Sunday, June 24, 2012

Why is solving India's inflation crisis important?

All of us are aware of India's inflation crisis. It is very disappointing, how we lost our grip on stable 4-to-5 per cent inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y CPI-IW inflation has exceeded the upper bound of 5 per cent.

All of us agree that there is something insiduous when 10% inflation effectively steals 10% of the value of my wallet or fixed income investments. In India, however, we often hear the argument "Yes, this is bad, but if high inflation is the way to get to high GDP growth, let's get on with it". It is, then, important to ask: Why is low inflation valuable?

Nominal contracting is very important

Complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.

Every society needs to adjust all the time, in response to changes in tastes and technology. When tastes or technology change, the structure of production needs to change, which involves renegotiation of (written or unwritten) contracts. These adjustments are costly. Contracting is costly, and renegotiating contracts is costly.

It is useful to think of a finite supply of adjustment as being available in the country. We should devote that full power of adjustment to the beneficial adjustments associated with changes in tastes and technology. In a place like India, where GDP doubles every decade, the requirement for adjustment is (in any case) large.

Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs.100, but that contract is thrown out of whack because of 10% inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.

Contracting is costly. Almost everything that senior managers do is to arrive at complex deals that create and sustain complex structures of production. This work is continually torn down by high inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.

Inflation messes up information processing

To continue on the theme of adjustment, the essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the `background noise' by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.

Building a sophisticated market economy is all about making long-term plans. When a firm decides to build an airport or a highway, this involves making NPVs over the next 20-40 years. This requires having a fair idea about future inflation. If inflation will fluctuate in the future, then firms will err on the side of caution when making plans about the future, i.e. investment will be reduced. I will stress that long-term investment, in projects such as infrastructure or heavy industry, relies critically not just on a long-term bond market (which, in turn, critically requires low and stable inflation) but also on the calculations happening in a spreadsheet about the NPV of the investment project, which involves projecting all revenues and all expenses for the next 20-40 years (which also critically requires low and stable inflation).

Impact upon pre-existing nominal savings

For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.

A civilised society is one in which people can make plans for the deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of even one bout of high inflation over the coming 25-35 years forces people to drop back to other mechanisms of protecting themselves in old age. What is needed is not just inflation control right now. What is needed is the environment of mature market economies, where outbursts of inflation are fully ruled out for decades to come.

Impact upon relationship with banks

In India, banks pay very low interest rates. While many interest rates have been deregulated, the interest rates paid by banks are held back by factors such as low competition and financial repression (i.e. forced purchases of government bonds).

When households expect inflation will be 12%, they will see a 4% interest rate paid by the bank as yielding -8%. This has many consequences. On one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, households tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.

If the financial system were regulated sensibly, then with high inflation we would immediately get higher nominal interest rates since buyers of 90 day treasury bills would demand higher interest rates to pay for inflation. This would reduce the damage caused by high inflation. In India, we suffer from bigger negative effects because of a faulty financial system.

These may seem to be small things but they actually are fairly large effects. Towards an understanding of the costs of inflation -- II, by Stan Fischer, 1981, argues that perfectly anticipated 10% inflation induces a cost of 0.3% of GDP on account of only one factor : excessive efforts by households and firms to hold less cash.

The rising prominence of gold

Gold is a barbarous relic; it is the investment strategy of choice for uneducated people. It is also a vote of no confidence in fiat money. Our failures in creating a capable central bank, which delivers sound fiat money, are taking Indian households back to their old ways. Many decades of progress in getting households to engage with the modern financial system is being undone in this inflation crisis.

A classic quotation

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become `profiteers', who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. 
Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.

From Chapter 6 of The Economic Consequences of the Peace, by John Maynard Keynes. Source: Who said ``Debauch the Currency'': Keynes or Lenin? by Michael V. White and Kurt Schuler, Journal of Economic Perspectives, Spring 2009.

But is there not a tradeoff between growth and inflation?

For a brief period, the empirical evidence in the US suggested that there was a tradeoff between inflation and unemployment. Here's the classic picture, for the 1960s in the US:

which shows a nice relationship where higher inflation has gone with lower unemployment. This evidence has led many people, particularly those concerned with the plight of the unemployed, to advocate higher inflation.

A look at the same evidence for the US, over a longer time period, shows no such tradeoff:

The idea that there is a tradeoff between inflation and unemployment is thus an artifact found in the minds of people who studied economics in the 1970s. This proposition was pretty much dead by the late 1970s. One by one, as central banks moved to inflation targeting, aiming and delivering 2% inflation, unemployment went down, not up. Hawkish central banks are the central story about how the stagflation of the 1970s was broken.

In the empirical literature, it is quite clear that by the time we get to double digit inflation, this has a discernable and negative impact on growth. This generally means that at a 95 per cent level of significance, you can reject the null of no effect, in conventional datasets. The conceptual reasoning above gives no reason for believing that there should be a threshold effect, that inflation above 10% should hurt growth but below 10% things should be fine. It could well be the case that when you get to smaller values for inflation (e.g. 9%) this effect size is not detected with conventional datasets at the 95 per cent level of significance.

It is interesting to look at the target inflation rate set in the numerous countries which have setup either de facto or de jure inflation targeting. The median value chosen has been: 2%. If people were convinced that inflation below 10% is not damaging to growth, inflation targets may have been higher. But instead, the typical inflation target in the world is 2%. This underlines the universal consensus in favour of targeting low inflation -- more like 2% and far below the 10% that we've got stuck with in India.

In the West, some people with a weak grip of economics, and strong sympathy for the unemployed, have argued that high inflation is a good thing because it helps reduce unemployment. In contrast, in India, economists have consistently found that the poor are adversely affected by inflation. There has not been a left-of-centre lobby that is soft on inflation, here.


There is no tradeoff between inflation and growth.

High inflation damages growth.

One element of India's growth crisis is India's inflation crisis.

It is important to think carefully about the accountability of the central bank. RBI is not in charge of India's welfare. RBI is in charge of India's fiat money. The one thing that RBI should be held accountable for is delivering low and stable inflation, i.e. for holding CPI-IW inflation within the 4 to 5 per cent range.

Low and stable inflation is an essential ingredient of the foundations of high economic growth in India. RBI can lay that platform. They can do no more. If they try to reach into other objectives, they damage this core.


  1. Plotting a scatter plot of inflation versus unemployment for a 40 year period for USA and then coming up with a statement that "One element of India's growth crisis is India's inflation crisis" does not seem very scientific to me.

    How can you make a statement on India by analysing the US data over the last 40 years? To begin with these two countries differ enormously in their economic structures. One of them is a developed country while the other at best is a low income country.

    Please give us some sound reasoning before making statement like "Low and stable inflation is an essential ingredient of the foundations of high economic growth in India." I am not interested in your ideology. Back up your claim with evidence.


    1. Almost everything we know in macroeconomics, worldwide, is rooted in the United States. There is no other country which has long time-series of data under the conditions of being a market economy.

      E.g. almost all the discussion about monetary policy and inflation in Australia is rooted in the US literature. The US is the lab in which macroeconomics was forged. I focused on the US in the 1960s and the US in a fuller perspective as the Philips curve was invented with the US data, and died when the US data stopped showing this relationship existed. It is this graph which embellished numerous textbooks, which have been studied by essentially anyone who thinks that there is a Philips curve. The guys who claim that there is a Philips curve in India are not showing such a graph with Indian evidence :)

      The basic logic of what we've figured out in the US has been transplanted in myriad countries with success. India is no different, particularly as we move forward towards becoming an ordinary market economy. On the latter subject, may I point you to: New issues in macroeconomic policy by Ajay Shah. In "Business Standard India", edited by T. N. Ninan. Business Standard Books, 2008.

    2. The issue here is not about whether or not other countries learnt their approach towards monetary policy or inflation from USA.

      My point was that you don't provide enough evidence about your view that the current slowdown in India is due to high inflation. India did have high inflation even before the financial crisis but it was able to maintain a descent pace of economic growth. I think the problem is more complicated. The global crises has made it difficult for small businesses in USA and other countries to get access to the finance their investment. In my view the growing inflation in many developing countries including India may be due to the zero interest rate policy of the US Fed. While US is keeping inflation in control it is exporting inflation to other countries including India.

      In general I agree that low inflation is good for any country. But, I don't think that high inflation is the primary cause for the slowdown in India.

      Regarding your example about Australia - It is true that Australia had lot to learn from economic history of UK and USA along with many other countries. But unlike India, Australia does have its own independent macroeconomic policy. India's macroeconomic policy is mainly controlled by IMF and academics embracing neo-liberal ideology inherited from USA.
      Australia is one of the few developed countries which dodged the financial crises. It could be the sheer luck that Australia is located near Asia that may have saved Australia. But it could also be partly due to the way the policymakers in Australia responded to the financial crises. While in the USA the government bailed out the banks by injecting money into the financial system, in Australia money was directly handed over to the citizens and residents.

      Ex post US policy failed to stimulate the aggregate demand because the banks refused to lend the injected money to the firms. However, in Australia since the money directly went to the pockets of the people the aggregate demand did improve.

      Thanks for the link to your paper.


    3. Dear Sriram,

      You say: "My point was that you don't provide enough evidence about your view that the current slowdown in India is due to high inflation. "

      In my blog post, I say: "One element of India's growth crisis is India's inflation crisis.". I did not say it's only due to high inflation. The inflation crisis is one element of our problems. There are others. As for mechanism: The argument is in the blog post : mucking up decision making of firms particularly on the long time horizons required in analysing investment, contaminating the decisions of households in saving e.g. with the bias towards gold, the academic evidence about the negative impact of inflation on growth beyond 10% (note: household inflation expectations in India right now are ~ 12%, which is over the 10% bound) and why we need to worry below 10% also.

      You say: "But unlike India, Australia does have its own independent macroeconomic policy. India's macroeconomic policy is mainly controlled by IMF and academics embracing neo-liberal ideology inherited from USA."

      I think RBI will be most amused if you characterise them as neo-liberal. There isn't a more left-wing central bank in the world, among large countries, than RBI.

      I only used Australia as an example. It could have been any country. Every single element of the monetary policy discourse, anywhere in the world, is rooted in the evidence drawn from the lab called the United States. There isn't any other comparable dataset. Yes, each country is different, and we need to adapt our ideas to local conditions, but there is no denying the fact that every scholar in this field is rooted in the US experience - for that's where all the foundational papers were done.

      You say: "In my view the growing inflation in many developing countries including India may be due to the zero interest rate policy of the US Fed. While US is keeping inflation in control it is exporting inflation to other countries including India."

      Please see this blog post, and the literature cited therein. INR moved up to greater flexibility in 2003, 2007 and RBI's trading on the currency market essentially ended in 2009. Thanks to this, the link between US monetary policy and Indian monetary policy has been broken. India now has monetary policy autonomy. From 2007 onwards, and particularly from 2012, we have had the choice of doing what we like. What we have done has failed: we have a raging inflation crisis on our hands.

      There is a two part decision on establishment of the monetary policy regime. First, the country has to decide to peg or float. If (and only if) you peg to the USD, you import US monetary policy. So regardless of what conditions in Hong Kong are like, right now the short rate in Hong Kong is zero. India started out pegging, learned that this was a bad idea, and moved away from it. However, while a pegged exchange rate regime is a monetary policy regime, a floating exchange rate does not pin down monetary policy. A floating exchange rate gives you the possibility of having a monetary policy regime. India failed that test. We did not step forward and articulate what a sensible monetary policy regime would be. If anything, we did the opposite: we loudly advertised the lack of knowledge about monetary economics at the RBI. It is not surprising that we're holding a raging inflation crisis.

  2. Wow, you have a lot of concern about "civilized" behaviour.

    "A civilised society is one in which..."
    "mature market economies"
    "Gold is a barbarous relic; it is the investment strategy of choice for uneducated people"

    You mean "civilized" like the Us of A with all its social problems, its middle class up to the neck in debt, government which has destroyed its 1990s sound economic policies, and with its rampant inequality? Or "civilized" like Europe who kept looking at the "market>" and forgot about real growth and its people and now is endangering generations to come for all its debt?.

    Finally, gold barbaric? someone should tell the China central bank then!

    China´s central bank recommends gold for value preservation

    Roubini says keep physical gold
    Buffet recommends Gold


    1. I apologise to all the gold bugs that I have offended :)

      Under Indian conditions, if you compare gold (zero to negative expected return, high volatility) against the INR (-10% expected return, zero volatility), there are indeed individuals for whom gold is superior. I say this as an indictment of our failure in constructing a sound fiat money, which is an essential piece of infrastructure underlying the market economy.

  3. Hi, I agree to most of what has been presented in the article. Just wanted to share couple of points: 1) INFLATION EXPECTATION does play a role in Indian context too (at least in the financial markets) and its emphasis can not be missed. 2) INVESTMENTS IN GOLD is no more an asset class for the 'uneducated' alone. Increasingly, the 'wealth advisers', catering to financial investors of all sizes, are encouraging 'investing' & 'diversifying' into gold (not just the paper variety), apart from real estate & commodities.

  4. Hi Ajay,

    While I agree that Inflation Expectations are important from an individual/project financing perspective, I have a few concerns regarding the Inflation Targeting (IT) policy adopted by Central Banks:

    1. IT forces central banks to adopt an expansionary monetary policy during the recessions to allow for growth. This credit expansion is the easiest way to generate asset bubbles. We need to consider the policies in the early 2000s post the dotcom bubble to understand the limitations of IT.
    2. IT provides no solutions for supply side shocks. The present case, unfortunately deals with supply shocks and bad fiscal policies. Given India's greater dependence on imports (oil), IT may not be very suitable.

    I believe that both fiscal and monetary maturity is critical for economic prosperity. This means creating institutions that can deliver the right message. While RBI may have faltered a few times, at present they have sent a clear message to the Government -get your stuff in order, until then no accommodating policy. Unfortunately India lacks a good fiscal policy framework/governance as we still live/believe in the Mai-Baap / License Raj era. I hope better sense prevails soon.


  5. The article gives insight into why inflation must be controlled and how it is dangerous to Indian economy.Inflation is certainly one variable that needs to be tackled with care and extreme focus as it is leading to degeneration of our growth.

    Developing country like India is more exposed to supply shocks,which causes high variability in inflation, thus impacting investment and consumption.Moreover,the rigidity of labour laws and the role of government in financials markets makes sure that prices will not give correct signals about policy.The impact of high inflation is evident from falling IIP numbers,low profits of companies.

    Inflation reduces investment and Productivity resulting in negative correlation between inflation and growth.

  6. Good post Ajay.

    >> I apologise to all the gold bugs that I have offended :)

    Bear with me for a diversion here... would you kindly venture to write an article on gold (or point to your earlier posts if any on your opinions on gold) as an investment.
    It is interesting that among all the PMs, central banks care only to hold gold for their reserves.
    China has begun pushing for gold ownership among its citizens - while RBI has decided to shoot Indian citizens in their foot when they attempt to bring in gold worth more than Rs.20k!

    Wouldn't gold "solve" any inflation crisis?

  7. In 2009 RBI bought 200 tonnes of gold from IMF.The gold price at that time was hovering around 17000-18000.But,I think the reason investors have faith in gold is supported by its long term chart.I am not sure if I can post the chart here,but here is the link
    The time series has strong upward trend and stationary,clearly indicated by the chart.Other assets classes and gold differ in this respect.
    But then what productivity does gold behold?How does it contributes to any productive task in the economy.A fixed deposit/equity investment channels funds in the economy.We cant say that for Gold.

  8. Sincere apologies of commenting so late to the post published date.

    You mentioned, 'In India, banks give low interest rate', I am not sure if that is true. I haven't seen interest rates to be high in Aus or US as compared to India.

    Aus skipped the crisis mainly because Govt here distributed funds directly to the tax payer accounts (no middle man + directly to impacted people). Also I think other aspect is that many less of Australia's investment was outside or towards quick money making investments. Inflation impact was felt in Australia but it was mild. They haven't seen high % in interest rate / returns / inflation.

  9. THE PROBLEM is everyone is printing.DOnt blame US dollors ...See the INR rotation .Today what does 100 rs buy .it is like 10 rs note 10 years back .It is not economic growth it is pure debt growth.Why everyone i shouting of rate cut .coz the govt debt has gone out of hand.THanx to MMS who is a IMF guy like krugman or greenspan .

    Economic growth comes from inovation and creative ways to make money.Today everyone makes money thru real estate.Gold value is still undervalued .

    Imagine gold goes to 2.5 lakhs 10 gms.What happens to rotation and debt growth.Btw that is hyperinflation .The govt debt is blowing up including indian debt.Hyperinflation happens when no one buys ur debt.German weimar was a similar thing.RBi is not doing enough .the rates have to be raised but they can do that politically it is a suicide.

    So what happens NEXT ...US bond yields taper or no is rising to 6%+ in the next 6 months.If u see may 2013 taper talk happened but itbottomed out in july 2012.
    THE great depression taught one thing... 1930 april was sovreign defualts started .Here it started 2010 but fed started Qe soon with the scary crash.

    Gold is not the answer to inflation it has no relation.When taxes increase public go into hiding into gold and land.

    Unfortunately I THINK INDIA is going to defualt and learn the hard way.

    HI AJAY WHY DONT U SEE GROWTH IN M3 supply it is exponential.And RBIs balance sheet expansion has been parabolic.It is doing the dirty work of GOVT just like the fed.


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