Reducing govt spending holds the key to fixing India's inflation worries

If the finance ministry wants private investment to revive, it must make things easy for it and resist the temptation to go on spending just because it can

A few days ago, the finance minister asked the private sector to invest more. This reminded me of several similar requests made by NDA finance ministers between 2000 and 2004. One of them was Yashwant Sinha. The other was Jaswant Singh. 

Their appeals fell on deaf ears because then, like now, the external environment was not good, and the domestic interest rates were high. In other words, it was too costly to borrow and invest when you weren't sure if you would be able to sell all the output from that investment. 

Precisely the same thing is happening now. The external environment isn't excellent and domestic rates are too high and likely to go up later this week. Nor is there enough demand to justify additions to existing capacity. 

But the RBI has been making money more costly by raising interest rates over the last three or four quarters, and it is being said, it is likely to go in for a significant increase now. This is because of conventional wisdom that somehow higher borrowing costs will bring down the rate of inflation, which is higher than the target rate of 6 per cent. 

Leaving politics aside because it will always be there, perhaps the RBI should hark back to the Sinha-Singh period. Bimal Jalan was RBI governor till 2003 and Y V Reddy after that. Jalan started cutting rates, and Reddy continued the good work. And the latter did this even though a general election was due in 2004 and inflation was at 5-6 per cent and rising. And in those days, there was no formal targeting. 

But now the finance ministry and the RBI are both running scared. So, instead of stimulating growth, they are choking it, thinking it will bring down inflation. Such defensive measures work sometimes. But mostly, they don't, as happened between 1996-2001 in the wake of the huge squeeze put on debt-fuelled investment first before the 1996 general election and then after the Asian financial crisis in mid-1997. 

As many experts have pointed out, this is primarily imported inflation, and monetary policy is not a very effective instrument anyway. The best thing would be to leave the interest rates where they are, surprising the markets in a good way. But to do that, a lot of courage is needed. 

Moreover, inflation, even when imported, has a simple cause: too much money chasing too few goods. This was so in 1973, and it was so in 1979. Since capacity utilisation now is still not full, that leaves only an excess of money in the system as the reason. 

And guess who is responsible for it? The government. Despite its attempts to keep the fiscal deficit under control, it had pumped far too much money into the economy during the Covid-19 period when output was falling. 

It's true, of course, that it pumped less money than many other countries. But that's not the point. The point is that in relation to Indian output, it pumped in too much. 

Of course, much of this was necessary during 2020 and 2021 for life support. But economic wisdom lies in knowing when to stop. However, our perennial election cycles have been a drag on economic wisdom. 

That's why the answer to our inflation worries lies not in high-interest rates — they have been raised enough — but in a reduction in government spending. If the finance ministry wants private investment to revive, it must make things easy and resist the temptation to continue spending just because it can. 

That would be shooting at the wrong target because, take it from me, the target will be missed, and we will be left with high rates and high inflation.