MPC should have said little sustained inflation will be good for economy

The last meeting of the Monetary Policy Committee (MPC) focused on low interest rates and the risks of inflation. The discussion on low interest rates was, it seems to me at least, a pointless one because the alternative is higher interest rates. Does anyone want that, ever?

The other issue, of inflation, deserves more attention because it’s important to recognise that while it always poses a political risk, there are times when it is an economic necessity. This is one of those times.

I am not sure if the MPC went into the sources of inflation. In any case, a single figure for it in a huge and diverse country like India is quite meaningless. And targeting it is even more so because a 4 percent target requires inflation to be negative in large parts of the country!  

At this point of the economic recovery, it is necessary to pay attention to the works of a pre-1945 economist. He was rated as being amongst the top five economists of the world by such men as Joseph Schumpeter, James Tobin and Milton Friedman.

His name was Irving Fisher and he made the hugely important point that when individual and corporate debt is a problem, it’s sensible to opt for inflationary policies to bring down the real value of the debt. 

The logic was that unless asset prices go back up to the level where repayment becomes easier, the economy will collapse into a deflationary spiral. He said in a bust credit booms the real value of the debt went up when prices and incomes fell precipitously. This made repayment very hard, if not impossible. 

But the legal system enforces repayment. This reduces the amount of money owed but not fast enough because the real value of the domestic currency has now risen.

So debts don’t get fully repaid, credit expansion declines, and the economy slows down. When the economy slows, incomes and prices fall further. And so on in an expanding circle.

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. The problem, of course, was how to do this. Inflation is a good way of doing it

But Fisher’s theory (1935) came up against Keynes’s theory (1936). Politicians preferred Keynes to Fisher and that was the end of his theory. Basically the banks didn’t want to be paid less in real terms than what they were owed.

In 1995 Ben Bernanke, who would later become the Chairman of the US Federal Reserve, explained why. He said Fisher’s solution would merely redistribute the burden of debt from one group to another without increasing consumption and investment spending. 

But at that time there was no proof for this and the Keynesian solution of putting money in all pockets was politically more appealing. It has ruled the roost since then.

But now Keynesian expansionism of central bank balance sheets has run its course. The marginal benefits from it will be negligible because it is going to take another two years for the virus to be fully controlled.

Thus, as T V Somanathan explained in an interview to Ira Dugal of Bloomberg, as long as there is uncertainty about this virus, people will hesitate to spend. So there’s no point in giving them money. He is dead right.

Simultaneously, however, there is also a huge need to lower the real value of debts so that they can be repaid easily. That’s why I think a little bit of sustained inflation is necessary. 

Its economic benefits far outweigh the political risk it entails.