Adi Sankara and Rational Expectations

Reproducing my weekly column for MINT published online on 15th August 2011 here.  I am also happy that I had touched upon ‘spillovers’ and the compensation for them in other areas.

The cost of West’s mistakes

Adi Sankara did not believe in the rational expectations model and hence he should have been awarded the Nobel Prize in economics for anticipating the credit booms and busts, monetary policy errors, Keynesian prescriptions that defy time and context.

Bare Talk | V Anantha Nageswaran

In his well-known Bhaja Govindam, Adi Sankara wrote Punarapi Maranam, Punarapi Jananam to indicate that human beings go through an endless chain of birth and death. Even those with a passing familiarity with Hindu philosophy would know that souls are born into this earth again and again until they have extinguished their vasanas (tendencies) or discharged their karma. In other words, if we learn the right lessons that life has to teach us, we do not have to repeat the cycle of birth and death.

That Sankara thought that we were doomed to go through that cycle means that he understood that human beings were capable of systematic errors. We are capable of refusing to learn from our mistakes. In other words, Sankara did not believe in the rational expectations model and hence he should have been awarded the Nobel Prize in economics for anticipating the credit booms and busts, monetary policy errors, Keynesian prescriptions that defy time and context, among others.

In fact, lately there has been a remarkable degree of convergence among some of the prolific economic commentators and academics. Interested readers can easily locate the source of the comments I am citing on the Internet. Simon Johnson thinks that the Tea Party movement’s success in extracting spending cuts from the US administration has meant that counter-cyclical fiscal and monetary policies have become almost impossible. Ken Rogoff thinks that the US and Europe should target an inflation rate of 4-6% so that the mountain of public and private debt could be dissolved. Robert Shiller laments the fixation with numerical debt-to-gross domestic product (GDP) ratios. Paul Krugman thinks that the US needs a fiscal stimulus, housing debt forgiveness and loose monetary policy. Writing about Europe, Daniel Gros thinks that only unlimited and open-ended purchase of bonds by the European Central Bank (ECB) could solve the European crisis.

In none of these opinions did Bare Talk come across any discussion or acknowledgement of the uncertain effectiveness and unknown consequences of their recommendations. Now, even if their prescriptions would solve the problems that they are meant to address, we should be aware of other problems that these solutions would create in their wake.

For example, many hold the belief that Asia will decouple from the woes of the West. In normal circumstances, decoupling will have gathered strength and proceeded satisfactorily. Not when both the US and Europe are politically divided and hence, economically clueless. Decoupling will disappear like a dream.

One early example is how the Swiss had wilted sufficiently to contemplate even a peg with the overpriced euro because the problems in the euro zone have pushed up the Swiss franc to such uncompetitive levels that they had no choice but to join the race to the bottom. A similar, if not the exact predicament, awaits the rest of the world, particularly Asia.

If the US, in the wake of promising the rest of the world that it would keep the federal funds rate at 0.0% to 0.25% until mid-2013, achieved ultra-negative real rates of interest, the ensuing liquidity inflows into developing economies will push up prices all around from assets to goods and services. It would exacerbate inequality and inflame latent social tensions in many Asian countries, forcing them out into the open.

If ECB joins the liquidity and low interest rate orgy dragging smaller non-single currency member states along for the ride, then prices of commodities will rise again. Already, the US department of agriculture has warned of the impact of the heat wave and drought conditions on corn production. Saudi Arabia is so ravenously lapping up its own oil production that fewer barrels of oil are available for exports.

All these costs could be at least contemplated and negotiated if the West acknowledged them. Up to a point, there is always scope for internal reforms, efficiency gains and productivity improvements in Asia. But if currencies and other prices rise rapidly, they would quickly overwhelm any nation, especially smaller ones. Their social stability and even sovereignty would be threatened.

There are things that the West can do to mitigate these costs. That first requires an acknowledgement of the external costs of pursuing solutions to problems largely of their own making. Once that happens, compensation can be considered in the areas of climate change, governance in global institutions, among others. However, when the opportunity presented itself to depart from the script in the selection of a replacement for Dominique Strauss-Kahn, Western nations closed ranks. That was unfortunate.

So, the paths for the West recommended by academics and pursued slowly by policymakers will lead to conflicts with the East. Decoupling will stall and even reverse. Prices of assets in emerging markets do not reflect these risks. Policymakers and investors are woefully underprepared for the coming tsunami of Western economic policy unilateralism.

(V. Anantha Nageswaran is an independent macroeconomic and investment strategy consultant, based in Singapore. Your comments are welcome at

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