On high inflation, here is what RBI needs to tell govt: It is your fault

All the research since 1980 shows that loose fiscal policy causes inflation, and the RBI MPC needs to tell the govt just that

Like a schoolboy being asked to write an imposition, the RBI convened a meeting of the Monetary Policy Committee (MPC) on November 3 to discuss what it should say to the government as to why the inflation target has been missed. Ridiculous it may be, but that's the law.

I can tell the RBI what it should say to the government, that too in just nine words: "Dear government, it's all your fault. Yours truly, RBI."

Lest anyone think I am being facetious, all the research since 1980 shows that it's always the loose fiscal policy that causes inflation because it induces a loose monetary policy. There's no chicken-egg problem here at all.

If governments didn't borrow so much from central banks, the price of money, the interest rate that is, would be very different and much lower. But government borrowing forces it up.

Governments, however, want to avoid paying that higher price. So they force central banks to have a contrived lower price. It's an age-old practice.

The problem is that while central banks can increase the rate, they can't refuse to lend to governments. Some countries — like India — go to the logical solution. They start owning the banks, which are then 'persuaded' by the central bank, their boss, to buy government bonds.

The Urdu saying captures this phenomenon perfectly: "Miyan biwi raazi, toh kya karega qaazi?" Hence, since the government and the RBI are in agreement, the letter to be discussed on November 3 is just a charade.

Written. Sent. Received. Noted. Filed.

The RBI has sent such letters since 1949. The difference is they were sent voluntarily. Now, this absurd law mandates it.

Unfortunately, some central bank governors, especially those parachuted in, take the drama of the government-RBI relationship very seriously. The current governor, however, is not one of them. Indeed, he and the finance minister are always in hitherto unprecedented agreement about what's to be done.

This level of convergence can be problematic because the real issue before the RBI is getting lost. It is no longer how to calibrate the price of money during times of great uncertainty.
 

Instead, the real problem is how to gauge risks to the economy posed by panic responses by central banks, RBI included. For this, governors need to act on the belief that risk is different from uncertainty. Thus, while others, including God, create uncertainty, the central banks create the risks.

So, though it's wholly true that uncertainty can't be managed, the risk can. It is totally counterproductive to treat the two interchangeably. But this is exactly what many governments did after the 2008 crisis — and this is what the central banks are doing now. The RBI is not an exception.

Thus despite the fact that it knows that the private sector has other sources of finance and that interest rates are important only for the government and its agencies and the interest rates far more to the government.

The private sector may pay more, but it also uses the money more efficiently. And there lies the rub.

While the Modi government has done a lot to make the private sector even more efficient, it's failed to make the central and state governments more efficient in their use of funds. The result is very high borrowing and high inflation.

Thus, India is one more item in the long list of proofs that loose fiscal policy causes inflation. And this is what the MPC needs to tell the government.

We will find out soon enough if it will. But I doubt it.