All of us are aware of India's inflation crisis. It is very
disappointing, how we lost our grip on stable 4-to-5 per cent
inflation which was prevailing earlier. From February 2006 onwards, in every single month, the
y-o-y CPI-IW inflation has exceeded the upper bound of 5 per cent.
All of us agree that there is something insiduous when 10%
inflation effectively steals 10% of the value of my wallet or fixed
income investments. In India, however, we often hear the argument
"Yes, this is bad, but if high inflation is the way to get to high GDP
growth, let's get on with it". It is, then, important to ask: Why
is low inflation valuable?
Nominal contracting is very important
Complex organisation of economic life involves myriad written and
unwritten contracts involving households and firms. The vast
majority of these contracts are written in nominal terms, i.e. in
rupee values that are not adjusted for inflation.
Every society needs to adjust all the time, in response to changes
in tastes and technology. When tastes or technology change, the
structure of production needs to change, which involves
renegotiation of (written or unwritten) contracts. These adjustments
are costly. Contracting is costly, and renegotiating contracts is
costly.
It is useful to think of a finite supply of adjustment as being
available in the country. We should devote that full power of
adjustment to the beneficial adjustments associated with changes in
tastes and technology. In a place like India, where GDP doubles
every decade, the requirement for adjustment is (in any case) large.
Inflation is an acid that corrodes all nominal contracts. Two
people may have agreed on a contract two years ago at Rs.100, but
that contract is thrown out of whack because of 10% inflation per
annum. That contract has to be renegotiated. Bigger values of
inflation corrode personal relationships also, given that there are
many financial ties within friends and family.
Contracting is costly. Almost everything that senior managers do
is to arrive at complex deals that create and sustain complex
structures of production. This work is continually torn down by high
inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.
Inflation messes up information processing
To continue on the theme of adjustment, the essence of a market
economy is adjustments to relative prices, reflecting changes in
tastes and technology. Firms learn about the viability of
alternative investments by watching relative prices
change. Inflation messes up this information processing. It
increases the `background noise' by making a large number of prices
change at once. This makes it harder to discern which price change
is fundamentally driven, and merits a response in terms of increased
or decreased production.
Building a sophisticated market economy is all about making
long-term plans. When a firm decides to build an airport or a highway,
this involves making NPVs over the next 20-40 years. This requires
having a fair idea about future inflation. If inflation will fluctuate
in the future, then firms will err on the side of caution when making
plans about the future, i.e. investment will be reduced. I will stress
that long-term investment, in projects such as infrastructure or heavy
industry, relies critically not just on a long-term bond market
(which, in turn, critically requires low and stable inflation) but
also on the calculations happening in a spreadsheet about the NPV of
the investment project, which involves projecting all revenues and all
expenses for the next 20-40 years (which also critically requires low
and stable inflation).
Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed
income investments are absolutely crucial in the financial planning
of these 25-35 years. These calculations can be destroyed by a short
bout of inflation.
A civilised society is one in which people can make plans for the
deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of
even one bout of high inflation over the coming 25-35 years forces
people to drop back to other mechanisms of protecting themselves in
old age. What is needed is not just inflation control right
now. What is needed is the environment of mature market economies,
where outbursts of inflation are fully ruled out for decades to
come.
Impact upon relationship with banks
In India, banks pay very low interest rates. While many interest
rates have been deregulated, the interest rates paid by banks are
held back by factors such as low competition and financial
repression (i.e. forced purchases of government bonds).
When households expect inflation will be 12%, they will see a 4%
interest rate paid by the bank as yielding -8%. This has many
consequences. On one hand, households and firms expend excessive
(wasteful) effort on minimising their holdings of low-yield cash. In
addition, households tend to shift away from fixed income
contracting with the formal financial system. Both these distortions
are caused by inflation, and exacerbated by flaws in the financial
system.
If the financial system were regulated sensibly, then with high
inflation we would immediately get higher nominal interest rates
since buyers of 90 day treasury bills would demand higher interest
rates to pay for inflation. This would reduce the damage caused by
high inflation. In India, we suffer from bigger negative effects
because of a faulty financial system.
These may seem to be small things but they actually are fairly
large effects. Towards an understanding of the costs of inflation
-- II, by Stan Fischer, 1981, argues that perfectly anticipated
10% inflation induces a cost of 0.3% of GDP on account of only one
factor : excessive efforts by households and firms to hold less
cash.
The rising prominence of gold
Gold is a barbarous relic; it is the investment strategy of choice
for uneducated people. It is also a vote of no confidence in fiat
money. Our failures in creating a capable central bank, which
delivers sound fiat money, are taking Indian households back to
their old ways. Many decades of progress in getting households to
engage with the modern financial system is being undone in this
inflation crisis.
A classic quotation
Lenin is said to have declared that the best way to destroy the
capitalist system was to debauch the currency. By a continuing process
of inflation, governments can confiscate, secretly and unobserved, an
important part of the wealth of their citizens. By this method they
not only confiscate, but they confiscate arbitrarily; and while the
process impoverishes many, it actually enriches some. The sight of
this arbitrary rearrangement of riches strikes not only at security,
but at confidence in the existing distribution of wealth. Those to
whom the system brings windfalls, beyond their deserts and even beyond
their expectations or desires, become `profiteers', who are the object
of the hatred of the bourgeoisie, whom the inflationism has
impoverished, not less than of the proletariat. As the inflation
proceeds and the value of the currency fluctuates wildly from month to
month, all permanent relations between debtors and creditors, which
form the ultimate foundation of capitalism, become so utterly
disordered as to be almost meaningless; and the process of
wealth-getting degenerates into a gamble and a lottery.
Lenin was certainly right. There is no subtler, no surer means of
overturning the existing basis of society than to debauch the
currency. The process engages all the hidden forces of economic law on
the side of destruction, and it does it in a manner which not one man
in a million is able to diagnose.
From Chapter 6 of The Economic Consequences of the Peace, by
John Maynard Keynes. Source: Who
said ``Debauch the Currency'': Keynes or Lenin? by Michael
V. White and Kurt Schuler, Journal of Economic Perspectives,
Spring 2009.
But is there not a tradeoff between growth and inflation?
For a brief period, the empirical evidence in the US suggested that
there was a tradeoff between inflation and unemployment. Here's the
classic picture, for the 1960s in the US:
which shows a nice relationship where higher inflation has gone
with lower unemployment. This evidence has led many people,
particularly those concerned with the plight of the unemployed, to
advocate higher inflation.
A look at the same evidence for the US, over a longer time period, shows no such
tradeoff:
The idea that there is a tradeoff between inflation and
unemployment is thus an artifact found in the minds of people who
studied economics in the 1970s. This proposition was pretty much dead
by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.
In the empirical literature, it is quite clear that by the time we
get to double digit inflation, this has a discernable and negative
impact on growth. This generally means that at a 95 per cent level of
significance, you can reject the null of no effect, in conventional
datasets. The conceptual reasoning above gives no reason for believing
that there should be a threshold effect, that inflation above 10%
should hurt growth but below 10% things should be fine. It could well
be the case that when you get to smaller values for inflation
(e.g. 9%) this effect size is not detected with conventional datasets
at the 95 per cent level of significance.
It is interesting to look at the target inflation rate set in the numerous countries which have setup either de facto or de jure inflation targeting. The median value chosen has been: 2%. If people were convinced that inflation below 10% is not damaging to growth, inflation targets may have been higher. But instead, the typical inflation target in the world is 2%. This underlines the universal consensus in favour of targeting low inflation -- more like 2% and far below the 10% that we've got stuck with in India.
In the West, some people with a weak grip of economics, and strong sympathy for the unemployed, have argued that high inflation is a good thing because it helps reduce unemployment. In contrast, in India, economists have consistently found that the poor are adversely affected by inflation. There has not been a left-of-centre lobby that is soft on inflation, here.
Conclusion
There is no tradeoff between inflation and growth.
High inflation damages growth.
One element of India's growth crisis is India's inflation crisis.
It is important to think carefully about the accountability of the
central bank. RBI is not in charge of India's welfare. RBI is in
charge of India's fiat money. The one thing that RBI should be held
accountable for is delivering low and stable inflation, i.e. for
holding CPI-IW inflation within the 4 to 5 per cent range.
Low and stable inflation is an essential ingredient of the
foundations of high economic growth in India. RBI can lay that
platform. They can do no more. If they try to reach into other
objectives, they damage this core.
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