Informed debate requires the processing of evidence, something in short supply in India.
This is the first part of a two part “letter” to the new RBI governor, Dr D Subbarao. New appointments give an opportunity for the new appointees, and old commentators, to make a new start, but only if need be! Thankfully, like the US but unlike Europe, the mandate of the RBI is to manage monetary policy as it affects both inflation and growth. Hence, the two part divide; the second article will deal with policy and growth.
There is advice aplenty on inflation and its causes, and its effects. My plea is that the Governor, regardless of the source of the question (from the PM to the aam aurat), ask the simple question before making policy: show me the evidence. The importance of this simple requirement is highlighted by the prevailing, and what passes for super conventional wisdom (SCW), in India.
SCW 1: Money supply growth, or its pattern, is a useful indicator of inflationary pressures in the economy. It is well known that in hyperinflation economies like Zimbabwe there is a very strong relationship between money supply growth and inflation. Even there, it is not at all clear whether money supply follows inflation or vice-versa. There is most likely a third cause in operation — a complete breakdown of the economic system and a regressive movement from a market to a barter economy. India is not, and has never been, even close to hyperinflation. But it still might be the case that in the wide range of inflation rates observed in India between 1950 and 2008, the pattern of money supply growth matters. Since 1980, average inflation in India has been 7 per cent with no single year above 13 per cent (in the crisis year 1991). But money supply growth has NO relationship with inflation during this time-period. Nor does money supply growth have any relationship with inflation during the period 1950 to 1972. But if we try to look at the relationship between 1950 and 2007, money supply shows up with a meaningful impact on inflation. What I am hoping to demonstrate is that to the extent the RBI, or anybody else for that matter, believes that the pattern of money supply growth matters, then the belief is based on just seven years of data, and that too in the global inflation period, 1973-1979.
SCW 2: Fiscal deficits matter, that is, the larger the fiscal deficit, the higher the inflation rate, ceteris paribus of course. It is not clear which of the first two SCWs is worse, but the fact remains that even the sign is wrong, that is, in the Indian experience higher fiscal deficits are associated with lower inflation rates! But relax, the statistical nature is insignificant — just as money supply growth is statistically insignificant.
If neither fiscal deficits nor money supply growth help explain Indian inflation (indeed, for most countries these two variables are insignificant and unreliable indicators of inflation — which makes you wonder what the advocates are smoking when they make the claim), then what does? Does it follow that we should just print money or let the government run even more amok with its irresponsible spending then it already does? Of course not — all I am saying is that within the very broad ranges of fiscal deficits and money supply growth observed in India, the indicators are not meaningful. What is most meaningful, and is the best indicator, is the median inflation in the world. More than 70 per cent of the variation in inflation rates is explained by this indicator — and yes, this inflation rate also peaked in 1994. In 1995, the RBI went on a kill inflation mission (they killed growth instead, but that is in the next article), little realising that the bulge in inflation in India in 1994 was part of a global phenomenon — just as in 2008, and as in the mid-seventies.
SCW 3: Indian interest rates are too low! This “wisdom” is gained by using inflation as measured by the wholesale price index (WPI) in India, and using the consumer price inflation (CPI) for other countries. The fact remains that regardless of the measure of inflation used (WPI, CPI or the GDP deflator), real interest rates in India are among the highest (and among comparable developing and developed economies, the highest) in the world. Of course, you can get whatever result you want by mixing apples and cumin seeds.
SCW 4: The inflation rate matters when it comes to winning elections. The Congress party will tell you this because it cannot get over the shock of making the huge policy mistake of tightening in the mid-nineties, and losing the 1996 elections, by a wide margin. The BJP will also tell you the same because it wants Congress to make the same mistake again. But just as with money supply growth, and fiscal deficits, there is precious little evidence to support this wisdom. Indeed, the evidence goes the other way — if you overkill the economy, the inflation rate may come down, but growth rates falter, and you lose elections.
But how does this result square off with the universal fact that in every opinion poll, consumers rank inflation as the biggest problem. That was the case in the first opinion poll in India, and I am sure in the last. But if everybody thinks that inflation is a big problem, then by definition, it is a meaningless statistic. It is like saying that we all believe that motherhood is good; we do; as we believe that inflation is bad. Where is the masala?
The author is Chairman, Oxus Investments, a New Delhi based asset management company. The views expressed are personal. E-mail: surjit.bhalla@oxusinvestments.com
