Wrong approach to inflation

In accordance with widely accepted economic theory, the Reserve Bank of India has been trying to cure inflation by raising interest rates. It has done so virtually every month; unfortunately, even after nearly a dozen such exercises, inflation still persists. As Sir Francis Bacon pointed out over four hundred years ago, a theory is merely a theory; it cannot be taken as fact unless it is confirmed by experiment. In the present case, the theory that inflation can be cured by making money costlier has not worked. It is not a fact.

This situation reminds me of one of Wodehouse's stories about Lord Emsworth. The Lord had scratched his leg thanks to the asinine attentions of a nephew. The contrite nephew brought him a lotion as a cure. The Lord liked its smell and applied it generously. The pain increased instead of decreasing. So, he applied it even more. Ultimately, unable to bear the pain, he washed it off, and got immediate relief. As Wodehouse explains it, the problem was that the medication was meant for horses and not for the delicate skin of a peer of the realm.

TACKLING UNEMPLOYMENT

Then, is inflation the real problem? Do we not also have uncontrolled unemployment? Is not the growth rate slackening? Have we contracted stagflation — inflation plus recession — rather than mere inflation? True, we are still growing, and therefore our disease cannot be absolute stagflation. On the other hand, our growth and employment are both less than what they should be for full employment. Hence, what we are suffering from should be described as “relative” stagflation.

I suggest that unemployment is worse than inflation. Unemployment results when productivity per employee exceeds consumption per employee. However, economies need some breathing space, some flexibility. Hence, economists accept “full employment” as equivalent to about 5 per cent unemployment. Otherwise, nobody will seek employment and the employers will suffer gridlock. Hence, we may take it that “full employment” occurs when consumption per employee is around 95 per cent of production per employee. Thus, employment depends on two factors – productivity and consumption. It is often suggested (particularly in developing countries) that a reduction in productivity is a good solution to unemployment. Hence, it is tempting to shift to labour-intensive, low-level technology.

CHOICE OF TECHNOLOGY

Unfortunately, reduction in productivity has an unacceptable handicap; it reduces prosperity; it increases employment by redistributing poverty rather than by promoting prosperity. For that reason, reducing productivity by adopting labour-intensive technology is undesirable; only an increase in consumption through better productivity is the desirable solution. Or, cost of production – hence interest rates – should decrease, not increase.

We may divide consumption under three categories – essentials, comfort goods and luxuries. Improvements in technology cut down employment in the production and supply of essentials. For instance, modern technology enables one farmer to produce enough to feed fifty or even a hundred families. It enables fewer people to produce and supply energy; modern transport enables many more people to move than did animal drawn vehicles. The same is true of comfort goods, too.

Modern farmers produce much more milk and vegetables than their forefathers did; modern industries need much less people to produce industrial goods; McDonald's need less people to serve tea or coffee than do wayside tea shops. Hence, technology is truly an employment destroyer.

At the same time, technology does make things cheaper and hence allows even the poor to consume more. Thereby, it increases consumption. On the whole it makes an economy more prosperous, even though it reduces the employment needed to produce essential goods and comfort goods.

Luxury goods, particularly luxury services, are a different matter altogether. Once, a journalist counted twenty-four persons who helped him to have lunch in the luxury hotel Savoy in London. Luxuries are expensive because, and essentially because, they need more people. Luxuries create and multiply employment. Hence, though it may sound anachronistic, the cure to unemployment lies in promoting the consumption of luxuries.

At the same time, we should not forget that luxuries are relative – for a hungry person, food, even a plain meal, is a luxury; for a middle class person, a holiday is a luxury; for the very rich, personal attendants are a luxury. Incidentally, public goods like security, roads, energy and water supply are luxuries for all – the fact they are luxuries is realised only when they fail.

President Eisenhower is said to have prevented large-scale unemployment immediately after World War II by promoting construction of highways. Investment in highways, telecommunications, energy supplies, water and sanitation increases some employment directly but does much more indirectly. Thus, investment in public goods is a good idea.

COMBATING INFLATION

If inflation is the main worry, it can be cured in two ways: negatively by reducing prices (i.e., raising interest rates) or positively by increasing incomes (i.e., by increasing employment). Milk and petrol are 40-50 times more expensive than what they were 40 years ago. Yet, their consumption is far higher, only because incomes have risen faster. Thus, the remedy for inflation lies more in increasing employment – and hence consumption – rather than by raising interest rates to make money costlier.

If a compromise is desired, the Reserve Bank can operate a two-part regime: Low interest rates for public goods like mass transport, roads, energy, water supply, sanitation as well as for housing the poor. That is already happening with the Delhi Metro and with highly inefficient subsidies for the poor. Incidentally, all these are long-term projects. Therefore, I suggest that instead of subsidies, all long-term rates be kept low (at 2 per cent?) whereas the Bank may toy with short-term rates in any manner it likes.

(The author is a former Director, IIT Madras. >blfeedback@thehindu.co.in and >indiresan@gmail.com )

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