The Hindu Business Line : When the remedy does not spell a cure

Raising interest rates may be a good thing in rich countries where people are over-indulging and are consuming more than necessary. In a poor country like ours, where people are suffering from perennial shortages, cutting own money supply can do more harm than good, says P.V. INDIRESAN.

“The only thing that stops falling hair is the ground” is a well known quip. Likewise, we can say that the only thing that stops rising prices is competition. That competition halts inflation is a fact that is generally forgotten when prices get out of control. Traditional remedy for inflation is higher interest rates, not more competition.

Elementary economics tells us that inflation is of two types — demand-pull or cost-push. Demand-pull occurs when money in circulation becomes excessive; cost-push occurs when production gets choked. Policy makers tacitly assume that too much money is the sole cause of inflation. On that ground, they make borrowing costlier by raising interest rates.

There are three problems with this assumption and this remedy. One, in rich countries, businesses are highly leveraged. Hence, interest rate adjustments are effective. In India, many industries, IT industry for example, hardly depend on bank finance. Hence, interest rate changes have less effect.

Two, interest manipulation tacitly assumes that the economy is monolithic — that inflation is due to too much money in every part of the economy and that there is no shortage of any product in the economy. That is rarely true: Currently, India is suffering from double-digit inflation. At the same time, there is a severe shortage of shelter, of energy and quite a few other essential needs such as water, education and healthcare.

Three, when interest rates are raised, less money is borrowed, there is less money to spend, demand reduces, and in its wake, prices do come down. At the same time, economic growth too comes down.

Thus reduced growth is the price paid to keep prices in check. We are witnessing that phenomenon already: industrial growth, sales of houses and vehicles have already come down.

Two-pronged approach needed

It is true that we do have some rich people who have more money than what they can spend wisely. Hence, we need a two-pronged approach: Contain the excessive spending of rich spendthrifts and stimulate the production of essential goods that are in short supply.

With increased supply of goods, prices will come down. In addition, the economy grows faster; it does not shrink the way it does when interest rates are raised.

In this case, we get a double benefit — less inflation plus higher growth. Here is the basic asymmetry between curtailing money supply and increasing production. Hence, as far as possible stimulate, encourage production; curtail money supply very selectively, only when and where necessary.

Production increases when entry costs are reduced and when operating costs too become less — when interest on long-term loans and working capital loans is reduced. That is exactly the opposite of what we are doing.

In India, political and administrative costs are even more onerous than financial ones. Hence, apart from financial incentives, we should reduce political and administrative entry barriers and operational constraints. The telephone industry is the most striking example of how prices tumble down when administrative barriers are cut down.

The Delhi Metro is the most glamorous example of how apparently uneconomical projects become a success when financial barriers to entry are brought down. (The capital Delhi Metro uses is virtually free; it enjoys 30-year-soft loans at 0.5 per cent interest rate.)

Extravagance and shortage

Let us therefore divide our economy into two parts — the extravagant part and the shortage part. Because there is extravagance, let us continue to keep interest rates high. At the same time, selectively, let us stimulate production of essential goods that are in short supply.

We need not make the list of exempted goods very long; we can limit that benefit to a few major items only.

For instance, we could liberalise the energy sector the same way we liberalised the telecom industry: We could go even further. On top of liberalisation, we may offer soft loans, the way we are doing to Delhi Metro, to anyone willing to utilise renewable sources of energy or locally available fossil fuel.

When newer sources of energy enter the field, oil producers will be forced to rethink their pricing strategy; they will be more circumspect in inflating prices the way they are doing now.

A similar credit facility may be extended to farmers. Instead of loan waivers, after the farmers have become bankrupt, we may provide them cheap loans and prevent them from becoming bankrupt in the first instance.

Similarly, schools, hospitals, mass transport systems, housing estates may be offered soft loans. Then, the cost of electricity, food, housing, education, healthcare and transport will all come down significantly, which is exactly what we need to do to curb inflation. These few segments are enough to cover most of what the poor and the middle class spend. For other less needy luxury goods and services, interest rates may be kept as high as desired.

Incidentally, we can look at rich people as a threat and tax them, or we can treat their disposable income as a resource; induce them to invest their surplus for the production of goods in short supply. Once entry costs are reduced administratively through liberalisation and financially through soft loans, many rich will be tempted to invest rather than squander their disposable income.

Liberalisation and low entry costs increase competition; competition improves efficiency; efficiency reduces prices.

We have seen that happen in telecommunications, in the automobile industry, in airlines and in a host of other instances. We see shortages and high prices in precisely those parts of the economy that are rigidly controlled.

The mango fruit analogy

There is a story of a foreigner who visited our country. His host gave him a mango and advised him to eat only the outer part and leave out the inner seed.

As he was leaving, as is the custom in South India, the host gave the visitor a coconut. Remembering the instructions given about eating mangos, the visitor tried to eat the coconut the same way.

We are not much different from that visitor: we borrow ideas from rich countries that do not have the kind of shortages of basic needs the way we have. We assume that our economy is monolithic and treat both excess and scarcity in the same way.

Critics will argue that the effect of raising interest rates is immediate while any stimulus to raise production suffers from long gestation periods. They will add that, in the face of imminent elections, no government can accept a post-dated cheque.

The criticism is not quite accurate; interest rate changes too take a long time to work through the system.

Further, history of Independent India tells us that people cast their votes not for past performance but for future hopes. Expecting to get more votes through high interest rates is a mirage. In contrast, a promise of more goods is likely to attract voters better.

Unfortunately, people have lost faith in the government. They fear that major projects will help only the rich and destroy traditional livelihoods of the poor. Stimulating production will not yield dividends until that fear is removed.

(To be continued)
(The author is a former Director of IIT Madras. Response may be sent to: indiresan@gmail.com)
This is 230th in the Vision 2020 series. The previous article was published on July 7.

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