Revolving door is jammed

Finally, there now seems to be agreement between New Delhi and Mumbai — high inflation will be a stubborn guest and monetary policy is the best way to control it

High inflation has rattled Indian policymakers — and rightly so.

Look at the sequence of events. First, finance minister P. Chidambaram admitted on Friday that India faces “difficult times”. Then finance secretary D. Subbarao said on Saturday that monetary policy would be the “first line of defence” against rising prices. And Reserve Bank of India (RBI) governor Y.V. Reddy suggested on Monday that there has been a flurry of activity over the weekend. He had a detailed meeting with his senior colleagues at the central bank on Friday, then called both the finance minister and the Prime Minister on Saturday, and added that he would also be consulting members of the technical advisory committee on monetary policy.

Reddy has been uncomfortable with inflation for many months. The finance ministry has been less worried. The finance minister himself did not seem to be too keen on higher interest rates till now. Overall, the government preferred to either underplay the inflationary pressures which were building up in the economy or play the blame game by attacking speculators in the commodity markets or profiteering steel and cement cartels.

Finally, there now seems to be agreement between New Delhi and Mumbai — high inflation will be a stubborn guest and monetary policy is the best way to control it.

But there is usually a collateral damage whenever interest rates are raised. The pace of economic expansion slows. I have earlier mentioned RBI’s research published in 2002 which showed India would have to sacrifice 2 percentage points of growth for every percentage point victory against inflation. The “sacrifice ratio” may or may not be that high, but some growth will have to be sacrificed to get inflation down.

There are ways to limiting collateral damage to growth. Monetary and fiscal policies should move in opposite directions: If you tighten one, then you loosen the other. So, a tighter monetary policy to attack inflation can be balanced with a looser fiscal policy to prevent demand from collapsing. And it works the other way round as well.

I remember what Massachusetts Institute of Technology economist Paul Krugman had told me in the course of an interview I did with him in 1998 for a business magazine. “If you take back demand through one policy, you should stimulate it through another. It’s like a revolving door,” he had said.

I had interviewed Krugman in the aftermath of the Asian financial crisis. The International Monetary Fund was under attack because it was insisting that the afflicted countries in Asia should cut government spending and push interest rates sky-high, in effect condemning them to deep recession. Krugman was then arguing that fiscal contraction should be offset with lower interest rates. Lower interest would lead to further speculative attacks on regional currencies; these could be prevented through capital controls.

The revolving door needs to be brought into play once again. University of California economist Barry Eichengreen reiterated the same point in an article published in Mint on Monday, on how Asian governments should attack inflation. “Tax cuts and increases in public spending on locally produced goods will limit the contraction in aggregate demand (because of higher interest rates),” he wrote.

India needs to walk through the revolving door. But there is one problem: The door is jammed. We already have a fiscal deficit that — if measured correctly — is at its highest level in more than a decade. It would be reckless to try and ramp up public spending right now, an invitation to an economic crisis. Compare this with the situation in China, where its government has a huge budget surplus that it can spend in times of trouble. In short, India does not have the space to use a looser fiscal policy to soften the blow from higher interest rates.

That brings us to a point that this column has repeated several times. The government wasted a great opportunity to knock India into fiscal shape. That would have been handy insurance against any trouble. But this government squandered the record taxes it collected, thanks to a five-year economic boom, on all sorts of well-meaning but wasteful schemes. We have seen three policies this year — the pay hike to the bureaucracy, the farm loan waiver and income-tax cuts — that will stoke demand and put further pressure on government finances.

The government seems to have completely misread the economic situation, loosening fiscal policy when we were on the cusp of high inflation. The next government will not have the freedom to spend when the economic slowdown starts pinching a year later.

It’s not the end of the “India story”. The rise in savings and investment rates, the efficiency that has come with economic reforms and globalization and the fact that we have a young population in the midst of an ageing world are long-term advantages.

But there will be intermittent problems. Are we prepared for the one that could be just around the corner?