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Time For A Contraction

A painful monetary course correction can lead to sustained long-term growth.


Updated: June 27, 2015 12:00:56 am
RBI, inflation, policy rates, Arvind Subramanian, monetary policy, Indian economy, T.B. Kapali column, indian express column This course of action — monetary contraction — will be very painful in the short term. But it will lay the ground for stable, sustained growth in the long term.

By: T. B. Kapali

The Union finance ministry’s Chief Economic Advisor (CEA) Arvind Subramanian recently raised an interesting question in his article ‘At the rate of?’ (IE, June 12). He asked whether it is appropriate for the RBI to target CPI (consumer price index) inflation and increase policy rates, when prices are actually falling, measured by the WPI (wholesale price index). He pointed out that the policy stance appropriate for consumers may not be so for producers. The CEA has called for more discussion on this issue.

This article argues that a “compartmentalised” monetary policy — one for consumers and another for producers — would be impossible. We need a correct diagnosis of the nature of the Indian economy’s ailment for determining the most effective cure.

In the last few years, growth in the aggregate measures of economic activity (GDP) have been in trend decline — at least stagnant — but we have had relentless double-digit inflation in consumer prices. The recent softness in consumer prices has, nevertheless, been accompanied by stubbornly high forward inflation expectations. The focus should be on trend inflation and economic activity. Besides, the plunge in global commodity prices could well reverse.

This phenomenon, called stagflation, is a nightmarish combination and has no easy solution. It is primarily because of people’s inflation expectations having gone completely out of control. Therefore, even as activity levels fall and a resources slack emerges, inflation remains high. If policymakers come down with a heavy hand on inflation, output (and employment) loss could be very high. On the other hand, trying to revive activity could exacerbate inflation.

Tragically, the NDA government, with its status-quoist approach to economic policy, has not attempted even a half-hearted attack on stagflation. Stagflationary conditions have been created by more than a decade of unrestrained CPI inflation. Early in the last decade, the spike in consumer inflation provided a stimulus to investment/ real activity. But now, with inflationary expectations well-entrenched, the stimulus has fizzled out.

If stagflationary conditions have to be eliminated, we have to start by bringing CPI inflation under control. The RBI says it is doing that. But is it, really? This doubt arises because financial conditions in India still remain very accommodative, going by a critical measure: the size of the RBI’s balance sheet.

The RBI’s strenuous efforts to retain the public debt management function validates the suspicion. The RBI’s balance sheet is currently as much as 25 per cent of GDP. This ratio was already high at 15 per cent a decade ago. The relentless monetisation of budget deficits and foreign currency assets (FCA) accumulation have since worsened the situation. Nearly a quarter of all outstanding government bonds are now being held by the RBI. For the record, the US Federal Reserve’s balance sheet of $4 trillion is also 25 per cent of the US GDP of $17tn — after three rounds of quantitative easing! But can there be a comparison at all between the supply responses of the highly flexible US economy and the gridlocked Indian economy?

After an initial boost to real activity in the early 2000s, the rampant expansion of the RBI’s balance sheet has, unsurprisingly, been producing high nominal but poor real GDP outcomes. Technically, this is stagflation. Provide subsidies and run deficits, but do not print them away. That is the biggest lesson from the current stagflation crisis.

The alternative is clearly for the government to fund itself in the markets — in perfect competition with other borrowers, such as households and the business sector, and without forcing banks to be “captive investors”. That is the surest way to keep the economy on an even keel. It will end financial repression, increase savings, squelch inflationary pressures and the resultant imbalances in investments and consumption.

This course of action — monetary contraction — will be very painful in the short term. But it will lay the ground for stable, sustained growth in the long term. The same long-term macroeconomic effects could also be obtained if the government were not to run up big subsidies and deficits. However, in a relatively poor country like India, that would not be desirable, let alone saleable.

The writer is a Chennai-based financial consultant.

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