Updated: May 25, 2022 11:54:50 pm
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Which is worse: high inflation or high unemployment? This is not just one of the more intriguing questions in economics but also a key concern among policymakers, not to mention among people.
In the short term at least, there is a trade-off between inflation and unemployment. Typically, when an economy goes through a phase of high inflation, chances are that the unemployment rate will fall. That’s because firms, enticed by higher prices, try to ramp up production by recruiting more people.
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Oddly enough, while high inflation may be robbing people of their purchasing power, it often ends up getting the unemployed a job!
Phases of dull economic activity often witness the reverse — low inflation but high unemployment.
So, which is worse?
One study, titled “The happiness tradeoff between unemployment and inflation” by David G. Blanchflower et al (2014), looked at data from Europe between 1975 and 2013 and found that while both higher unemployment and higher inflation lower well-being, unemployment depresses well-being more than inflation. In fact they found that unemployment hurt well-being considerably more than inflation.
“Our estimates with European data imply that a one percentage point increase in the unemployment rate lowers well-being by more than five times as much as a one percentage point increase in the inflation rate,” states the study.
At one level, this sounds plausible as well. While inflation undermines our purchasing power — Rs 100 this year does not buy the same set of goods that it bought last year — yet it has its upsides such as more people might be getting off the “unemployed” lists and more people may see their wages rise sharply etc. What’s the upside of high unemployment?
And yet, when it comes to political costs, and especially in India, the choice is not so simple. India has always had lots of people who were unemployed or underemployed or involved in disguised employment.
Take the last few years. No matter which set of data one looks at, India has been facing rather high levels of unemployment since 2016. And yet, the ruling party continues to enjoy considerable popular support.
Contrast this with the fate of governments that allowed inflation to stay high.
The UPA-II comes to mind immediately. If one looked at retail inflation figures, UPA-II allowed inflation to hover around 9%-10% level for the last four years of its five-year term. Of course, this was not the only reason but a persistently high level of inflation did play a big role in UPA’s spectacular defeat in 2014.
In 1998, the ruling BJP government in Delhi (state) was at the receiving end of a similarly stunning loss when a spike in onion prices ended up giving a sweeping mandate to Congress’s Sheila Dixit, who went on to win two more successive terms as chief minister.
It can be argued that the political sensitivity to high unemployment and high inflation varies from country to country and is perhaps hugely influenced by a country’s past.
For instance, in the US, where the mass unemployment of the Great Depression in the 1930s was a particularly painful experience, even the central bank’s mandate gives equal weightage to achieving “maximum employment” and containing inflation.
In India, it would appear that governments should fear high inflation more than high unemployment. At least the current government certainly does seem to think so.
As soon as it became clear that high inflation cannot be wished away and is likely to become even worse if immediate steps are not taken, all policymakers have swung into action — quite in contrast to the government’s denial of any unemployment-related stress.
While the RBI has already raised interest rates earlier in May and is expected to continue raising rates in the coming meetings, the government, last week, did its bit and decided to cut taxes levied on fuel as well as customs duties on the imports of several raw materials.
Was this the right decision?
More broadly speaking, what should the government do in terms of the fiscal policy — that is, its expenditure and taxation — at a time when the RBI is set to tighten monetary conditions in the economy?
This is again one of the more contentious questions in economics and the prescription changes depending on one’s ideology and understanding of what is causing inflation.
The first thing to understand is that a fair amount of the current inflationary spike is due to high costs of fuel (which India largely imports) as well as other imported raw materials. The high cost is both because of higher prices of these products themselves — say costlier crude oil — as well as a high level of taxation.
It is also important to understand that monetary policy does not have a direct solution to controlling such “cost-push” inflation. It cannot make fuel prices lower by raising interest rates. All it can do is to control demand in the economy. By slowing down the overall demand — and, by corollary, the overall GDP growth rate — tighter monetary policy is expected to allow the “supply” more time to be more in sync with the “demand”. It is for this reason that tighter monetary policies tend to drag down economic growth.
Given the fact that India already does not have a robust demand, a tighter monetary policy can trigger a scenario where India’s overall growth momentum takes a hit. As the Chief Economist of the leading international bank, who did not wish to be identified said, “if one considers the so-called Hindu rate of growth of 4% GDP growth as inadequate for India, then, yes, we could be looking at stagflation.” Typically, stagflation requires a contraction or stagnation in GDP growth.
A good way to counter such “cost-push” inflation and reduce the chances of going into stagflation is for the fiscal policy to step up and cut taxes on fuel and other imported raw materials. It is noteworthy that whenever a government levies (or increases) a customs duty, it essentially taxes its own people by making imports costlier.
Reducing taxes on fuels and imported raw materials will not only moderate inflation but also increase overall demand — something the RBI’s monetary policy cannot achieve.
“Reducing such taxes on fuel will serve the economy in both ways,” said Pronab Sen, former chief statistician of India, while speaking to this reporter last week, just hours before the government announced its decision.
What about the government’s spending? Should that be increased or decreased? Should the government prioritise directly spending money to provide income support to the poor who are the hardest hit by inflation or should it, instead, prioritise spending on building infrastructure?
The starting point again is to note that the RBI’s tighter monetary policy will provide a contractionary impulse to the economy.
How? Sen explained.
“Tighter monetary policy will reduce the demand that is driven by borrowed money,” he said. “As such, as interest rates go up, you will see private sector firms cutting back on fresh investments. Similarly, you will see a reduction in consumption that is driven by borrowing — for example, demand for housing will likely take a hit,” he said.
The question is: if these big drivers of demand will falter, should the government step in or let things be?
Sen believes the government should step in. “Government should step up public investment in order to make up for the (likely) fall in private investments,” said Sen.
In other words, even though the government’s revenues may be falling, it should not allow capital expenditure — that is the expenditure that goes into making productive assets such as roads, bridges, schools etc. — to falter.
Sen was also clear that the government should spend on small projects such as rural roads and affordable housing instead of big projects and that too in urban areas. That’s because it is in such projects that millions of Micro, Small and Medium Enterprises (MSMEs) will be able to participate.
“The MSMEs are the lower arm of the K-shaped recovery. Public investment in such projects will provide avenues for the MSMEs to get back into the game.
N R Bhanumurthy, Vice-Chancellor of Dr B R Ambedkar School of Economics, Bangalore, also underscores the need for the government to “ring-fence capital expenditure”.
“It is important to remember what the government is spending its money on,” said Bhanumurthy. If the government’s borrowing money to spend on everyday consumption needs then it will only worsen the inflation. On the other hand, if the government is borrowing money to spend on building assets that will allow the economy to be more productive in the future, then the government is justified.
What do you think the government should do? Also, which is the bigger problem for India: high unemployment or high inflation? Share your views and queries at email@example.com
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