Higher inflation may not be a bad thing at this point

Version II of ad hoc treasury bills needed, and time for this solution to work is between now and October

How do you make a deflated balloon inflate? You blow air into it. And how do you make a deflated economy inflate? By blowing money into it. 

This simple solution is called the Modern Monetary Theory (MMT) by self-important economists. But what the economists don’t tell you is how much money to blow in. You blow too little and the economy remains flaccid. You blow too much and like the balloon it runs the risk of bursting i.e. running into high inflation. 

The world doesn’t give India any credit for finding the right way of dealing with this problem but it did find a way: back in 1955. The idea was simple. At the end of each week the Reserve Bank of India (RBI) would lend the government Rs 50 crore which would be paid back on Monday. This device came to be known as the issuance of ad hoc treasury bills. 

The system worked well till Rajiv Gandhi used these bills to finance massive budget deficits. That is, he blew too much air into the balloon. It burst in 1991 and in 1994 the Narasimha Rao government announced that it had decided to stop borrowing via these bills. In 1997 it even entered into a formal agreement--how ridiculous can you get!--with the RBI to end them.

The agreement said three things. One, that the government would now have the equivalent of an overdraft. Two, that this would not be a source of financing investment. And three, that it would not show up in the budget deficit.

What the founding fathers of this self-denying arrangement didn’t take into account was calamities that stopped the economy dead in its tracks. But this has happened now. Hence my question: has the time come to devise Version 2 of ad hoc T-bills? If not why not? 

The standard answer is that this runs the risk of causing high inflation and outflow of foreign portfolio investment if the deficit becomes too high. Well, yes, in normal times. But these are not normal times. Far from it. Indeed, as far as inflation is concerned we need it very badly. 

The theoretical support for this comes from an American economist who, had not the Keynesian solution appealed more to politicians, would have been the man to turn to. His name was Irving Fisher.

His solution was straightforward. When asset prices have collapsed, the government needs to get them back to a level where debts can be repaid because when debts don’t get repaid, banks go bust. When banks go bust, credit dries up. When credit dries up, the economy shrinks or even collapses. 

The best way to tackle this problem, he said, was to somehow get the real value of the debt back to the (lower) level at which it was contracted by causing inflation. This is what governments do to their own debt. So why not to private debt, too?

Basically, this means returning the price level to the level it was prior to deflation. But he also added a critical condition: this had to be followed by price stability. 

This is what India needs to do now. There are two simultaneous ways to do it. One is to monetise government debt, meaning the RBI prints notes. In other words what I had suggested back in December 2018: ad hoc treasury bills version II. 

The other way is to raise administered prices. The government has been doing this for petroleum products. The policy has to be extended to everything else. Lastly, there is always the question of timing in policy. But this time there is no choice. 

The time is between now and October. Twitter: @tca_tca