The Hindu Business Line : Is our monetary policy `sound'?

Once in a while, it pays to sit back and judge objectively how instruments of monetary policy are being used. How should "monetary stability" be measured and how well has the RBI delivered on that goal? What effect has 55 years of discretionary monetary policies had on the purchasing power of the rupee? asks SHANMUGANATHAN N.

In a recent interview, the Reserve Bank of India (RBI) Governor, Dr Y. V. Reddy remarked that an Economics professor from the US had complimented him on India's monetary policy, which he had described as `sound'. The interviewer then said commentators on their channel also agreed with that assessment.

To most people, the monetary policy is a jugglery of a few variables — interest rates and ratios — and it is used to monitor inflation, employment, etc. And after the annual policy announcement, bankers and economists offer their opinions on how the current policy promotes growth, will control inflation, and so on. But once in a while, it pays to sit back and judge objectively how the instruments of monetary policy are used. In doing so, we should measure real outcomes against the objectives.

Measuring monetary stability

The RBI (www.rbi.org.in) defines its basic function thus: "... To regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage." Indeed, central banks the world over recognise monetary stability as their core function. So how should "monetary stability" be measured and how well has the RBI delivered on that goal?

Monetary stability refers to the ability of a currency to maintain purchasing power over a period of time. In an ideal world, this would be measured against a comprehensive basket of goods that not only includes data that is used for CPI (consumer price index) calculations but also other asset prices, such as real estate and financial assets. Given that accurate data for such a calculation is not available, one has to rely on indirect methods to determine monetary stability.

The option then is to measure the stability against another currency. The question is whether this comparison should be against another "paper" currency, such as the US dollar, or against the historical free market choice of gold? Since all currencies in the world today are completely flat, any paper currency comparison would not serve the purpose as what we would then be measuring is relative stability and not absolute stability and remember, we enjoy/suffer on the basis of absolute price levels changes in India.

Against Gold

So how has the rupee fared against gold in the last 55 years? Since 1950, gold prices has increased from Rs 98 for 10 gm to nearly Rs 10,000 today indicating that the rupee has been debased by 99 per cent. Look around and you would be hard pressed to find anything for which the prices have not gone up at least a 100 times, in the last 55 years. It is indeed puzzling that a policy that has caused such prolific debasement is described as "sound."

From the graph, one might conclude that the policies from 1950 to 1970 were indeed "sound." That conclusion is erroneous for the following reasons:

Gold prices increased from Rs 98/10 grams to Rs 185 in the above period. But because of the scale of the graph, the near doubling looks like a flat line.

Gold prices were fixed by the US Fed at $35/ounce during the above period. Further, the exchange rate of the rupee with the US dollar also was not market-determined. Hence gold prices before 1970 are not nearly as useful for economic analysis as the ones subsequent to 1970 as the lingering ties to gold was cut-off with the Smithsonian Agreement of 1971.

When we usually talk about this, there are lots of questions. Here are some of the FAQs:

May be the current policies are indeed `sound' and what has caused the above debasement are the historical practices.

The graph of gold prices indicates that the debasement has been fairly continuous, although the rates have differed at different points in time. So the difference is not in terms of direction but pace. Even arguing that short-term movement in gold prices is not indicative, the current growth of M3 at 20 per cent-plus indicates that we continue to run a loose monetary policy.

Maybe the current gold prices are not correct.

Current gold prices are undervalued by a factor of 10, if not more. So if anything, the debasement is actually greater than the 99 per cent.

How am I sure that the accompanying inflation has not made the citizens better off?

Studies have demonstrated the ill-effects of inflation. A school teacher in the 1950s and 1960s would have had a monthly income equivalent to two sovereigns of gold. By the time she retired, 30 years later, her salary would have been less than the value of two sovereigns of gold. So even with the seniority gains, her purchasing power was actually decreasing during the period of employment. In relation, you could compare what a CEO of a private company makes today compared to his/her predecessors.

This is not to decry CEOs making higher inflation-adjusted salaries. The point is that the effects of any inflationary practice get distributed unevenly and usually the people who gain are a privileged few at the expense of the masses.

Three questions

Historically, it has been proven that the best way to ensure monetary stability is to stop the debasement at the source. For 100 years before 1914, we had zero per cent inflation as the world was operating on the classical gold standard. The world moved away from the gold standard not because the system failed, but only because it worked too well — it prevented governments from printing money at will. What the world has learnt in the subsequent 90 years is that to provide the power to debase the currency and expecting political leaders not to use it is naïve.

The issue in our case is easily understood by asking the following three questions:

What effect have 55 years of discretionary monetary policies had on the purchasing power of the rupee?

If you agree that the purchasing power has been eroded in a very significant way, then who has benefited from such inflationary practices?

If you conclude that inflation leads to a transfer of wealth from the masses to the privileged few, then what should be done to prevent future inflation?

It is also incumbent upon all citizens to ask these questions. The attempt here has been to answer the above questions briefly - but readers do not necessarily have to agree with the assessments. What is more important is that we have an objective debate on the above issue.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in.)

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