Can The Reserve Bank Of India Tame Inflation?

The Reserve Bank of India hiked key policy rates for a third time on September 16, 2010 in a bid to quell rising inflation in India. Will it be successful in taming this monster which has run rampant for the better part of the past three years? Unfortunately, in my view, the answer is in the negative. The RBI has neither the understanding of what causes price inflation nor the will to take tough choices to contain it.

To cure a disease, it must first be diagnosed correctly. It is futile just treating the symptoms. Such is the method adopted by the RBI. I have no confidence in our policymakers’ ability to zero in on the root cause of inflation. They’ve blamed everything from international oil prices to a below-average monsoon for the rising prices. These are at best proximate causes and at worst excuses to divert attention from their own failures.

As famed economist Milton Friedman declared,”Inflation is always and everywhere a monetary phenomenon.” Therefore, to understand why there is rampant inflation in India, we need to look at the stock of money or money supply. The M3 money supply metric consists of currency notes in circulation, demand deposits, time deposits and bank reserves with the RBI. From the RBI’s website, the growth in M3 since August 2009 has been 15.1% and the growth in the previous year had been 19.9%. Therein lies the cause of the massive rise in prices witnessed by India, a huge growth in the money stock. In fact, since 1994, the money supply has grown by 15% on average per annum, thoroughly debasing the rupee and making life more difficult for the poorest of the poor. Inflation of the money supply transfers wealth from the poor to the rich through the Cantillon Effect which is why we constantly see headlines in newspapers saying growth in India has not been inclusive.  Well, DUH!

It is an absolute falsehood to declare that price inflation is the result of rapid economic growth. Nor is it acceptable to trade-off higher inflation for higher growth. In fact, the two have very little to do with each other. High growth rates follow from high real savings that are subsequently reinvested into higher order capital goods such as machinery or R&D. High inflation follows from increasing the money supply.

The fact is, rapid economic growth should cause a decline in the general price level. This phenomenon was most commonly witnessed under the gold standard but also as recently as 2005 in China. Under the classical gold standard followed in most countries around the world in the 19th century, prices declined even as economic growth exploded. At the height of the Industrial Revolution from 1869 to 1879, in the United States, real GDP growth averaged 6.8% per annum while general prices declined an average 3.6% per year! In fact, despite several gold discoveries in the US in the 19th century, particularly in California and Alaska, the general price level declined by 51% from 1800 to 1900. In other words, what cost $100 in 1800 would cost just $48.94 in 1900.
Most of these lessons, however, are lost on our policymakers (to be fair, they are lost on policymakers all over the world). There is a widespread belief that inflating the money supply is the cause of economic growth and the price inflation that follows is a result of economic growth. Therefore, I’m not holding my breath waiting for a sustained drop in inflation in India.

To control inflation, first and foremost, the Indian government needs to stop running huge budget deficits. Most of the budget deficit is financed not by borrowing in the debt markets but by monetization by the RBI. The RBI in effect exchanges freshly printed rupee notes for government bonds. When this base money gets into the banking system, it is multiplied several times by the banking sector through a process called fractional reserve banking which causes a large increase in the money supply. 

Secondly, India is running a huge trade deficit of about US $135 billion over the past 12 months. In order to close this deficit, the rupee needs to be weakened to stimulate export growth. This weakening is accomplished by the RBI’s purchase of foreign currencies with freshly created rupees, again increasing the money supply and pushing prices higher.
Lastly, a serious effort to curb money supply growth will push interest rates on home loans and auto loans closer to the 15-20% range. Such a push would likely trigger a massive recession which is politically unacceptable. The RBI governor has categorically stated that he will not accept high unemployment and low growth just to curtail inflation. In my opinion however, such a policy is wrongheaded. Inflation must be addressed first and foremost at all costs before worrying about GDP growth as it weakens the production structure of our economy. Sometimes it’s better to retreat a little, regroup and then advance instead of plunging headlong and losing our way.

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