The Hindu Business Line : Growth, inflation and interest rates

Oftentimes, inflation is a by-product of growth, as India is experiencing, and the policy response is usually to raise interest rates. But there may be other solutions too that will not slow the economy.

"Are we encouraging crony capitalism? Are we doing enough to protect consumers and small business from the consequences of crony capitalism?

— Dr Manmohan Singh, Prime Minister

India has entered the trillion-dollar club, whose other members include the US, the UK, Japan and Germany. India's GDP stands at around Rs 41,00,000 crore. The stock market capitalisation is also close to this figure. There are 14,765 `crorepati' shareholders with a collective net worth of over Rs 65,000 crore. There are 2,55,202 individual investors holding shares worth Rs 84,500 crore (BSE Web site).

The country is home to 37 of the world's top 100 billionaires. India's GDP is growing at 9.2 per cent. Only China with 11.1 per cent and Costa Rica with 10.2 per cent are ahead of India.

Has India. then, suddenly become a prosperous country? Is it no longer true that India is a rich country with poor people? Alas, as one Cabinet Minister pointed out, the 9.2 per cent growth is only for just 0.2 per cent of the people.

Growth and Poverty

There can be no doubt that poverty has come down but still a fouthh of the country's billion-plus people remain poor. Development economists believe that even the poor act rationally in the straitened circumstances. If they do not succeed in overcoming endemic poverty, it is not because they have miscalculated, but because the market for land, credit or insurance has failed them. "The great redeeming feature of poverty," George Orwell wrote after his excursions in the social gutters of Paris and London, is "the fact that it annihilates the future."

Economists have known "immiserising growth," which actually decreases welfare. Technology and innovation accelerate growth. Technical progress, which increases the efficiency of labour, is known as the Harrod-neutral model. The labour force in efficiency units increases faster than the number of workers available. It is thus labour saving. It looks as though India's growth model in the past decade is fashioned this way.

This has to be contrasted with the Hicks-neutral technical progress model, where the efficiency of all factors increases in the same proportion. It is difficult to explain how farmers suffer acutely at a time of record growth. Where has the country failed them? Can the blame be laid at inflation doors?

Inflationary Growth

The ideal target for macro-economic management should be a state of non-inflationary growth, where there is growth of economic activity without any tendency to inflation. Most economists are sceptical of the ability of the authorities to prevent fluctuations in inflation. They view a small positive average rate of inflation as a more sensible target than a mean inflation rate of zero.

Those watching the Indian economic scene would have noted a subtle difference in approach between the Reserve Bank of India and the Ministry of Finance on inflation targeting and marching towards a 9 per cent growth rate. Chinese philosophers have two concepts of Yin and Yang used to describe opposite but complementary forces found universally, as also in the financial sector.

The Finance Ministry prefers soft interest rates; the RBI is scared of inflation. The Finance Ministry sees growth where the RBI sees an asset bubble. Both have conceptual differences about foreign inflows and the road map for opening the economy to Foreign Direct Investments. Monetary policy as a weapon for controlling inflation has not always succeeded.

During the 1980s the monetary policy became the central economic instrument used by the governments of the US and Britain, in the belief that the control of inflation was the key to stable economic growth, and the level of inflation was determined by the growth in the money supply.

However, money supply proved very difficult to control (and even to measure) and interest rates became a rather blunt economic tool, and a less dogmatically monetarist stance was assumed. Hence, by handing over control of the money supply to an independent central bank, a policy pioneered in New Zealand and adopted in Britain in 1997, a government can escape blame when things go wrong and continue to praise itself when they go right.

Bubbles and central banks

India has not gone that far. The RBI cannot be compared to the Bank of England or the US Federal Reserve. Adam S. Posen, a senior fellow at the Institute for International Economics, US, writing for the Peterson Institute, cautions central banks not to be in the business of trying to prick asset price bubbles because the connection between the monetary conditions and the rise of bubbles is rather tenuous. Raising interest rates or reducing the amounts available to the banks for lending, will only cause a recession.

"The cost-benefit analysis," says Posen, "hardly justifies such pre-emptive action". All that is necessary to prevent havoc by bubbles is good banking supervisions (Working Paper Series, Why Central Banks Should Not Burst Bubbles, January, 2006, Peterson Institute for International Economics).

In the last one-year, short-term interest rates have gone up considerably in all countries. Inflation is a global phenomenon. India's interest rates are no doubt on the higher side. Mere monetary measures alone may not succeed in arresting inflation.

Other avenues, such as increasing productivity, catering more efficiently through the Public Distribution System to the needs of the lower income groups and think of a dual interest rate regime, need to be explored.

Captains of industry owe the growth in profits to the low interest regime of the past five years. The fixed income groups had suffered in the bargain. Is it not time to restore the cuts in small-savings interest rates (Post-Office, NSC, EPF, etc) imposed three years back? That may be the least that the government can do to help the fixed-income groups at the receiving end of inflation.

(The author is a former Chief Commissioner of Income-Tax.)

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