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While the world still grapples with the Covid-19 pandemic, new challenges have surfaced in the last few months: Russia’s invasion of Ukraine has exacerbated a global post-Covid-19 cost-of-living crisis, leaving the poor in both the developed and developing worlds struggling to access food and fuel.

In an interview with ProMarket, economist Raghuram Rajan speaks about the different challenges facing the developed and developing worlds. Dr. Rajan is the Katherine Dusak Miller Distinguished Service Professor of Finance at Chicago Booth. He was the governor of the Reserve Bank of India (RBI), the Indian central bank, between September 2013 and September 2016. Between 2003 and 2006, Dr. Rajan was the Chief Economist at the International Monetary Fund.

In this interview, which has been condensed for length and clarity, Dr. Rajan speaks about the long-term economic and political consequences of inflation, the risks of sovereign bankruptcies in South Asia and developments in the world of central banking that one must be wary of.

I’d like to start with the question of inflation. You’ve written and spoken about the causes and effects of inflation in the US and the developed world, but much of the developing world is also facing inflationary shocks.
Do you think the origins for this are different in emerging economies, and so should the solutions? Alternatively, with central banks like India’s reluctance until recently to address price rise, are we looking at higher tolerance for inflation now?
I don’t talk about monetary policy in India but I can speak about inflation’s implications for the developing world. Clearly, what’s happening in the developed world is that there is genuine excess demand relative to available supply. You can see this in the tight labor markets. Chairman Powell keeps referring to the 1.9 available jobs for every unemployed worker: that’s a suggestion of how tight the labor market is.

One reason this is so tight, especially at the lower end, is that older workers—64 years and above—have stayed away from the labor market. Another is that there is a regional mismatch between where the jobs and workers are. But particularly important is that immigration has been low in the last two years, with fewer people coming in to fill jobs at the lower end, so the market for relatively unskilled workers is tight. This has created some wage pressure there.

Since anybody who wants a job now can get one with a reasonable income, spending has been strong. Firms have been able to pass through price increases without seeing a significant fall in demand. That’s the traditional inflation happening now in industrial countries.

We may need slower growth if you want reasonable levels of inflation.

In emerging markets, it’s a little different. I would say there is some element of supply constraints, partly because of global supply chains being snagged, partly because of commodity prices rising, but partly also because, in countries like India and Brazil, the upper-middle class has a lot of spending power while the lower middle class hasn’t done very well during the pandemic. So there you might see some elements of inflation skewed towards the things the upper-middle-class spends on.

The big problem is that this kind of inflation, even if it originates from supply constraints, remains high, it becomes more generalized inflation and then you get problems with wage-price spirals and so on. Already you see high wage growth in certain sectors of the Indian economy, in tech for example, though this is driven more by global demand than local. I think in general the fear in the emerging world is that this is not classic demand-push inflation, it has some elements of it and the added supply constraints mean that you have to make demand correspond more to supply.

What do you think central banks in emerging markets should be doing in response? Are they reducing the money supply fast enough?

Countries like Brazil have been raising interest rates for some time to slow down demand and make it balance better with supply. That is the general reaction across the emerging world. These are not countries necessarily with very high growth and they may want more growth.

Isn’t that where the tension is, though? Between balancing recessionary trends post-Covid-19 with runaway inflation?

I don’t think there’s a post-Covid-19 recession in South Asia; the recovery is far slower than expected compared to how far and how quickly it went down during Covid-19. In general, the problem is that the economy can only grow as fast as it is capable of growing, and to the extent that the supply side is damaged either within the country or globally, demand has to adjust. We may need slower growth if you want reasonable levels of inflation.

Do you see governments in emerging economies willing to accept this trade-off?

Unless they can significantly ramp up the rate of reforms to energize growth in other ways. On the fiscal side, many governments are stretched by past debt. But perhaps on the reform side, they can create changes that can energize growth more.

What kind of reforms are necessary?

Typically, reducing some of the constraints on business creation. In the US, you’ve seen a lot of business creation during the pandemic, people are getting more entrepreneurial. Finding ways that credit can expand without creating non-performing bank assets, improving the credit delivery process, and reducing some of the red tape that surrounds labor hiring; there are a bunch of reforms one can think of, you have to do it carefully and negotiate with the relevant stakeholders to make it happen. If done, this could increase the pace of growth and may be the only option left for a number of emerging markets because you can’t press the monetary accelerator and you certainly don’t have much fiscal room left.

I think what we’re seeing instead is that countries are becoming more insular post-Covid-19, battening down the hatches so to speak, imposing trade tariffs, etc.

I think you are right and they are becoming more insular, usually because of bad economics. It’s always simplistic to think “I can raise my tariffs and I create growth.” Well, in reality, I don’t create growth, just rents for my existing industrialists, and I don’t increase the pace of growth significantly over time. You create the illusion of protecting national champions and creating national champions, but if you look at the growth picture, not much changes.

You’re offering big subsidies and tariff protections to industrialists, at the expense of the local consumer. But all this is disguised as patriotic nationalist economics—imagery, which, I think we’ve seen happen before in the world and it’s happening again now in too many countries.

Another cause for worry is the high rates of unemployment in India, especially among the youth. This joblessness leads to discontent and a breakdown of communities.

That is a real danger: that unemployment rates stay high, especially for the lower middle class and that creates more inequality and divisions, and (room for) entrepreneurial politicians who cater to these divisions. (Perhaps they say) “let’s focus on recovering these former Hindu temples which now have mosques (standing there)” rather than focusing on actually enhancing jobs.

I do think what India needs is a program of strong, sustainable and equitable growth, that brings together all minorities, including women and Muslims, into the fold and takes them along. Otherwise, these tensions will just grow.

If we focus on just the Indian growth number right now, we’re not doing too badly apart from the dramatic plunge during the pandemic but if you add in that the women’s labor force participation is worse than in Saudi Arabia—people don’t believe me when I say this—these are pressing issues that need to be solved.

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