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Resource centre on India's rural distress
 
 

Forget Inflation Targeting -Prem Shankar Jha
-The Indian Express
 
It has only managed to kill manufacturing and employment growth 
 
In the 1950s, misapplied economic policies gave India one of the lowest growth rates in the world for 30 years, and left it behind East and Southeast Asia. Now another set of policies is completing its economic ruin. The architect of this is the RBI and its instrument of choice, the interest rate.

Indian business has been begging for a lowering of interest rates since July 2011, basically to no avail. In November 2014, when its confident expectation that the Narendra Modi government would bring them down began to evaporate, it swamped the meeting of the World Economic Forum in Delhi with entreaties for an immediate reduction. Finance Minister Arun Jaitley has urged the RBI to lower interest rates several times since the BJP came to power — as have Minister of State for Finance Jayant Sinha and Arvind Subramanian, the chief economic advisor. All three have tried to avoid a head-on collision with the RBI and preferred to appeal to its good sense. But Governor Raghuram Rajan has fobbed off these pleas with two measly quarter-percentage point cuts, which have done nothing to revive consumption, investment or sentiment. Instead of recognising his error, Rajan has again ignored the government’s pleas and speciously blamed “a spike in food inflation” — an annual occurrence during lean season — and commercial banks’ refusal to pass on his rate cuts to borrowers for his “inability” to cut rates any further.

The confrontation between the RBI and the finance ministry seems total. The government has tried to find a face-saving way of reasserting its authority by proposing to set up a seven-person committee to determine interest rates, provided that four members are its, and not the RBI’s, nominees.

New Delhi has the right to overrule the RBI, but is intimidated by the fear that the international financial community will see this as a return to autarchy and shy away from investing in India. Rajan has sought to reinforce the RBI’s autonomy by championing the doctrine, popular among central bankers, of “inflation targeting”. This requires central banks to aim for a target — ideally of low, steady inflation because that creates the best climate for investment — and raise or lower interest rates accordingly. The rationale is that investors need price stability to make decisions, so stability automatically maximises investment and thus growth. Rajan has claimed that, far from destroying growth, his policies are safeguarding India’s capacity for sustained growth “in the long run”.

The trouble with this doctrine, as Joseph Stiglitz argued in a paper, is that changes in interest rates lead directly to changes in prices and output only when all the conditions postulated for general equilibrium are satisfied. That is, there are many producers competing in the market and no trade unions, wages and prices are completely flexible, and there is full or near-full employment of labour and capital. Since this is a mathematical ideal that has never existed in the real world, except perhaps momentarily at the very beginning of industrialisation, inflation targeting has no theoretical foundation. The case for it rests solely on its observed effects. And here the evidence of a correlation, which was slender even before 2008, has disappeared even in the industrialised countries.

What Stiglitz pointed out in the context of the global financial crisis holds equally true for India’s crisis of growth. For inflation targeting has neither brought down inflation nor promoted economic growth. On the contrary, through the last seven years, inflation has declined and growth has spurted only when interest rates have come down.

The reason, as Stiglitz warned in 2008, is that in India, as in most developing countries, inflation in both 2006-08 and 2009-11 came through international trade because of huge global oil, food and commodity price increases triggered by China’s voracious demand. By the same token, inflation measured by every price index except the cost of living, disappeared rapidly in the second half of 2014 because of the severe, and deepening, slump in the Chinese economy. Curbing the growth of demand in India did not make the slightest dent. What it did was to kill the growth of manufacturing and employment.

Jha is a senior journalist and author