The Indian economy has not been doing well for the past year or so. The currency has spiralled downwards versus the dollar (and other currencies), growth projections have been revised downwards, and the central bank has very publicly warned that the rate of non-inflationary (should actually be called non-accelerating inflationary) growth has been substantially impacted by, inter alia, supply constraints, commodity prices and fiscal pressures. India is facing stagflation, with stagnation being re-defined as simply a drop in the growth rate.
There is a standard narrative that underlies most explanations of what’s happening. The United Progressive Alliance (UPA) government, prodded and misguided by Sonia Gandhi and the National Advisory Council (NAC), has spent way beyond its means. Fuel subsidies, NREGA (national rural employment guarantee Act), Right to Food, etc., are all manifestations of this. Fiscal discipline has been thrown to the dogs, and now we’re bearing the consequences.
The standard narrative is intuitively true, almost trivially so. It seems obvious that a profligate government causes inflation and impedes growth. That is how most banana republics have conducted macroeconomic policy in modern history. That is how India got its high inflation of the 70s and the 80s, resulting finally in a balance of payments (BoP) crisis in 1991. And that is how we have landed in the mess that we have.
There is just one small catch. The standard narrative is at odds with received macro-economic theory, both orthodox and heterodox. Let me explain.
Most intermediate textbook treatments of inflation will identify three ‘causes’ of inflation: cost-push, demand-pull and monetary. The first operates through the supply side, e.g. a bad monsoon will push food prices up. The second through the demand side, and the third through central bank (in)competence. This rather sterile slicing and dicing is easy prey to the Milton Friedman challenge: Supply-side and demand-side inflations are about relative prices, which do not necessitate an increase in the overall price level. Inflation is everywhere and always a monetary phenomenon.
Don Patinkin, a Chicago-trained macroeconomist who created the post-1950 monetary economics orthodoxy—followed by monetarists and Keynesians alike—in his magnum opus Money, Interest & Prices, used to quip that this was not a particularly edifying formulation. Since the price level is the inverse of the purchasing power of money, he likened it to the banality that the price of potatoes is a potato phenomenon. Epic as that take-down is, it’s useful to retain Friedman’s maxim for analytical purposes. We will see why.
At heart of the Patinkin-Friedman debate is a fundamental disagreement over the interpretation of the quantity theory of money (QTM), which has been the orthodox right-of-centre neoclassical position on money and the price level since David Hume. QTM states that the long run level of prices depends on the level of the money supply, formalized in the equation of exchange MV = PY, with V and Y held constant, or more properly, fully anticipated, so that M is proportional to P. As Friedman also said, in the 200 years since Hume we have moved one derivative beyond him, so that we now believe that delta M (changes in money supply) is proportional to delta P (inflation). The Patinkin-Friedman disagreement is about whether the causality in the equation of exchange must be established through other means (Patinkin) or whether it could be taken as obvious - delta M causes delta P (Friedman).
To infer causality from (or impose causality onto) an equation that’s always true is an ill-disguised sleight of mind, so I tend to go with Patinkin. However, the Friedman conception has an important insight to offer. If you believe in the autonomy/free will of the central bank, and if you believe in the special character of money—both fairly uncontroversial positions—you must ask yourself, what was the central bank doing? If you’re investigating inflation, you must pause and ask—what is the central bank’s reaction function? If there is something, a bad crop, a technological change, a profligate government, anything really, that puts upward pressure on some prices, does it follow that the economy must experience an increase in absolute prices? Moving one derivative beyond, if there is unanticipated inflationary pressure somewhere, must the overall inflation rate of the economy increase?
So what does all this arcane monetary theory have to do with India’s fiscal deficits and inflation? Well, simply this—by the orthodox theory, for fiscal deficits to cause inflation, those deficits have to be monetized. The central bank has to bankroll the government. That’s what banana republics do. That’s what India and RBI used to do. However, in line with most of the world, India’s fiscal deficits have been bond-financed for quite some time now. When the sovereign credit is commercially bought and sold and commented upon, fiscal profligacy should simply result in an increased interest rate on government securities (G-Secs). Broad-based inflation does not directly follow.
There’s a heterodox left-of-centre challenge to this orthodoxy— Neo-Chartalism— in which fiscal deficits are even more benign. Governments, as monopoly issuers of their own currency, never run the risk of ‘default’ on domestically held debt, so real interest rates don’t spike. Monetary quantities are endogenously determined in the macroeconomic system and thus not really of separate interest, and while fiscal deficits may cause inflation, this is a soft constraint that only really matters when the interest rate on government debt starts approaching the growth rate of the economy. At 15% (nominal) annual GDP growth and 8% (nominal) yield on government debt, India is not even close.
So regardless of what you believe about the fiscal profligacy of the Indian government, and whether you choose to side with the orthodoxy or the heterodoxy, it does not necessarily follow that there must be inflation.
The writer is a London-based consultant. This is the first of a five-part series in which 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.”