The Hindu Business Line : CPI is the way to go, not WPI

The World Economic Outlook (WEO) 2008 suggests an important data change with policy significance regarding measuring inflation. We are, in fact, using the wrong measuring gauge, says S. VENKITARAMANAN.

The policy-makers of the world, viz, the Finance Ministers and the Governors of the central banks of various countries, have gathered in Washington on their semi-annual get-togethers. They have gathered at a time when the world is threatened by a serious systemic collapse of the financial institutions, especially in the advanced economies.

The World Economic Outlook (WEO) 2008, which has come out, does a competent job of analysing the circumstances that led to the present financial crisis. It points out that, as a consequence, the world economy is faced by the threat of a recession.

The advanced economies, in particular the US and Europe, confront the prospects of slowdown, affecting, in turn, the other economies of the world, which are naturally linked to the economies of rich countries.

There is considerable emphasis in the report on the need for better regulation and supervision in various countries.

There is an implicit emphasis in the WEO 2008 that weakness of regulation and supervision was responsible, to a large extent, for the collapse of major mortgage banks such as Fannie Mac and Freddie Mac and the subsequent linked developments. Leading financial institutions on Wall Street, such as Bear Stearns, Lehman Brothers, AIG, failed as a result.

In contradictory situation

The authorities in the developed nation are caught in a contradictory situation. They are caught between a rock and a hard place, in the sense that they have to handle the responsibility of nursing the institutions under stress by pumping in liquidity and at the same time nurturing the growth impulse in the economy without encouraging inflation.

This aspect applies equally to the dilemma faced by policy-makers in the developing world. Their liquidity shortage, however, flows out of the credit crunch in the advanced economies.

According to IMF’s projections of growth of different countries in the world, the world output is expected to grow by 3.9 per cent in 2008 and 3.0 per cent in 2009 as against a growth of 5 per cent in 2007 and 5.1 per cent in 2006.

The higher rate of growth in 2006 and 2007 was primarily based on the contribution of the economies of emerging markets, especially the Asian economies, which grew at 10.0 per cent in 2006 and 8.4 per cent in 2007. They are expected to grow at 7.7 per cent and 6.1 per cent in 2009.

China, in particular, had grown at 11.9 per cent in 2007 and is expected to grow at 9.7 per cent in 2008 and 9.3 per cent in 2009.

India, on the contrary, grew at 9.8 per cent in 2006 and 9.8 per cent in 2007 and it is expected to grow at 7.9 per cent in 2008 and 6.9 per cent in 2009.

The differences between India and China may be considered to be small, but they are significant. It is worth noting that Brazil, one of the resource-rich countries of the BRIC nations, is expected to grow only at 5.2 to 5.4 per cent in 2008 and 2009.

Need to recapitalise banks

The WEO concentrates its attention on the need for policy coordination between different countries of the world in handling the financial difficulties arising from the US financial situation.

In keeping with IMF’s advice, various central banks of the world in Europe, Asia and the US have started taking coordinated measures to infuse more liquidity and to restore trust and confidence in their financial system so that credit can resume its flow.

While the WEO notes the boldness of the US plan for taking over the distressed assets, there is a reference in the report to the need for recapitalising banks also as a priority.

In fact, Mr Gordon Brown, the Prime Minister of Great Britain, has gone on record with this view ahead of the WEO 2008. He has gone ahead with infusing capital into a number of financial institutions in order to prevent them from collapse.

There is a message in this for the policy-makers of the world so long under the influence of Washington Consensus. Infusing State-owned capital into banks is perhaps a better means of restoring financial confidence than the Paulson remedy of using public resources for buying distressed assets. Incidentally, I see that President Bush has also followed Gordon Brown’s example by infusing State capital into many US banks.

Inflation management

The WEO, as usual, contains a number of carefully studied observations on the various economies of the world. In particular, I was struck by the reference to inflation management. In line with other major documents of the international system, the WEO measures inflation through consumer prices and not by changes in wholesale prices.

In fact, this is in line with what most famous economists of the world, such as Gregory Mankiew and Robert Samuelson, have advised in their textbooks on macroeconomics. In their view, the CPI is much closer to the public experience of the impact of inflation than the producer price index, which is what is measured by WPI.

IMF seems to agree with this view. Should the RBI be far behind? In this context, a Table in the WEO, reproduced here (see Table) is relevant.

This shows that unlike the figures of +12 per cent for inflation, which were published in India by the RBI and Government based on the WPI, Indian inflation is adjudged by the IMF to be closer to 7 per cent. While it is true that we in India have been habituated to measuring inflation by WPI, it would be appropriate to change the practice and follow the example of international agencies, especially the IMF. In short, CPI is the way to go and not WPI.

Wrong measuring gauge

The Finance Minister, Mr P. Chidambaram, is an avid student of economics, especially documents such as WEO. No detail will escape his eagle eye. Although he is not attending the Fund-Bank meeting at Washington, I am sure he would have perused and studied carefully the WEO 2008 data and the tables in the report.

While the WEO offers advice on policies to manage the crisis, it does suggest an important data change with policy significance regarding measuring inflation.

We are, in fact, using the wrong measuring gauge. It is far better if we follow the international practice with all that it implies for monetary policy in India — an immediate rate cut of nearly 5 per cent that has substantial fiscal and growth implications.

While the WEO talks about recession and the possible effects of the financial collapse in the US, it also draws attention to the danger of global imbalances, especially in view of the declining dollar. It advises a coordinated effort to prevent a total collapse of a different kind, but equally serious as the one that we have recently seen.

The IMF needs to formulate a coordinated plan for handling such emergencies. We need a global central bank to undertake such plans — Shades of Lord Keynes!

Notwithstanding declining inflation measured on CPI basis in the emerging Asia, there is a reference in the report to the dangers of over-heating. Fortunately, this does not refer to India, but to the oil-exporting countries, which “suffer” from a surplus of foreign exchange and, as a result, increasing money supply and higher prices.

The remedy for this is obviously higher imports and higher investments by oil-exporting countries. There is a noteworthy absence of the usual homily against over-heating in emerging economies, which have a relatively low inflation based on CPI.

( blfeedback@thehindu.co.in)

More Stories on : Economy | Financial Markets | S Venkitaramanan

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Restoring the market

CPI is the way to go, not WPI

Is Ratan Tata a Marxist?

UPA’s tightrope walking

Out of season session

Europeans are looking for united solutions

Deposit cover

Land acquisition pains