to the extent these actions have been taken in the last several years, I think it bodes well for the discipline that it’s likely to install. You can see that the entities where these disciplinary actions were taken, the moment new management came in place, they cleaned up their books and raised capital on a far more proactive basis than what was being done before.

In my view, this kind of discipline is at present not possible on public sector banks. This is why in my view, the overriding of the RBI and the Banking Regulation Act by the Bank Nationalization Act is fundamentally problematic because it means that a very important part of regulatory discipline is not present, besides market discipline not being present for the public sector banks.

The third point, though, I would tend to agree that the supervisory function itself could be strengthened. I think the number of supervisors that the Reserve Bank has is very few compared to the total size of the financial sector that it has to cover. It has to cover banks, as well as non-banks. It’s no longer a Hindu undivided family. There are private banks in this system, and the private banks experience depositor discipline in a far more violent fashion than public sector banks. Public sector banks are losing their deposits at a much more gradual pace because of inefficiency, but then there’s a governance problem at a private bank.

It reflects in the depositor withdrawals very, very quickly. The supervision function needs to be strengthened, both in terms of the head count, but I would say also in terms of specialization. Clearly, the supervisors need to have a ring view, 360-degree view, of the financial sector, but some of them also need to be made career supervisors because your experience as a supervisor gets stronger and stronger as you start monitoring larger and more complex entities.

At RBI, a blueprint was put in place during my time and then subsequently on how to create such a supervisory cadre, a special vertical that people grow as career supervisors during their lifetime. I think that kind of specialization would help.

I think RBI can also rely much more on analytics, market-based data. The Financial Stability Unit at RBI, which produces the Financial Stability Report, runs, in my view, fairly good stress tests. They could be also brought up to speed with what the macroprudential stress tests in the United States look like. Very detailed data analysis and modeling goes into calibrating these stress tests. I think these stress tests produce numbers for each bank as to how much capital do they require in a stress scenario. I think they could be given a bigger role in both the supervision and the regulation functions of the RBI.

India’s Bad Loans Problem

ACHARYA: I would say more than supervision, in my view, the bigger problem is the fact that losses on Indian banks’ loans are not recognized in time. Most of the recognition happens after the loss has materialized. Now, when you provide for losses after a default has happened, banks start doing this calculation: “If I resolve this bad loan and take a loss, how much capital will I have to put up relative to evergreening it and doing the slow provisioning that the central bank is going to ask me?” In contrast, in a good system like the United States, by the time a loss has happened, you have to provide for it 100%.

Once you have provided for 100% on a loan and a default, you want to recover as much of your provision back as possible. The accounting system, the provisioning system, actually is not just an accounting system. It’s actually an economic incentive. If you backload the provisioning, there is no desire to resolve the bad loans. If you frontload the provisioning, then when default occurs, the bankers have all the incentives to actually resolve the losses.

I go back here to the classic work of Caballero-Hoshi-Kashyap of Japan. I have done a huge body of work on Europe, which shows that essentially systems that allow provisioning to be of very poor type and losses to not be recognized, they give rise to zombie lending. They give rise to evergreening, extending the majority of loans, and pretending as though all is okay even when the borrower has defaulted. That raises the cost of borrowing for healthy borrowers in the system, and actually throws the economy into a tailspin of low productivity and growth because of this poor allocation of credit that’s taking place.

There’s this proposal to have the Indian version of IFRS, which is called IND AS [Indian Accounting Standards]. If that is adopted, it would actually shift the system to smoother anticipated provisioning. It is not without its own share of complications because models have to be used to calculate anticipated losses, but there are simple tricks. You can require a minimum level of provisioning so that no one can mark down the required provisioning below a certain level, but we need to move in this direction.

Otherwise, I can tell you, no matter how strong the supervisors are, the pressures to forebear will remain as long as we have public sector banks, as long as we have fiscal dominance pressures, and as long as we have defaults in the economy. And as of now, we are looking at all of these three situations.

India’s Informal Economy

RAJAGOPALAN: Ordinarily, when we think about fiscal stimulus or monetary stimulus, the assumption is that there is good targeting, that we actually have good data on the economy, that we know which are the sectors where the stimulus is being provided. If it’s a monetary stimulus and it’s being managed through interest rates, then actually the entire economy is plugged into the formal credit system.

In India, that’s simply not the case. There’s a huge unorganized sector. Eighty percent of India works in this unorganized sector. Not all 80% is removed from the formal credit system, but a large part of it is still removed from the formal credit system. What are the additional challenges that an Indian central banker has when it comes to using fiscal and monetary policy instruments to stimulate the economy or to temper the economy and so on?

ACHARYA: I think there are certainly huge data challenges at specific points of time. Clearly, if you think about the post-demonetization phase, it was very important to be able to understand what’s happening in the formal economy. We don’t capture it as well in our data. That certainly leads to difficulties in getting the right growth numbers, especially in the first and second estimates that the statistics office comes up with.

Second, I would say on the inflation front, the challenges are somewhat muted in my view because I think in its wisdom, the inflation-targeting framework is based on a consumer price index, and in my view, it’s good that it puts a significant weight on food because what you find is that in India, food inflation has a tendency to generalize into other forms of inflation because it affects household inflation expectations in a very, very significant way. A series of papers at the Reserve Bank have shown that food and fuel are very important components in affecting inflation expectations in India.

I used to check with my mom every month when I was in India as to what were the—I call it the “Pav bhaji“ index. What is the cost of the peas, onions, tomatoes and potatoes, mainly the last three—tomatoes, potatoes and onions—because they are very volatile, but they do shape what the average person in India thinks, as we call it, monghavaaree [dearness] in the food in the Indian languages. That affects inflation expectations in a very significant way.

It’s also a way of ensuring that the monetary policy decision is not skewed towards the urban economy entirely, that food, which is a very big part of the consumption basket of the poor, actually also gets an important weight in the decision-making of the central bank.

Technocrats versus Bureaucrats in India

RAJAGOPALAN: There has been a lot of talk about importing technocratic, highly specialized talent to run the [Reserve Bank] in India and whether that model works or not. The recent history is a little spotty. Dr. Rajan’s term was not renewed; both Dr. Urjit Patel and yourself had to leave before you completed your respective terms. A lot of the discussion that unfolded, a lot of what I read between the lines from your lectures and from the lectures of your other colleagues, it seemed there is some fundamental tension between outside technocratic expertise and the Indian bureaucracy and the way the institutional arrangement that protects the bureaucracy functions.

Do you have a view on this because it seems like the role of the central banker and the deputy governors is so highly specialized, given the size of the Indian economy, that it can’t possibly be done by just anybody? At the same time, it’s not a very smooth working relationship.

ACHARYA: First, I think the idea that the early experience is enough to do central banking, to me, doesn’t cut it. It is a very specialized field. There are complexities at work. The thing about a central bank is that it has to worry not just about the direct consequences of its policy, but also the general equilibrium unintended consequences of its policy. To do that, you do need some organizing principles and frameworks.

You have to be able to spend some time thinking about the [Mundellian] trilemma that we touched upon earlier in our conversation because if you don’t have the trilemma at the back of your mind when you’re doing monetary policy, capital controls, and exchange rate policy, you’re going to be hit by unexpected shocks and surprises because when you try to fix one thing, the pressure is actually building up somewhere else.

So this idea that we don’t need technocratic expertise altogether is wrong, in my view. You do need technocratic expertise. Contextual experience in India is, of course, important to someone who’s at the Reserve Bank. But see when technocratic experts are brought in, it’s not like they are working in a vacuum. There is the whole institutional apparatus. RBI has extremely capable experts on the Indian economy.

The second point I would stress is that I think what has happened is that we have overall, but especially in the last 10, 12 years, we have started regressing a bit towards the centralized, nationalized organization of the economy that we had in the ’70s and ’80s and gradually started abandoning our confidence and faith in the post-liberalization mode of functioning. We liberalized several sectors; we undertook massive disinvestments during ’98 to 2003. Global growth was very strong, so it was easier actually to undertake some of these reforms and see the returns on them.

Post global financial crisis, once the global headwinds to growth have risen, India, instead of realizing that we needed the next set of liberalization and divestment reforms, has instead resorted to quick fixes. It has resorted to debt-fueled stimulus. It has resorted to more and more populist programs spending. And it has resorted to greater and greater fiscal dominance of the financial sector in one way or the other, trying to engineer the pressure of the economy to steer it towards public finance. As a result of these policies, what has happened is the technocratic voices that are trying to keep the focus on reforms, in my view, have basically faced a resistance from the bureaucracy and the government.

To me, it is not actually a conflict of foreign-trained economists versus others. To me, it’s a conflict of ideologies. It’s a conflict of market-based liberalized, decentralized economic structure of the economy and that view of the world with the traditional way that we were doing things in the ’70s and ’80s. I think the bureaucracy and the government are regressing towards that mode of functioning of the economy.

It seems that what has happened is the Keynesian economics has been taken so seriously by the governments that I think even Keynes would actually revolt and want the states to become somewhat smaller. I think in the process, the lessons that the Austrian economists had drawn from the over-centralization by the state are completely forgotten, that there’s a crowding out of the private sector. There’s a lack of entrepreneurial spirit. There are missing signals in markets.

All of these important side effects of the state being too large, the Hayekian view or the von Mises view, I think it has got lost, unfortunately, especially in the developed economies. In emerging markets, the reliance on governments is too high to start with. In my view, this is the theme of our times, that the state is becoming overarching in its presence, and rather than enabling the private sector to grow through the provision of public goods, it’s actually trying to take over the provision of the private goods itself.

RAJAGOPALAN: The latest set of central bankers we’ve had, you all sound like elevated libertarians who can’t control the government’s spending problem, fundamentally. That seems to be the issue.

Acharya’s Intellectual Influences and Journey

RAJAGOPALAN: I want to move on to the last segment of the show and ask you some questions which are more personal to you and your influences. You were trained as an engineer and then you switched to finance and economics in your graduate work, and then eventually became a professor, which led you to the path of joining the RBI for one term. Can you talk us through this intellectual journey and what led you to this point?

ACHARYA: The long and short of it was that I wasn’t too excited about computer science. I think I was doing well in it, but I wasn’t breathing it. In my undergrad, I started questioning myself. Is this what I am meant to do? I think it was a little bit of self-discovery, self-exploration. As part of that, I took an elective in international finance in my last year at IIT Bombay with Professor Pushpa Trivedi. I felt it had a nice mix of what was happening in macro at the country level on trade, exchange rates, capital flows. Yet, all of it was in the end rooted in what was happening to households on the ground. I started liking this mix of macro and micro that course exposed me to.

We had a family friend who had just finished his PhD at NYU Stern in finance. I spoke to him. He said business and finance is a very exciting field. It can be very analytical and theoretical. If you want, you could be solving the most complex stochastic differential equations if you like. But if you want, it can be very applied, data-oriented. You could be solving very real-world problems. You could be in academia; you could be in industry. All of these are options.

So I said, “Let’s try it.” I applied for a PhD. It was too late. I’d already applied for a PhD in computer science. So I applied a bit late in finance. I came here to NYU, then I changed my major after the first year to finance. Actually, what was a very critical part of shaping my intellectual interest were actually the three summer jobs that I did at JP Morgan during my PhD. I started out wanting to be in industry actually.

I said these summer jobs would be a way that I get these jobs. I worked one year on the fixed income floor, one year on equities, and one year in the credit risk. It was all modeling, derivatives related modeling. The last year I was there, you had had the Southeast Asian crisis, Russian default, and then long-term capital management was about to fold up. That was the time I realized how important financial stability is. It’s really like the lifeblood of the economy and that many times these institutions tend to collapse together because they’ve had correlated bets when a common macro shock hits them.

When they fail, you could have a complete choking up of credit to the rest of the economy, a freezing up of the markets and that this is the time these central banks actually come in and start playing some important roles, through a lender of last resort, etc. Then I think it gave me direction in my research. I said, “Oh, this is interesting.” Maybe one should really be thinking about modeling systemic risk. Why does it become inefficiently large? What is the market failure there? Why should governments and central banks be needed to intervene? In what forms should those interventions be? When will they intervene too far and actually create problems of their own?

I started thinking about not just market failures, but also about regulatory and government failures. That has been a common theme of my research, which is, I’m looking at the intersection of market, regulatory, and government failures as a way of explaining the outcomes that we are observing.

I do both theory and empirical work because I like the back and forth. I like to do theory but then test it. Then based on what I learned, maybe go back to the theory and refine it or take it in a completely new direction. I think the central banks are an excellent place for academics like me because your theory and research is so closely aligned with policymaking. There’s so much learning on the ground that happens when you are at these places.

I do think the scientific discipline of economics and finance is useful inside central banks. I’ve been there, I’ve come out, and I’m not of the view that the world is so complex that we have to abandon our models. If anything, it is exactly the opposite. The world is so complex that you need organizing principles. If you don’t use organizing frameworks, you can justify anything, and if I could say, get away with murder, so to speak.

RAJAGOPALAN: Who are some of your intellectual influences?

ACHARYA: At a very deep intellectual level, I would say it’s a mix of Keynes and Hayek, which most people would think is a conflict. But to me, it is actually that they were both right in their own ways, but at different points of time or different states of the economy. I would say, regulatory interventions are required, but I think regulatory interventions can go too far.

I think government policies are required to come out of a crisis, but they can also have their own share of crowding-out effects of their own. I think of myself as a hybrid of Keynes and Hayek in views on how to interpret the world, central banks, and markets. I think in an intellectual sense, probably that has been the heaviest influence, thinking about the two of them together and striking a balance between them.

I think for an Indian finance person graduating in the late ’90s, of course, Dr. Raghuram Rajan was the inspiration for many of us. He had been in the field of banking. He had a very meteoric rise. Then he went on to become the chief economist at the IMF, the governor of the RBI. I think to me, he was an inspiration because it made you believe that one can do it, that you can be in this field. You can come from outside first, come from outside to the academia here in the United States, and then go back from the US to India to do these jobs. Of course, I very much admired his research and thinking as well. I think it was more as a role model that you can do it. That sort of confidence gets instilled in you.

Lastly, I would say, I have been a big fan of the micro research that’s been done on banking. Especially, I would say the work of Doug Diamond, who wrote down the first models of liquidity transformation being done by banks, diversification of risks being done by banks to give a safe contract to deposits, the importance of short-term debt in a bank, the immediacy of demandable deposits, etc. because I think these are the most fundamental concepts that underpin the institution of banking.

They help you understand that even if tomorrow you regulate banks and a shadow banking shows up, if the functions they are performing are in the end about providing this immediacy or diversifying risks, you will see banking style outcomes because if it quacks like a duck, it’s probably a duck. I consider his contributions to banking theory and understanding intermediation is probably the most path-breaking, at least in the last 30, 40 years.

RAJAGOPALAN: Do you write every day? Do you sit in the same spot every day when you write? Do you have music playing when you write? What’s the process by which you write?

ACHARYA: The only thing that I do every day is listen to music. I don’t write every day. I try to play tennis every day, but it’s too expensive in Manhattan to do that. Writing happens in spurts. I think research in general happens in spurts. I guess you are thinking about it all the time. I would say, most of the papers are written in a few hours when that spark happens. You crack the first-order condition of the model you’re trying to write down and what it means, or you get the right chart or the right test that’s done.

Of course, it’s a culmination of a lot of thinking and painstaking efforts that are not bearing fruit for the most part. I work in spurts. There are times when nothing happens. There are hours when everything comes together. Also I find the same with my writing. If I write every day actually, I find I don’t write very well. Sometimes you have a clear idea on how you want to pitch it. You have to brood on it. I almost ruminate, and I find I’m ruminating on it for days and days at stretch, and only then the whole thing comes together.

I think if anyone has writer’s cramps, I’m the person who has these. As [Ernest] Hemingway put it, “It’s like a treachery of your own body.” A cramp is like a treachery of—my body is always treacherous to me. I think different people have different styles. I work well with coauthors. I’m good at compartmentalizing work, and then I’m good at letting people write the papers if they want or letting them do the tests if they want. But I breathe it. To me, that’s the most important thing. I felt I didn’t breathe computer science, but I breathe banking crises.

As the joke goes with my colleague Ed Altman, when a firm fails, he opens a bottle of wine. If it’s an S&P 500 company, he opens champagne. I say that when a sovereign or a municipality defaults, I throw a party. Because I’m doing everything on financial crises and I need these data points.

RAJAGOPALAN: I’ve heard you sing and you sing really well. You’ve also composed an album called Yaadon Ke Silsile. It’s hard to peg the genre, but if it was one, I would say it’s a very R.D. Burman, Kishore Kumar sort of inspired genre of music. Who are some of your musical influences? How did you get into music?

ACHARYA: I think I grew up as a child listening to a lot of music that was being played at our family. I think I had no active interest, I would say. I always liked poetry, etc. It was only in IIT Bombay that I took to music more seriously. I used to be in a wing, which was in one of the parts of the dorms at IIT that had three really fabulous singers. They were the ones who encouraged me to sing, first by taking part as a freshman in some cultural events and then eventually the shows.

My sense is everyone in India thinks they are singers. They all think they are professional singers. I also thought I could be a professional singer. At some point, we started doing the shows. I think the main thing is that I listen to a lot of music. I listen quite keenly, maybe more to the melody and the poetry than to the instrumentation. That’s what eventually got me to composing the album. I wrote the tunes and the lyrics. The arrangement was done by a professional arranger.

In terms of influences, I think I would say yes, S. D. Burman, R. D. Burman. Kishore Kumar combo is my most favorite. In terms of lyricists I like, of course, Sahir Ludhianvi and Gulzar, Majrooh Sultanpuri the most. I think Javed Akhtar is always evergreen, both with the scripts as well as with his lyrics and writing. Of course, it’s hard not to like Lata Mangeshkar‘s best songs when she was at her prime. I think it is such sublime quality overall. I can listen to the Beatles all day long, for months together, and I keep doing that. Every now and then, I go through this phase.

I like a lot of jazz actually because I like the experimentation and the unstructured quality of it. There are phases when I go through— I just switched to listening to Hindustani classical and Western classical because suddenly I get tired of the mainstream music and I feel I need something calmer and something that’s a lot deeper and makes you reflect and contemplate and ponder, and then I go through these phases. But when I have to go to bed and I’m not falling asleep, a good thoughtful Kishore Kumar number does it for me.

RAJAGOPALAN: What are you reading right now?

ACHARYA: I want to read Isher Ahluwalia’s memoir Breaking Through. As some of you know, unfortunately, she just passed away a few days back. I’m keen to read about her journey as an economist.

RAJAGOPALAN: I have to ask you the final question, which is also the most important during the COVID times, which is what are you binge-watching right now?

ACHARYA: The only thing I binge-watch is tennis.

RAJAGOPALAN: The French Open?

ACHARYA: Yes, the French Open highlights. I go back and watch a lot of classic matches. Tennis is the only thing I binge-watch. I don’t binge-watch any other TV or cinema or anything.

RAJAGOPALAN: Thank you so much for your time. You’ve been so generous. Thank you for being on the podcast.