The Hindu Business Line : Credit Policy: Orwellian logic at work?

Inflation is the result of synchronised currency debasement by central bankers the world over. The markets understand this better and have been sending the right message through rising gold prices, particularly during the last few years. The RBI would do well to read the signals and take appropriate measures, says SHANMUGANATHAN N

Black is White.

George Orwell, in 1984

The Orwellian phrase refers to “… a loyal willingness to say that black is white when party discipline demands this. But it means also the ability to believe that black is white, and more, to know that black is white, and to forget that one has ever believed the contrary. This demands a continuous alteration of the past, made possible by the system of thought which really embraces all the rest”.

When I first read Orwell in college about a decade ago, I dismissed it as one of those fringe thought processes.

It still remains a fringe-element as far as the mainstream media is concerned, but for those who have had the opportunity to objectively look at the some of the Government-published reports around the world, Orwell offers the perfect explanation on how some obviously smart and intelligent people could be so wrong about some very fundamental issues.

Any number of pronouncements from the recent policy statements of the Reserve Bank of India can be used to make the above case. But the claims on inflation would work best as inflation is a topic that is easier to understand and where misconceptions are rather widespread. When Dr. Y.V. Reddy as part of his Credit Policy spoke about the threats to inflation from higher oil prices, it is exactly the Orwellian phenomenon at work.

Inflation and oil

As this article explains, the reality is that it is not higher oil prices that are causing inflation, but the exact opposite: inflation is causing oil prices to rise.

In a couple of earlier articles I have explained what inflation really is and how the purchasing power of the Indian rupee has been debased over the last few decades (“Inflation, the Unusual Suspects” Business Line, April 7, 2007 and “Is Our Monetary Policy Sound?” Business Line, January 11, 2007). To summarise the same here, inflation is simply the expansion of money and credit within the economy. The result of this expansion in the supply of money is increased prices. As explained in the earlier articles, what increased prices really reflect is the lower purchasing power of the currency.

Synchronised debasement

To give a more understandable comparison, a central banker defining inflation in terms of consumer prices is much like a physician defining fever in terms of the body temperature. Medically, fever is just an infection and the symptom of this infection is increased body temperature. So the RBI referring to oil prices causing inflation is much like a physician saying that the increased body temperature is causing the infection.

For sure, there are certain other factors that are pushing up oil prices and few people understand this as well as we do (refer http://kinghubbert.blogspot.com). But a substantial portion of the oil price increases over the last few years could be directly attributed to the policy of synchronised currency debasement as practised by the central banks around the world.

Priced in the market currency of gold rather than the paper currencies issued by central banks, oil prices are still up over the last few years, but much less than the nominal increases indicate.

So, if the oil prices are going up for reasons other than currency debasement, isn’t the RBI at least partially correct? Again, the answer is “No”. The reason is that while prices of individual commodities are governed by the demand-supply dynamics of that commodity, the price of a basket of consumer goods is governed by the aggregate supply of money.

Thus, while prices of oil might go up for reasons specific to oil, this increase, by definition, would reduce the amount of money chasing other goods causing their prices to fall.

So, what causes the prices of a representative basket of consumer goods to increase will always remain just one factor — monetary expansion beyond what is physically produced in the economy.

What should RBI do?

There are a couple of issues here. First, for the RBI to realise that the current policy of massive currency debasement (how else to describe a policy that allows money supply to grow at 20 per cent plus?) is going to be a disaster even in the near term. Once it is convinced, there would arise the issue of how to communicate this to Indian industry that has been used to a very lax policy for the last several decades and even more so in the last few years.

If the RBI does indeed act to protect the purchasing power of the currency (by cutting the growth in money supply by as much as 50-75 per cent and also simultaneously increasing interest rates), the consequences for industry and the average citizen would not be pretty in the short run.

It’s going to be higher interest rates, falling asset prices and a seemingly reduced demand. But all it would mean is that we reduce a few percentage points (the froth) of the growth we are witnessing. If we avoid or even delay the above steps, then what we would witness in the years ahead is an environment of spiralling prices for food, energy and other commodities.

Rupee appreciation

For sure, the above actions are going to cause a significant appreciation of the rupee against the US dollar and there is going to be great clamour for intervention from the exporting community.

But since the US Fed is decidedly going down the path of inflation to pay down their debts, it makes little sense for the RBI to follow suit.

The ideal situation would be to benchmark the Indian rupee against gold, but the least the RBI could do is to benchmark it against a basket of currencies such as Euro, Chinese Yuan, Canadian Dollar, Swiss Franc, and the Japanese Yen.

Markets are ahead

Are we hopeful that the RBI would act as above to protect the purchasing power? Frankly, “No”. So far, the actions of the RBI could be better explained using Orwell.

A few months back, the RBI delivered back-to-back increases in interest rates of 0.5 per cent each. The rationale as explained then was that the markets failed to recognise the message with the first increase and, hence, the second one was necessitated.

Quite contrary to the RBI’s perceptions, in our opinion, the markets are actually well ahead of the central banks in understanding the inflationary concerns.

Perhaps, the RBI would do well to understand the message that the markets have been sending through gold prices for the last several decades, and more particularly during the last few years.

In dollar terms, gold prices have more than tripled in the last five years and the only message that increasing gold prices deliver is a decreased confidence of the markets in fiat currencies. We only hope India’s central bankers learn to appreciate and understand these market signals.

(The author is a Director at Benchmark Advisory Services. He can be contacted at shan.sundaram@benchmarkconsulting.in . His previous articles can be accessed at http://financial-musings.blogspot.com)