In the past few weeks, there have been some noteworthy developments. The Finance Minister and the Chairman of the Council of Economic Advisers to the Prime Minister have both independently, and vigorously, protested that IMF’s downgrade of India’s growth forecast is inaccurate. India will grow much faster than the IMF predicts, they argue.

In fact, the IMF has been generous with India’s growth forecast of 3.75 per cent. World Bank data, computed on a purchasing power parity basis, shows that actual growth for the year ending 2012 was 3.2 per cent.

The Reserve Bank of India has hiked interest rates by 25 basis points in an effort to curb inflation, yet again raising the cost of capital for Indian businesses.

On the same day, the World Bank has released a report on the ‘ease of doing business’ in all of the countries of the world. It is a global ranking, across numerous important dimensions, with an overall score.

Costs of Doing Business

India is at rock bottom. India’s overall ease of doing business rank is 134, preceded by that of Uganda and the Republic of Yemen, and followed by Ecuador, Lesotho and Cambodia. India is absolutely one of the worst countries in the world to do business in.

It is impossible to start a business in India; it is impossible for Indian companies to engage in global trade; and it is impossible for businessmen and others to enforce contracts. On ‘starting a business’, India’s rank is 179; on ‘obtaining construction permits’ India’s rank is 182; on ‘trading across borders’ India’s rank is 132; and in ‘enforcing contracts’ India’s rank is 186.

The last is telling. It is the worst score of all countries. It implies that no one keeps their word in India; there is no rule of law; and, there is no enforcement recourse whatsoever. Businessmen engage in economic activities in India at their own risk.

The normal assumptions that human beings make, as to the cause and effect relationships between investment input and goods and services output, are warped, as there is uncertainty over outcomes.

Unpredictability is the order of the day. India is a gamble. Businessmen may stand to lose everything, and more, that they have invested.

They may get involved in litigation activities for a decade, if not a generation. So, why invest?

If we review the facts on gross domestic capital formation in India, given in the chart in the seven-year period of 2005-06 to 2011-12, growth in both private sector and public sector capital formation has fallen.

Growth in domestic capital formation is a pre-requisite for the growth in gross domestic product.

It is axiomatic that inputs lead to outputs, and a consistent reduction in inputs can only lead to a consistent reduction in outputs.

The facts show that for almost a decade, Indian businesses have been cutting back on investment.

This period has been one of high interest rates, and enormous economic environmental uncertainty, leading the World Bank to conclude that India is one of the world’s worst countries to do business in. All of these have contributed to the overall economic growth slowdown.

Investment and Inflation

But we know that when firms invest, modern technologies, processes and procedures are brought in, and all of these collectively help to raise productivity and lower inefficiencies.

Nevertheless, since India businessmen will not invest, the ability of the Indian economy to become efficient has been fatally compromised.

The outcome of the above situation is that costs of transacting businesses are extraordinarily high in India. India is oppressed by supply-driven inflation, fundamentally a result of sky-high transaction costs of doing business.

Yet, no thought has been given to reducing these transaction costs. Instead, interest rates are raised on the faulty premise that inflation is a monetary phenomenon. The cost of capital for businesses, firms and individuals rises, further fuelling inflation, as these extra financing costs are passed on to consumers.

At the core of India’s inflation problem is high transaction costs, thanks to the inefficiencies of doing business. These costs are passed on to consumers, fuelling inflation. Costs in India are also extremely sticky. Once they have risen, they show no signs of declining.

The lack of productivity, and high transaction costs, has fuelled an inflationary spiral. Inflation in India can show no abatement; within a rational expectations framework, businessmen assume that things are going to get bad, be bad, and remain bad. Adjustments are made to prices to cushion further inefficiency shocks.

Forecasts of cost-driven uncertainties and inefficiencies are continuously factored into prices, creating a self-fulfilling prophecy of inflation. Prices rise to cover costs in one period, but these prices form the basis of costs factored in for the next period. Thus, inflation in India is sticky, and not a money supply issue or a monetary phenomenon.

In the last decade, India’s economic policy making has been driven by monetarist ideas. But how wrong, and how devastatingly negative in outcome India’s interpretation of monetarist ideas has been. It has shrunk growth rates and exacerbated inflation.

Intellectual crisis

That arch monetarist, late Nobel Laureate Milton Friedman, had written an article titled ‘The Role of Monetary Policy’ in the American Economic Review , (page 17 of issue 1, March 1968), in which he had stated that what was needed was: “a monetary climate favourable to the effective operation of those basic forces of enterprise, ingenuity, invention, hard work, and thrift that are the true springs of economic growth. That is the most that we can ask from monetary policy at our present stage of knowledge.”

Clearly, the doyen of the School of Money Supply Control, within the portals of the Academy of Economic Policy Analysis, saw an important role for motivating businessmen to make investments and engage in entrepreneurial ventures.

The triggers for such outcomes would be a business environment with certainty of outcomes, low transaction costs, and a low cost of capital. For the latter, the monetary policy instrument required to provide investment incentives would be low interest rates. Hence, the recent raising of interest rates flies in the face of the late Friedman’s prescriptions.

India’s policymakers have been intellectually inconsistent. They have not created a business climate where entrepreneurs are incentivised to make investments.

In formulating and implementing policies to spur high growth, the processes that underlie business activity in India have been overlooked. There is not just an economic crisis in India, but a chronic policy crisis, and an acute intellectual crisis.

(The author is Professor of Technology Strategy, University of Texas, Dallas.)