Wednesday, August 08, 2012

The macroeconomics and public finance of inflation in India - 5

(This is the final in a 5-part series that was earlier planned as one long post. If you haven't, you should read the earlier posts first. This tries to bring it all together.)

It's worthwhile to do a quick re-cap of the main stylized concepts that I have argued for earlier, before we try to tie them all up together.

1) A fiscal deficit does not directly lead to inflation. It has to be monetized or something wonky has to happen in the government bond markets.

2) To the extent that India has a fiscal deficit, the interest payments (though numerically smaller than the expenditure outlays) are what's driving the deficit at the margin. Interest payments look sustainable at current interest rates and growth rates. The Indian state is playing a commercially viable financial intermediary, creating a pool of assets at various maturities that services the savings demand of our households.

3) To the extent that India has a primary deficit that casts questions on sustainability of government finances, it results from being under-taxed, not over-spent.

4) Flagship spending schemes have a plethora of public-choice issues, but the pure macroeconomics behind them is quite simple and uncontroversial. The effects on inflation, if any, are best analysed through the lens of an AS/ Philips curve.

5) 1 and 4 imply that to have any shot at understanding inflation, it is imperative to look at the central bank's monetary regime, and its own evaluation of aggregate supply.

RBI's monetary regime

RBI officially tries to maintain inflation around 4% in the medium term, while maintaining growth prospects and allows the currency to float as per the market, while trying to reduce volatility in currency price. It's an admirable, if somewhat convoluted, set of macroeconomic stability goals. But the actual performance of the Indian inflation seems to fly in the face of what its central bank is trying to do. We have consistently overshot 4% and not just in the last couple of years. Atleast since 2005, inflation has been more than 6%. Yet, the RBI seems to have a relatively credible inflation-fighting stance, with most of its criticisms being directed at currency interventions or micro-management.

But even more surprising than the credibility is the fact that RBI itself seems to be wary of monetary tightening to actually try and achieve its goal to make inflation 4%. Ostensibly, this would not do much for inflation, but kill growth. Which is to say, RBI believes that the AS curve is horizontal on the downside. At the same time, it seems wary of monetary easing to actually try to boost growth, because this would only create inflation, not boost growth. Which is to say, RBI believes that the AS curve is vertical on the upside! This is RBI in its own conception, operating between a rock and a hard place, operating at that miraculous inflection point on the AS curve where it turns from being near-horizontal to near-vertical.

If you don't buy this story as it stands, that's because you shouldn't. One can indeed land at such a jarring discontinuity in the AS curve, but it has to be a matter of sheer fluke, rather than a series of fiscal failures that gradually led to the discontinuity. And if the central bank manages to optimize within this shoddy hand that the government has dealt it with, that will also be a matter of fluke, not effective monetary policy. One should expect to see either accelerating inflation, or growth in a downwards spiral with stable prices/inflation. Not both at the same time.

But what if RBI was, through design or default, optimizing something completely different. Not growth nor inflation, separately. A combination of the two, taken together, treated inseparably. What if it was targeting nominal income growth - that simple idea which has taken the popular macro/monetary discourse in the developed world by a storm.

The evidence would certainly suggest so. Nominal GDP at factor cost (GDP at market prices net of the indirect taxes and transfers of the government) has grown at a remarkably consistent rate in India. Over the past 6 years, the average growth has been 16% per annum, with a standard deviation of 1% (both logarithmic - all data calculated from national income accounts available with MOSPI). It's the nominal aggregate in India with the lowest coefficient of variation (mean divided by standard deviation). As far as macro-stabilization goes, this is what is being stabilized. Not the price level, whether measured through consumer prices or the GDP deflator. Not nominal GDP at market prices. Not real GDP. Nominal GDP, at factor cost.

Has the RBI been living a Sumnerian dream - stabilizing aggregate demand (net of fiscal stabilizers) and letting the supply side play itself out?  If yes, how? It could be by design - Subba Rao always strikes me as a remarkably well-clued man, but that's not enough. It could be by default, trying to stabilize some other key metric (like credit growth) and ending up stabilizing the nominal gross domestic income because of certain stable relationships in the Indian economy that haven't broken down as yet. I don't really know, but the implications are interesting.

For one, all inflation is stagflation. Or, more correctly, any increase in inflation will necessarily be seen as a decrease in growth. Just like the twin deficits, this is not a double whammy, but two sides of the same economic fact resulting from the central bank's monetary policy reaction function. Secondly, there are no inflation expectations driven independently by the central bank, but whatever we see is a result of the interplay between the private sector and the government. It's not the AS curve that has the strange kink, it is the AD curve.

This story flies in the face of what the RBI claims to do, but it explains the stylized facts. It is also consistent with the intuition of the standard narrative, when that intuition is suitably enhanced through the argument that expectations of inflation in India may be dependent on the fiscal stance, macro theory notwithstanding. We are so used to monetized deficits causing price rises that we continue to believe the same even though the fiscal regime in India has actually changed substantially, through design or default.

(Christopher Sims, last years's Nobel prize winner, has an explanation of how inflation expectations may be fiscal and how rate hikes by the central bank may be counter-productive in that scenario. His argument invokes the fiscal theory of the price level, which I don't quite agree with, and works through the nominal rates on government debt, which seems quite stable, so one doesn't have to take it at face value. However, just like Friedman's maxim and the sectoral financial balance approach, the Sims conception adds a dimension and mechanism in the operation of macroeconomic policy that we should keep in mind.)

With this in mind, what remains to be analysed is, if the AS curve becomes more steep, causing 'stagflation', what comes first - inflation expectations, or a supply crunch? And if there is a supply crunch, what is it?

Investment - the missing link

So what is the expectation of inflation in India? Recall the fact that 10 year g-secs trade at close to 8% yield. The current inflation is in excess of that. If the current inflation is expected to continue, savers are ok with negative real rates on their savings. In a capital deficient country like India, this seems rather absurd. If you think that this may be the result of financial suppression - of the central bank mandating banks and investors to hold a certain proportion of their assets as g-secs - consider the fact that when the SLR was recently cut from 24% to 23%, most banks were anyway sitting on 28%-29% of their assets as g-secs (plus gold).

There are two possibilities. Inflation expectations really are high, and real interest rates really are that low. If that is true, then the degree of risk aversion implied by that fact means that within the next 5 -10 years, India will see macroeconomic woes that will make our current predicament seem like a walk in the park. Then, we will know what a true stagflation is.

But if that is not the case, and real interest rates are positive, this means that the current inflation is perceived as transitory and inflation expectations in the medium term are actually tracking the RBI's target quite closely. If so, that would be a tremendous macroeconomic achievement by our central bank and fiscal authorities - we have adjusted to the new fiscal regime and RBI is able to stabilize current aggregate demand even while maintaining medium term price stability. So we should turn back our focus on the current supply bottleneck. And what could that bottleneck be.?

The most solid empirical evidence points to investment. This is especially important, because today's investment is tomorrow's capital. An investment bottleneck in the AS curve is most likely to persist from the short term to the medium term. Current inflation is most likely to be endogenized if it results from an investment shortfall. Even if we have somehow achieved macroeconomic Nirvana, an investment shortage can bring us back to our ugly past.

Note that this is not a particularly 'right-ist' view. Axel Leijonhufvud, whom I consider the foremost Keynesian, has done some excellent work exploring the micro-foundations that affect this crucial link between inflation and investment. His ain argument is that proper financial intermediation breaks down in high inflations, especially for longer term capital needs. His work focuses on monetary regimes that are substantially less stable than the RBI today and 'high inflations', for which India's 8%-10% does not really qualify. But it arguably holds even for the RBI's regime, if people are likely to go back to the old ways of thinking about our profligate government, and if our particular investment needs are especially long term.

India's and UPA's greatest failure on the fiscal front has been its utter failure to prevent the fall in investment - and indeed abetting the fall through some bone-headed moves.


So, in the end, if it all does come down to a fiscal failure, and it does come down to supply bottlenecks, and if it does come down to how inflation expectations in India may possibly be fiscal, just why have I spilt so much electronic ink? If the standard narrative is broadly true, why try to dismantle it before putting it back together again?

I think its important to come to the right conclusions, but it is also important to do so through the right analytical framework. It helps you focus your criticism, and it helps you see some successes where you may only have imagined macroeconomic failures. I hope I was able to clarify how it's investment, not government spending that we should focus our minds on. I hope I was able to demonstrate how the 10 year yield is an important variable to watch out for. And if my posts help clear the absolute clutter that one reads in the Indian print media in the name of macroeconomic and public finance analysis - stuff like negative returns on savings, twin deficits, stagflation, outcries against tax hikes - I would consider my job done.


Contemplationist said...


I attended the RBI governor's presentation @ the Asia Society in New York last night. He hardly eluded to the fact that inflation is always, and everywhere a monetary phenomenon as Milton Friedman put it. He mentioned many "inflationary pressures" like increasing government spending, supply shocks and what not.

He also defended the Directed Lending program that forces banks to use a certain percentage of their funds to invest in politically favored sectors like agriculture. He defended it by saying that 60% of the population survives on Agriculture. I wanted to ask a curt question whether this was not more accurately called off-the-books-welfare.

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