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Inflation and Public Policy: Contemporary Dilemmas

There has been much comment by the media and criticism by business that the policy of hiking interest rates to combat inflation will hurt investment and growth. But what has India's experience been on the relationship between the real interest rate and the inflation rate?

COMMENTARYseptember 6, 2008 EPW Economic & Political Weekly12Inflation and Public Policy: Contemporary DilemmasSugata MarjitSugata Marjit ( is at the Centre for Studies in Social Sciences, Calcutta.There has been much comment by the media and criticism by business that the policy of hiking interest rates to combat inflation will hurt investment and growth. But what has India’s experience been on the relationship between the real interest rate and the inflation rate?Economic problems, particularly those which rise to the status of social criticality, draw self-confident comments, policy suggestions, numerical assertions and predictions from various quarters but possibly despair and frustra-tion from institutional authorities and technical experts engaged in a deeper understanding and resolution of the problem. As important events of today arerendered useless tomorrow by the all-powerful media, we are naturally more interested in quick solutions rather than in an understanding of the problem. The business lobby is angry about an increase in interest rate and they claim, in popular national magazines, that a rising interest rate will shave off 2 percentage points from our 9 per cent GDP growth rate. Even the most erudite economists and poli-cymakers such as the chairman of the United States Federal Reserve or the gover-nor of the Reserve Bank of India (RBI) will think 10 times before committing them-selves to such a numerical figure. But that does not prevent business journalists or business lobbies from publishing a state-ment, which may distort the choice of right set of policies. More recently the govern-ment has also come out with a prediction of a lower growth rate, but not as low as sug-gested in some business quarters.Close on the heels of such assertions, follow demands by a political party to compel theRBI to fix the rupee/$ exchange rate at Rs 39 a dollar. Again an economist will shudder with fear and apprehension if she has to announce a “socially optimal” nominal exchange rate because she is liable to her discipline, years of training and the associated logic. But politicians are not burdened by such baggage. Thus, an instruction to RBI is thought to be a reasonable way-out from inflation. Demands for windfall tax on oil compa-nies are also suggested. But such demands do not need special mention as they are targeted as a “firm specific tax” where the “firm” concerned belongs to the “enemy” of a set of powerful politicians. In this commentary we try to talk about the relationship between the rate of infla-tion, the real interest rate and the GDP growth rate. We are not going to explain such a relationship, but we intend to focus on statistical associations. This will give us some handle on what to expect of our growth rate if theRBI keeps on raising the nominal interest rate in the face of a sus-tained rise in prices. This will also indi-cate, however loosely, the association between inflation and growth, a proxy for a version of the Indian Phillips curve, given the well known pollutants in official Jamalpur struck the eastern embankment near Hempur village in the Navhatta block of Saharsa district, 75 km below the Bhimnagar barrage. The floods uprooted half a million people and engulfed 96 villages in Saharsa and Supaul districts. People could go back to their villages only after the Holi festival of 1985 when the breach was plugged. Bindeshwari Dubey of the Congress was the chief minister that year. In 1991, there was a breach in the western embankment near Joginia in Nepal that led to a political crisis in Bihar and the minister of water resources had to resign his post. This resignation was never accepted by Lalu Prasad Yadav who was the chief minister at the time. This was a repeat of the Bahuarawa breach where the river had receded after eroding the embankment. The Kusaha breach took place in the regime of Nitish Kumar and it will take about a year to get the complete story. Thus, virtually no ruling party (including the administration under presi-dent’s rule) can claim that it was not involved in such an accident. Yet, the blame game and mud-slinging continues unabated. There is no history of these breaches being plugged before March of the following year. As far as the flood victims are con-cerned, they bear the brunt of the disas-ter, irrespective of which party is in government. It is also a fact that the breaching of the embankments will con-tinue in future in full view of the political parties, the water resources department, police, and the administration. Given the magnitude of the disaster, in all probabil-ity the flood victims will be left to fend for themselves. All these debates notwithstanding, the need now is to reach help to the flood victims in all possible ways and provide them support until the next kharif crop season. [Map 1 has been reproduced from the article ‘Gerrymandering, Poverty and Flooding: A Perennial Story of Flooding’ by J Albert Rorabacher,EPW, February 16, 2008.]
0 0 0 0 0 0.00 4.00 8.00 12.00 16.00 20.00 0 0 0 0 0 0 Rate of inflation
COMMENTARYEconomic & Political Weekly EPW september 6, 200815not capture many such things. But it will be really worthwhile if some serious work is initiated in tracking the relationship between inflation and GDP growth.As hinted earlier, excessive liquidity growth coupled with rising world prices are plausible factors fuelling the current infla-tionary trends. The RBI has been adopting a method of raising the CRR and repo rates, thus eventually raising market interest rates from time to time. Given an ineffective steri-lisation process, this is the strategy one would naturally recommend, though I would believe we could have been more aggres-sive on this front and the interest rate should have been raised earlier. The issue of whether the rising interest rate will hurt GDP growth seems to have been resolved by the business and media. It is now left to the people working in the academic and policy spheres to appreciate their wisdom.A fundamental question in this context is what really causesGDP growth in India. If one can identify such a set offactors, then the next question will be how changes in real interest rates affect such factors. Several contributions such as by KhasnobisandBari(2003), Subramanian (2008), Marjit and Das (2008), Nagaraj (2008), etc, have dealt with similar issues. It is mostly a rise in “productivity” of some sort that drives our growth. The overall rate of investment, i e, the aggre-gate investment/GDP ratio was moderate even two to three years ago notwithstand-ing the fact that suddenly there has been a huge upsurge, thanks to a phenomenal rise in private investment. But one must remember that our high growth phase did coincide substantially with a fairly moderate rate of aggregate investment. Simply speaking, the rate of physical capital accumulation has not been substantial if we take an average of the last10 years. It will be somewhere around 25 per cent ofGDP. The next issue is whether real interest rates affect long-term investments. There have been many studies, including a firm level study con-ducted at the Centre for Studies in Social Sciences, Calcutta, some years ago on behalf of theIDBI, which show that real interest rates do not explain private invest-ment. There are many other factors such as expectations about future demand and infrastructure which are far more impor-tant. Thus physical capital accumulation does not explain our growth process and physical capital accumulation is not very much influenced by the real interest rate.Table 2 demonstrates the absence of a significant correlation between real interest rate and GDP growth rate. Again this correlation might be an outcome of combi-nation of systematic and idiosyncratic shocks, etc. But prima facie there is no evidence that the growth rate will be drastically altered with an increasing real interest rate. Now we come to the most shocking rev-elation and refutation of popular wisdom. Table 2: Pre-and Post-Reform Rate of Growth of GDP and Lending Rate Year Lending Inflation Rate Real Lending Growth Rate Based on Rate Based Rate of WPI (AC) on WPI GDPPre-liberalisation 1980-81 16.518.24 -1.74 7.21981-82 16.59.337.176.01982-83 16.54.9011.60 3.11983-84 16.57.538.977.71984-85 16.56.4710.034.31985-86 16.54.4112.094.51986-87 16.55.8210.684.31987-88 16.57.469.0410.51989-90 16.57.469.046.71990-91 16.510.26 6.245.6Post-liberalisation 1991-92 17.88 13.74 4.141.31992-93 18.92 10.06 8.865.11993-94 16.25 8.357.905.91994-95 14.75 12.60 2.157.31995-96 15.467.997.477.31996-97 15.96 4.61 11.35 7.81997-98 13.83 4.409.434.81998-99 13.545.957.596.51999-2000 12.543.27 9.276.12000-01 12.29 12.083.608.485.82002-03 11.92 3.418.514.02003-04 11.46 5.466.008.52004-05 10.92 6.484.446.92005-06 10.75 4.386.378.82006-07 12.25 5.426.83 9.72007-08 12.75 2.869.899.62008 12.75*10.94*1.818.1*Source:Handbook of Statistics on Indian Economy, RBI Bulletin, and EPW Current Statistics.*Source of the data for lending rate in RBI Bulletin; June volume, and prime lending rate is the average value for the months of February, March, and April 2008.*Source of the data on inflation rate for 2008 is EPW, Current Statistics; volume: June 28-July 4, and value of WPI is for the month of June 2008.*Source of the data for the growth rate of GDP is RBI Publications, Survey of Professional Forecasters – Results of Third Round relating to Fourth Quarter ended March 2008, and it is a forecasted value for the year 2008-09.Correlation Table 2 Growth Rate of GDP Pre-ReformPost-ReformAllYears (1980-2005)Real lending rate based on WPI -0.352 0.041 -0.169 Change of Growth Rate of GDPChange of real lending rate based on WPI -0.258 0.3007 0.437Call for Conference Papers...The Character and Trajectory of the Indian Economic Formation in an Era of Globalisation 26- 28th November 2008University of Delhi, IndiaContact: indian.formation@gmail.comWeb:, this conference relates to two preceding theoretical attempts within social science to understand the specificity and dynamics of economic formations: viz. the European transition debate, and the Indian ‘mode of production’ debate. The aim of this conference is to facilitate discussion and clarification of the quantitative and qualitative aspects of the trajectories discernible in the Indian economic formation. The focus is not to characterise processes in any one sector alone. On the contrary, this conference seeks to unravel the changing interrelationships of various sectors of production and circulation, as well as the linkages that exist with metropolitan capital. In this regard, the actions and reactions of the Indian state in reproducing a totality must analytically be held as of considerable import.The opening keynote will be given by eminent University of Delhi historian Professor K.M. Shrimali. This conference has been initiated mostly by Indian scholars. However, the participation of researchers of economic formations in the wider South Asian context is very much anticipated and sought. Indeed, the conference expects much discussion of inter-regional and inter-national economic connections.All interested scholars should submit their work address, a provisional paper title and a one page abstract to the organising committee at deadline for abstract submissions is 15th September 2008.A conference registration fee of 150 USD applies to delegates employed or sponsored by institutions/agencies outside of South Asia. The registration fee (towards accommodation, food, etc,) for scholars from South Asia outside Delhi is Rs. 500/- and for the student scholars the fee is Rs. 100/-. On behalf of the conference organising committee:Kumar Sanjay Singh, Rakesh Ranjan, Arjumand Ara, G N Saibaba and other teachers of the University of Delhi, Rona Wilson, Ph.D. scholar, JNU, New Delhi and Simon Chilvers, Ph.D. scholar, Faculty of Graduate Studies, York University, Canada.The conference is endorsed by Journal of Peasant Studies, Capital & Class, Conference of Socialist Economists, and Human Geography.
COMMENTARYseptember 6, 2008 EPW Economic & Political Weekly16Global Financial Crisis: A Long Way from RecoveryIgnatius ChithelenWhile there are optimists who expect a revival in the economic downturn in the United States, a downturn which has had a negative impact on the emerging markets, the pessimists counter that there will soon be more financial turmoil as the housing crisis, credit contraction and losses worsen. With the balance heavily tilted towards the bearish case, this article argues that most economies and financial markets around the world are likely to be flat or down over the next few years.The global financial crisis, the worst since the depression of the 1930s, is unlikely to end soon. Since it began in mid-2007, the United States (US) econ-omy has had tepid growth. Some econo-mists say the US is currently in a recession, together with Japan and the European Union (EU). In fact, the Japanese economy shrank at an annualised rate of 2.4 per cent in the April to June quarter, while that in theEU fell by 0.2 per cent. The downturn in the developed countries has had an impact on other countries: growth in most emerging economies has slowed considerably. On the financial side, bank credit growth in the US contracted at an annualised 5.8 per cent rate in the April to June quarter, the largest drop since such data were first collected in 1947. This credit tightening has spread from the US, dampening eco-nomic activity at all levels and around the world. At one end, even solvent, high income Americans find it difficult to qualify for loans to buy a home. At the other end, several major projects in developing coun-tries have halted due to lack of equity and debt capital, including plans in India to add 90,000 MW of power capacity by 2012. Equity indexes in the developed countries are in a bear market, with declines of over 20 per cent. The losses are far mere severe in emerging stock markets, notably in the major ones of China and India.Housing CrisisSince the crisis was triggered by collaps-ing home prices in the US, it is likely to come to an end only after prices reach a bottom. Stable home prices “will clarify the level of equity in homes, the ultimate collateral support for much of the finan-cial world’s mortgage backed securities”, says formerUS Federal Reserve Bank (Fed) chairman Alan Greenspan [Green-span 2008]. Over $ 6 trillion of such secu-rities were created by Wall Street firms, by packaging individual home loans made in the US.1 Already some $ 500 billion in losses on these securities have been recog-nised by financial and other institutions around the world. But it is the fear of the size of the unrecognised losses, and its impact, that is crippling financial markets. President George Bush initially said that his government had no responsibility to bail out home owners, especially housing speculators. But, under pressure from Republican congressmen worried about losing their seats in the upcoming Novem-ber elections, the Bush administration has taken some measures. In July the govern-ment said it is explicitly backing the debts of Fannie Mae and Freddie Mac (the largest US housing finance companies), thereby ensuring adequate and cheap funding for these institutions, which together provide financing for 80 per cent of loans being cur-rently made to home buyers; most of the other 20 per cent is financed by the Federal Figure 1 (p 14) plots the rate of inflation against the real lending rate, ie, the real prime lending rate between 1980 and 2008. It depicts a clear negative relationship. As the rate of inflation goes up, whatever be the response of RBI policies and private sector strategies, eventually real lending rate actually goes down! It is well known that rising inflation, ceteris paribus, is a boon to borrowers; in real terms they have to pay back less than the initially contracted amount. If lending was inflation indexed, the real lending rate should remain the same before and after inflation. If the nomi-nal rate adjusts less than the inflation rate, the borrowers must gain and that has hap-pened in all the years. Whenever the rate of inflation increased, the borrowers mainly the business groups always retained some advantage from higher inflation.The problem is that the mythical story of a rise in interest eating into incentives to invest and hence paralysing growth, rotates around economic arguments developed in the pre-historic age of the discipline of Economics. For reasons obvious to many, much wisdom is dug out of its grave by the captains of modern day finance and technology experts for pressurising the government and creating policy paranoia of some sort. This also calls for a method of corporate accounting which must look into the “real” side of the problem. ReferencesBasudeb, Guha-Khasnobis and Faisal Bari (2003): ‘Sources of Growth in South Asian Countries’ in Isher Judge Ahluwalia and John Williamson (eds), The South Asian Experience with Growth, Oxford University Press, New Delhi.Marjit, S and K P Das (2008): ‘Financial Sector Reform for Stimulating Investment and Economic Growth: The Indian Experience’,ADB Volume, Oxford University Press, New Delhi (forthcoming).Nagaraj, R (2008): ‘India’s Recent Economic Growth’, Economic & Political Weekly, 43 (15).Subramanian, A (2008):India’s Turn: Understanding the Economic Transformation, Oxford University Press, New Delhi.Ignatius Chithelen ( is with Banyan Tree Capital Management, New York.

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