Ruling dilemma

RBI Governor Raghuram Rajan says inflation is no more restricted to food items but is quite widespread in distribution and visible in both manufacturing and services.

ON December 12, two sets of just-released official economic indices caught the media headlines. One was that the lead indicator of industrial growth, the Index of Industrial Production, pointed to a contraction of 1.8 per cent in industrial production in the organised sector during October 2013 compared with the corresponding month of the previous year. That was the 12th consecutive month during which industrial growth was indifferent or poor. For a government that had been making much of the high growth registered during a large part of its two-term tenure, this was cause for discomfort since it has been trying to underplay the growth decline in the run-up to the 2014 Lok Sabha elections, claiming that it was a temporary blip that had touched bottom.

The other indicator that won attention was the month-on-month retail price inflation, which was reported to have touched 11.24 per cent in November 2013. This was a record high for the period since January 2012, when that rate could be first calculated on the basis of the newly introduced headline All-India Consumer Price Index. In fact, the month-on-month rate had risen continuously from its already high level of 9.52 per cent in August 2013. For the Congress, which leads the United Progressive Alliance (UPA) government and is seen as having lost heavily in the recent Assembly elections because of high inflation, among other factors, this news was a blow. In what was perhaps an acknowledgement of this assessment, Finance Minister P. Chidambaram declared, “It is common knowledge that the government of the day will pay a price for high inflation, especially if inflation persists over a long period of time.”

There is a feature of this inflationary surge that needs underlining. Earlier, the understanding was that retail inflation was the result of the inflation in food prices. This argument was used to “justify” some degree of inflation. The government argued that food inflation was partly because of the state giving farmers the benefit of higher support prices and partly because of high growth having made people richer and capable of consuming more food, including vegetables, meat, fish and eggs, resulting in temporary supply-demand imbalances that were driving up non-cereal food prices and triggering inflation. In sum, inflation was being presented as the short-run cost of ensuring long-run gains. However, as Reserve Bank of India (RBI) Governor Raghuram Rajan recognised recently, inflation was no more restricted to food items but was quite widespread in distribution and visible in both manufacturing and services. He also admitted that India was among the few large countries that were suffering from consumer price inflation even when the economy was “relatively weak”.

A corollary of this is not just that the kind of arguments used to “justify” inflation lose their relevance but that it is not demand-side but supply-side, including cost-push factors, that seem to be the basic trigger for price increases, which are then aggravated by temporary supply-demand imbalances and speculation. If there is one common factor that explains this inflation driven from the supply-side, it is economic reform. There are many links between neoliberal reform and inflation. India’s vulnerability to the effects of changes in international prices has increased with trade liberalisation.

Increased industrial concentration owing to the dilution of anti-trust measures and reduced regulation tend to encourage a profit-driven escalation in the prices of certain manufactured goods, as is exemplified by pharmaceuticals. Imbalances between demand and supply of primary products are accentuated by the government’s reluctance to release additional food through the public distribution system in order to limit subsidies. The effort to reduce subsidies has also resulted in a continuous increase in the prices of commodities such as petroleum and fertilizer whose prices are administered. The list is long and almost endless. What the recent inflation experience suggests is that while the earlier regime of intervention and regulation is criticised for generating a high-cost (and, therefore, a high-price) economy, the processes of liberalisation and deregulation are the ones that are creating a high-inflation economy.

In the event, the government is stuck with simultaneously addressing the twin problems of slow growth and high inflation, or “stagflation”. This twin problem, reflected in the trends noted above in two diverse indices, is of significant import, given its implications for the likely performance of the economy in the months before the elections and for politics within the UPA. Under normal circumstances, a period of slow growth should be one in which inflation is low because depressed demand “helps” keep prices under control. This gives the government policy space inasmuch as it can resort to fiscal policy measures (such as increased spending to boost government demand) as well as monetary policy measures (low interest rates and large liquidity infusion to drive debt-financed private investment and consumption) to spur growth without bothering about inflation.

However, this time around, even before the now more friendly fiscal and monetary arms of the government (the Finance Ministry and the RBI) decided to come together to consider the policy options they had to address slow growth, they faced two handicaps. The first was that the government’s commitment to neoliberal economic reform required it to prioritise a reduction in the fiscal deficit at all costs. Given its preference not to raise taxes to mobilise additional resources, curbing the deficit required reducing subsidies and hiking administered prices that would spur inflation, and reducing expenditures that would slow growth.

Stated otherwise, given its objective of incentivising private investment by exercising forbearance with respect to direct taxation and its decision to adopt self-limiting legislation such as the Fiscal Responsibility and Budget Management Act, the government had straitjacketed itself into a state of fiscal policy paralysis. The problem is that given revenue trends, the government has already neared its targeted fiscal deficit for this financial year and is arithmetically not in a position to meet even budgeted revenue expenditures. In the event, at this politically crucial moment for the Congress and the UPA, the Finance Minister has decided to require all departments to curtail expenditure substantially relative to what was provided for in even the lean Budget he presented.

That makes monetary policy the only lever available to further macroeconomic objectives. It is here that the second handicap comes into play: the economy is mired in stagflation. Which macroeconomic objective should the central bank focus on when formulating its monetary policy? Should it seek to push the gross domestic product (GDP) and restore the glory of the high growth the UPA basked under, during the 2003 to 2008 period? Or should it address the inflation that is clearly damaging the UPA’s electoral prospects? If it is the former objective that should be pursued, then what is required is a cheap and easy money regime that would expand credit and support debt-financed spending and demand. If it is inflation that must be tackled, then monetary policy must be geared to restricting credit and making it more costly so as to discourage debt-financed expenditures and suppress demand. That would, obviously, be adverse for growth.

Class angle

There is a class angle to all this. As a range of democratic and oppositional actors have stressed, the effort to curtail expenditure is resulting in a sharp cutback in welfare expenditures directed at the poorest at a time when inflation is already imposing huge burdens on them. If, in addition, the government focuses on “growth-promoting” monetary policy measures to spur debt-financed demand, inflation will remain high and only worsen. But that is the policy direction that big businesses, such as the recession-hit automobile companies, favour. Hence, a choice needs to made between alienating big business and the large sections of the media it controls when an election needs to be financed and fought, and alienating much of the poor whose votes can make a huge difference.

However, if the government decides to hike expenditures aimed at the poor and ignore the demands of business for a significant lowering of interest rates and easing of money supply, it will still have to find more direct ways of addressing the supply-side-driven inflation. That, as the earlier discussion implies, requires withdrawing from an unthinking adherence to reform. More so because choosing to roll back reform requires imposing controls on the foreign capital that may, in response, choose to exit the country, precipitating balance of payments difficulties.

Needless to say, these are not easy decisions to make. But for the political section of the Congress, which now recognises that it has for too long left crucial economic decisions with important political implications to those who are politically irrelevant and ineffective, these are issues that must be addressed.

Losing the next elections to a resurgent Indian Right is not just bad for the Congress but also for the first family that has used it as the vehicle through which it remained politically relevant. It could also mean the disintegration of the Congress as a party. Sidelined voices such as that of Rajiv Gandhi-loyalist Mani Shankar Aiyar seem to be shouting out that message. But it is not clear whether they can and will be heard. It may also be far too late to correct the immense damage that has been done, both economically and politically.

It is testing times for the Congress, but largely of its own making. Unfortunately, it is testing times for the nation as well.