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Inflation Control in a Free Market
Dipankar Dasgupta Bookmark and Share

The Union Budget estimates the nominal rate of growth for the Indian economy to be 12.5 per cent during the current fiscal. While it is impossible to figure out the manner in which this number was arrived at, the government has predicted further that the inflation adjusted real growth rate for the same year will be 8 per cent. Simple arithmetic requires that the difference between the nominal and real growth rates equals the rate of inflation. Thus, for the government's claims to be realized, the rate of inflation for 2010-11 should be 12.5 – 8 = 4.5 per cent. This raises a serious dilemma needless to say, since the economy is tottering right now under a two digit rate of inflation.

How do the policy makers explain the raging inflation? According to the Finance Minister himself, the fault lies with the monsoon, or Lord Indra, as he had dramatically suggested. If it does not fail us once again, the rate of inflation will fall he assures, reaching down to 5 per cent or so around December. If his hopes are fulfilled, the arithmetic we began with will not be totally compromised.

This simplistic explanation of inflation can hardly count as news for our hapless populace. India's policy makers have always identified the monsoon as the ultimate determinant of the state of our economy. The viewpoint does not lack a basis altogether, but it also reveals a fatalistic component in our point of view. We have failed, in other words, to build the necessary infrastructure, harness the appropriate technology or even formulate workable economic policies to deal with the vagaries of nature.

In the Annual Policy Statement for the fiscal year 2010-11, the Governor of RBI, Dr. Subbarao, has presented a somewhat more sophisticated explanation of the inflation we are currently witnessing. He believes that the phenomenon owes its origin partly to the situation prevailing in industry as well. His perception is driven by the recent escalation in the prices of non-food manufactured items. Despite earlier increases in the repo rate and the reverse repo rate, the real policy rates (i.e. the difference between the nominal rates and the rate of inflation) are still negative. A negative borrowing rate in real terms leads to greater demand for loans by industry and consumers, to finance working capital and purchase durable consumer goods respectively. This has helped industry to grow and the Governor finds increasing evidence that pressures on production capacity have worsened the price scenario. Producers, given inadequate capacity relative to demand, are charging more. The RBI has therefore held industry as well as agriculture to be responsible for our inflation. The perception is shared by Dr. C. Rangarajan too, who chairs the Prime Minister's Economic Advisory Committee.

Dr. Rangarajan as well as Dr. Subbarao recommend a possible tightening of monetary policy, which translates into a rise in the price of credit, i.e. the rates of interest. The matter is still under discussion of course and, unless the monsoon decides to oblige in the meantime, the public is likely to witness a rise in borrowing rates. The return on savings too should move up, thereby tempting risk-averse members of the public to divert their investments to term deposits in banks.

Higher interest rates could rein in demand for industrial products, thereby lowering the non-food part of inflation. Of course, it could also affect industrial growth negatively, but political compulsions will probably force the government to assign greater weight to inflation control than growth enhancement, at least in the short run.

In this context, Professor Kaushik Basu, Chief Economic Advisor to the Government of India, has come out with a truly imaginative suggestion for inflation control. It might appear to run counter to common economic logic, since he recommends freeing up petro markets much in the spirit of the Parikh Committee recommendation. Professor Basu believes that this will ultimately lower inflation, even if there is an immediate increase in prices.

Quite clearly, the Parikh argument by itself is based on sound economic principles. Distorting prices away from market determined values leads to inefficient allocation of resources, since an artificial lowering of the price of a vitally important but scarce input invariably leads to its incorrect economic use. Professor Basu cites the example of low priced kerosene being smuggled across to Nepal and Bangladesh to be sold at a higher price. Adulteration of diesel is yet another of his examples. Quite apart from resource misallocation, the public sector oil companies are incurring losses on account of kerosene, diesel and LPG subsidization. To compensate them for their losses, the government's deficit has been rising to unsustainable levels.
 
Both the opposition as well as the government's allies are up in arms against the implementation of the Parikh recommendations, since they fear that a removal of subsidies will affect the most vulnerable sections of the population, thus jeopardizing their vote bank calculations.

As noted above, Professor Basu argues that far from intensifying inflationary forces, the Parikh Committee recommendations will reduce the rate of inflation, not immediately perhaps, but eventually. Allowing the oil companies to sell at market prices will diminish the government's subsidy bill and this, according to him, should have a salutary effect on inflation control.
 
The logic underlying the Basu view calls for elaboration. A fall in the government's deficit will lead either to a lower borrowing by the government from the public or reduced creation of new money by the RBI to meet the government's needs. In the first case, the rate of interest on government bonds will fall bringing in its wake a general fall in the rate of interest. With borrowing costs reduced, industry could charge less for its produce. In the second case, the government's money demand from the Central Bank would fall without an accompanying rise in the rate of interest that an RBI led tight monetary policy demands.
 
Needless to say, with private industry benefiting from the fall in the rate of interest, capacity pressures could build up as the RBI Governor has warned, but the consequent rise in price could partly be mitigated my the fall in borrowing costs. And this should ultimately lower the rate of inflation, especially so if supported by a favourable monsoon.
 
Quite obviously, the poor man's fuel will still need to be subsidized. This is best done by identifying the poor, allowing him to purchase fuel at lower than market prices and compensating the seller for the shortfall. There will be an associated subsidy bill, but there will be no price distortion accompanying it. The resources the government saves by deregulating the oil sector would go a long way towards financing the new subsidy.

Tying up petroleum prices with the world market, replacing cross subsidization and offering direct subsidies to vulnerable sections of the population will not only lead to better resource management but also leave more money in the hands of the government for building infrastructure, a sine qua non for growth. And, to the extent that a part of the growth in infrastructure will hopefully make agriculture less vulnerable to the whims of nature, in the medium run at least, productive capacities will improve, thereby taming the rate of inflation over time.

The government has moved now in the direction of market linked prices. However, for the Basu suggestion to have the intended effect, the government must make a determined effort to remove corruption associated with the identification of the poor as well. A true challenge lies here, since the success of the Parikh-Basu line of thought depends crucially on locating the poor. So long as the poorer sections of the population are protected through direct subsidies, the pains associated with the short term inflation will be far less than what politicians appear to be suggesting.

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06/28/2010
More by :  Dipankar Dasgupta
Views: 1717               
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