It’s worthwhile to do a quick recap of the main concepts that I have argued for earlier before we try to tie them all up together.
1) Fiscal deficit does not directly lead to inflation. It has to be monetized or something spiky has to happen in the government bond markets.
2) To the extent that India has a fiscal deficit, the interest payments (though numerically smaller than the expenditure outlays) are what are driving the deficit at the margin. Interest payments look sustainable at current interest rates and growth rates. The Indian state is playing a commercially viable financial intermediary, creating a pool of assets at various maturities that services the savings demand of our households.
3) To the extent that India has a primary deficit that casts questions on sustainability of government finances, it results from being under-taxed, not over-spent.
4) Flagship spending schemes have a plethora of public-choice issues, but the pure macroeconomics behind them is quite simple and uncontroversial. The effects on inflation, if any, are best analysed through the lens of an AS/ Philips curve.
5) Points 1 and 4 imply that to have any shot at understanding inflation, it is imperative to look at the central bank’s monetary regime, and its evaluation of aggregate supply.
RBI’s monetary regime
The Reserve Bank of India (RBI) officially tries to maintain inflation at around 4% in the medium term, while maintaining growth prospects and allowing the currency to float as per the market and trying to reduce the volatility in currency price. It’s an admirable, if somewhat convoluted, set of macroeconomic stability goals. But the actual performance of India’s inflation seems to fly in the face of what its central bank is trying to do. We have consistently overshot 4%, and not just in the last couple of years. At least since 2005, inflation—whether measured by final consumer prices, wholesale prices, or the GDP (gross domestic product) deflator—has been at more than 6% every year. Yet, RBI seems to have a relatively credible inflation-fighting stance, with most of its criticisms being directed at currency interventions or micro-management of the financial sector.
Even more surprising than the credibility is the fact that RBI itself seems to be wary of monetary tightening to actually try and achieve its goal to keep inflation at 4%. Ostensibly, this would not do much for inflation but kill growth. Recall the AD/AS diagram. RBI believes the AS curve is horizontal on the downside—shifting the AD curve inwards reduces real growth. At the same time, it seems wary of monetary easing to actually try to boost growth, because this would only create inflation, not boost growth. Which is to say RBI believes the AS curve is vertical on the upside! This is RBI in its own conception operating between a rock and a hard place, operating at that miraculous inflection point on the AS curve where it turns from being near-horizontal to near-vertical.
If you don’t buy this story as it stands, that’s because you shouldn’t. One can indeed land at such a jarring discontinuity in the AS curve, but it has to be a matter of sheer fluke, rather than a series of fiscal failures, that gradually led to the discontinuity. And if the central bank manages to optimize within this shoddy hand that the government has dealt it with, that will also be a matter of fluke, not effective monetary policy. One should expect to see either accelerating inflation or growth in a downwards spiral with stable prices/inflation. Not both at the same time.
But what if RBI was, through design or default, optimizing something completely different. Neither growth nor inflation, separately. A combination of the two, taken together, treated inseparably. What if it was targeting nominal income growth—that simple idea which has taken the popular macro/monetary discourse in the developed world by a storm. (The idea is that a central bank should keep the total nominal spending, the nominal GDP, which is equal to the total money flow in the economy, on a stable path. This path could be of 5% growth, 0% growth or 15% growth, depending on the economy. But it is deviations from this path, and not any other measure, that signify whether monetary policy is too loose or too tight).
The evidence would certainly suggest so. Nominal GDP at factor cost (GDP at market prices net of the indirect taxes and transfers of the government) has grown at a remarkably consistent rate in India. Over the past six years, the average growth has been 16% per annum, with a standard deviation of 1% (both logarithmic—all data calculated from national income accounts available with MOSPI). It’s the nominal aggregate in India with the lowest coefficient of variation (standard deviation divided by mean). As far as macro-stabilization goes, this is what is being stabilized. Not the price level, whether measured through consumer prices or the GDP deflator. Not nominal GDP at market prices. Not real GDP. Nominal GDP, at factor cost.
Has RBI been living a Sumerian dream—stabilizing aggregate demand (net of fiscal stabilizers) and letting the supply side play itself out? If yes, how? It could be by design—RBI governor D. Subbarao always strikes me as a remarkably well-clued man, but that’s not enough. It could be by default, trying to stabilize some other key metric (like credit growth) and ending up stabilizing the nominal gross domestic income because of certain stable relationships in the Indian economy that haven’t broken down as yet. We don’t really know, but the implications are interesting.
For one, all inflation is stagflation. Or, more accurately, any increase in inflation will necessarily be seen as a decrease in growth. Just like the twin deficits, this is not a double whammy, but two sides of the same economic fact resulting from the central bank’s monetary policy reaction function. Second, there are no inflation expectations driven independently by the central bank, but whatever we see is a result of the interplay between the private sector and the government. It’s not the AS curve that has the strange kink, it is the AD curve.
This story flies in the face of what RBI claims to be doing, but it explains the stylized facts. It is also consistent with the intuition of the standard anti-government narrative in India, when that intuition is suitably enhanced through the argument that expectations of inflation in India may be dependent on the fiscal stance, macro theory notwithstanding. We are so used to monetized deficits causing price rises that we continue to believe the same even though the fiscal regime in India has actually changed substantially, through design or default.
(Christopher Sims, last years’s Nobel prize winner for economics, has an explanation of how inflation expectations may be fiscal and how rate hikes by the central bank may be counter-productive in that scenario. His argument invokes the fiscal theory of the price level, which I don’t quite agree with, and works through the nominal rates on government debt, which seems quite stable, so one doesn’t have to take it at face value. However, just like Friedman’s maxim and the sectoral financial balance approach, the Sims conception adds a dimension and mechanism in the operation of macroeconomic policy that we should keep in mind.)
With this in mind, what remains to be analysed is if the AS curve becomes more steep, causing ‘stagflation’, what comes first—inflation expectations or a supply crunch? And if there is a supply crunch, what is it?
Investment—the crucial link
So what is the expectation of inflation in India? Recall the fact that 10 year G-secs trade at close to 8% yield. The current inflation is in excess of that. If the current inflation is expected to continue, savers are ok with negative real rates on their savings. In a capital-deficient country like India, this seems rather absurd. If you think that this may be the result of financial suppression—of the central bank mandating banks and investors to hold a certain proportion of their assets as G-secs—consider the fact that when the statutory liquidity ratio was recently cut from 24% to 23%, most banks were anyway sitting on 28-29% of their assets as G-secs (plus gold).
There are two possibilities: Inflation expectations really are high, and real interest rates really are that low. If that is true, then the degree of risk aversion implied by that fact means that within 5-10 years, lending and spending of all forms will drop and India will see macroeconomic woes that will make our current predicament seem like a walk in the park. Then, we will know what true stagflation is.
But if that is not the case, and real interest rates are positive, this means the current inflation is perceived as transitory and inflation expectations in the medium term are actually tracking RBI’s target quite closely. If so, that would be a tremendous macroeconomic achievement by our central bank and fiscal authorities—we have adjusted to the new fiscal regime and RBI is able to stabilize current aggregate demand even while maintaining medium term price stability. So we should turn back our focus on the current supply bottleneck. And what could that bottleneck be?
The most solid empirical evidence, in research conducted by the International Monetary Fund, points to investment. This is especially important because today’s investment is tomorrow’s capital. An investment bottleneck in the AS curve is most likely to persist from the short term to the medium term. Current inflation is most likely to be endogenized if it results from an investment shortfall. Even if we have somehow achieved macroeconomic nirvana, an investment shortage can bring us back to our ugly past.
This is not a particularly ‘right-ist’ view. Axel Leijonhufvud, a Swedish-American economist who is perhaps the foremost parser of true Keynesian thought, has done some excellent work exploring the micro-foundations that affect this crucial link between inflation and investment. His main argument is that proper financial intermediation breaks down in periods and regimes of high inflations, especially for longer term capital needs. His work focuses on monetary regimes that are substantially less stable than RBI today and ‘high inflations’, for which India’s 8-10% per annum does not really qualify. But it arguably holds even for RBI’s regime, if people are likely to go back to the old ways of thinking about our profligate government, and if our particular investment needs are especially long term.
India’s and the United Progressive Alliance’s greatest failure on the fiscal front has been their utter failure to prevent the fall in investment—and indeed abetting the fall through some bone-headed moves.
So, in the end, if it all does come down to a fiscal failure, and it does come down to supply bottlenecks, and if it does come down to how inflation expectations in India may possibly be fiscal, just why has so much electronic ink been spilt? If the standard narrative is broadly true, why try to dismantle it before putting it back together again?
It’s important to come to the right conclusions, but it is also important to do so through the right analytical frameworks. It helps you focus your criticism, and it helps you see some successes where you may only have imagined macroeconomic failures. I hope I was able to clarify how it’s investment, not government spending, that we should focus our minds on. I hope I was able to demonstrate how the 10-year yield is an important variable to watch out for.
India has great macroeconomic challenges in front of her. Unless we focus on the right levers, we risk losing the plot to minor irritants.
The writer is a London-based consultant. This is the last of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment.
“These are the author’s personal views.”