The claim ‘reducing inflation does not hurt growth’ is fallacious.
We lost the first 40 years after Independence to mindless pursuit of socialism; one is afraid that inflation targeting, and its sub optimal target levels is seriously denting growth as well as employment, the much needed ingredient to reap demographic dividend.
After the double-digit inflation at the turn of the last decade arising out of monetary expansion for tackling the 2008 global financial crisis, the RBI has been slamming the breaks through tighter money controls. This was formalised by inflation targeting from January 2014 which has prescribed a target 4% +/- 2%. India’s growth has never reached its the demonstrated potential of 8-9% ever since. As argued here, not all the blame could be laid on GST or demonetisation and inflation control seems to have more causal linkages for sluggishness. This article explains the negative side effect and explores two alternatives.
It is argued that reducing inflation has no impact on growth. Historical evidence, of course, presents a few exceptions, but the surrender of growth momentum to China since the late 1980s could be largely attributed to high interest rates maintained to tackle inflation by the West, stifling their investments for growth, aided further by China’s undervalued currency.
Let’s see the fallacy behind the claim “reducing inflation does not hurt growth”. Growth causes additional demand and needs supply. Can any growing economy operating tightly produce these additional supplies at same cost efficiencies and levels? Unlikely. These would come at increasing costs, causing inflation. Cost of additional supplies in the short term increases more sharply but may taper over a period. But for a fast-growing economy which adds demand and new capacities every year there will always be upward price pressures. Price inflation is higher as a result.
Prof Dholakia (till recently a member of Monetary Policy Committee of RBI and now a Director of RBI) in an article in the Journal of Quantitative Economics (2020) estimates that the long-term growth consistent with the current inflation targets and CAD is 5.6%, a whopping shortage of 2.4% from the objective and demonstrated potential of 8%. In his opinion, 8% could have been achieved with 5.4% to 6.0% inflation and CAD of 2%.
Thus, without the sub-optimal inflation targeting over the last 7 years, our GDP would be about 21% higher today, leaving aside effect of demonetisation and GST. The approximate cumulative loss till date is a whopping 91% of current GDP (what economists call the sacrifice ratio). A 21% higher output per annum could have meant that our employment now could have been higher by about 7% (by Okun’s law of trade-off between growth and employment, assuming 1% job created for every 3% growth).
India’s unemployment rate is estimated by various people at around 6-8% in the last 6 months. Assuming 4% as inevitable “natural” rate of unemployment, the net additional employment required to wipe the deficit (8% less 4%) would be around 4% at the maximum. A 7% additional employment (that’s nearly 3.5 cr jobs) could have provided jobs to all those who wanted it by now.
The welfare loss due to new entrants not finding jobs, as is now happening, is huge. A false start can have lifelong impact, job losses can cause suicidal despair, besides being poor advertisement for others around, while the impact from inflation is lot more benign. Empathetically, the ratio of welfare loss caused to unemployed youth versus fixed income earners suffering loss in purchasing power is significantly more.
This dictates that we should be lot more sensitive to unemployment than loss of purchasing power. It may be easier to tackle the latter by protecting the purchasing power of the vulnerable retired up to some basic limits than compensate the unemployed without cultivating their dysfunctional dependence on the government.
If one uses models from other economies at similar stage of per capita income and growth like India’s now, a 2% drop in inflation from 8% to 6% increases potentially causes unemployment by 0.25% to 0.50%, but a similar change from 4% to 2% might dent employment by 1.5% to 2%. Given this, it is baffling how RBI maintains the same 2% band on both sides of its target. If 2% was justifiable on upper side, it should be less half of that on the lower side i.e. middle rate of 4%, upper limit of 6% and lower of 3.2%.
It is time to re-engineer and look at alternatives. (1) Instead of targeting inflation, we can direct our efforts at those affected by inflation and provide protection to them. Protection up to a limit (by whatever means) might be far cheaper at higher inflation levels when mostly the fixed income earners are affected. Hopefully more youth will be employed. While the exact calculations can be empirically worked out, for a starter we could operate at 8% upper limit and 4% lower limit with action to be triggered when the inflation falls below 5.5%. (2) RBI or monetary policy need not carry the burden of balancing things and protecting either the pensioners or job seekers. It can become relatively benign. Given the target 8%-9% real growth and a tolerable inflation of 5.5%, it can inject money at 13.5% and leave protecting fixed income earners to the government, even if such a step would be extreme. Government is serious on fiscal deficit targets, hence trouble from that front is unlikely. It should observe stricter discipline with MSPs and wage revisions. It would be good for the government and RBI to reach an agreement on a band for these.
Ideally, government should target real growth as per potential (say 8%-9%) and monetary policies should support such growth. Instead, the tail has been wagging the dog for the last 7-8 years and growth and employment have become supplicants.
The writer is author of Making Growth Happen in India.