Home / Opinion / A monetarist history lesson for India

The Indian economy continues to grapple with high inflation and a significant slowdown in growth. Retail inflation numbers released this week based on the Consumer Price Index accelerated to 10.09% in October from 9.84% in September. In fact, retail inflation has averaged 9.5% over the last six years while wholesale price inflation has averaged 8.6% during the last three years. Why are we in this mess in the first place?

In the aftermath of the global financial crisis of 2008, both the government and the Reserve Bank of India (RBI) pursued highly expansionary policies to prop up the faltering economy.

Large public sector pay increases (following the Sixth Pay Commission) and the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) were rolled out and the RBI cut interest rates substantially. The key fact is that inflation can persist only if demand consistently outstrips supply. Fiscal expansion raises demand because the government increases its purchase of goods and services. At the same time, deficits crowd out productivity-enhancing investments in new plant and machinery as the government borrows funds otherwise available to private investors. RBI played its part by reducing the repo rate (the rate at which RBI lends to banks) by four percentage points between September 2008 and March 2009. In short, policy successfully managed to stimulate demand while choking supply. As a result, the economy’s potential growth fell and inflation raised its ugly head.

To deal with the inflationary pressure, the central bank raised the repo rate by three percentage points between April 2009 and October 2013.

However, despite these policy actions, the inflation rate continues to remain stubbornly high. There are two important reasons for this. First, RBI failed to reverse course quickly and withdraw its stimulus after the economy bounced back from the effects of the global financial crisis of 2008. In fact, in his last public appearance before he stepped down as RBI governor, D. Subbarao acknowledged this. He said, “With the benefit of hindsight, I must admit in all honesty that the economy would have been better served if our monetary tightening had started sooner and had been faster and stronger."

Second, and perhaps more importantly, the government’s fiscal stance compounded the problem by undermining the central bank’s ability to rein in inflation expectations.

The situation we face today is not unique. There is, in fact, a lot of similarity between our present predicament and the situation that led to higher inflation in the UK in the 1970s. In the 1970s, Britain’s economy was in serious trouble. Growth slowed because of industrial inefficiency and unemployment was rising. To generate more growth and employment, successive governments resorted to fiscal and monetary stimulus, which only produced inflation. When Margaret Thatcher entered office in 1979, inflation was rising rapidly. The budget was in crisis and was expected to deteriorate further with pay awards (promised by the previous Labour government) on top of the usual spending pressures. In response, the Thatcher government adopted a decidedly monetarist stance in which fiscal policy became subordinate to meeting money supply targets.

The cornerstone of this was the medium-term financial strategy, a gradualist plan involving the pre-announced tightening of monetary and fiscal policies.

However, the announcement failed to command immediate credibility. In response, long-term interest rates rose initially, indicating a lack of confidence in the government’s announcement.

In order to enhance credibility, the budget of 1981 raised taxes by 2% of gross domestic product (GDP) to cut the deficit, even though the economy was in a recession. This was unpopular, not least among the economics profession. In fact, 364 economists (including our own Nobel winning economist Amartya Sen) were signatories to a letter which was published by The Times newspaper protesting against the government’s fiscal and monetary policy in general and against the 1981 budget in particular.

Nevertheless, this approach to policy was unequivocally vindicated by events. The tax rise brought inflation (and inflationary expectations) down decisively and was crucial in finally creating market confidence in the policies’ durability.

The Thatcher government’s disinflation strategy teaches us that prudent anti-inflation policy includes containment of the deficit to an amount that can be comfortably financed without printing money. The reason is deficits today must be eventually paid for by running surpluses or by printing money. If one assumes that the government would not default on its debt obligations, then money financing is eventually required in the absence of severe cuts in public expenditure or a rise in incentive damaging taxes. If citizens come to believe that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of money today, thereby driving up the prices of goods and services.

In sum, it is insufficient to announce and maintain restrictive monetary policies unless accompanied by a coordinated reduction in budget deficits. This is what history teaches us.

Naveen Srinivasan is a professor of economics at the Indira Gandhi Institute of Development Research, Mumbai. Comments are welcome at

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