The inability to admit that they made a mistake is a hallmark of small men in big positions. Dr Y V Reddy, the governor of the Reserve Bank fits the bill. Obsessed with preventing inflation from exceeding five per cent, he began to restrict the supply of money in october 2006 by raising first a variety of ancillary interest rates. In January 2007, he redoubled his efforts and through a succession of increases in the Cash Reserve Ratio (CRR) between then and July, sucked more than Rs 50,000 crore out of the credit base of the economy.

These have set off a chain reaction of destabilising changes in the Indian economy. But instead of acknowledging his mistake and correcting it, Reddy is scurrying around ever more frantically putting out the bush fires caused by his actions, while the mistral he conjured up continues to blow.

Isnt the economy still growing at nine per cent ? And hasn’t inflation halved? If I wore blinkers, like a horse, and looked only at the domestic economy, I might be tempted to agree. The inflation rate has come down from over 6 per cent in December to 3 per cent in October, the banks are awash in lendable funds, and several of them have lowered their mortgage rates for loans to home owners. August’s industrial growth recovered to 10.3 per cent from the dip to 7.1 in July. So the overheating is over and the economy has returned to the monetarists’ nirvana of inflationless growth.

But the picture changes the moment we take off the blinkers and the external economy comes into view. The rise in interest rates began to attract short term capital to India. This pushed up the exchange rate for the rupee. So the investors found themselves gaining even more and brought still more money into India. This money began to flood the banks with fresh deposits at precisely the time when higher interest rates had led to a very sharp contraction in the demand for non-food credit. In desperation the Reserve Bank, began to buy up huge sums of foreign exchange to prevent an even sharper appreciation of the rupee. But that only worsened the plight of the commercial banks, for the money had to be deposited somewhere.

This was the lesser of the bush fires that Mr Reddy had started. The appreciation of the rupee slowed the growth of exports, but more importantly, it caused a jump in imports that doubled the trade deficit for the first five months of the new fiscal year. In textiles, exporters stopped receiving orders.

So then came the first attempt to put out a bush fire. Big Indian investors had reacted to the two per cent increase in prime lending rate caused by the January and April hikes in the CRR by borrowing abroad, not to meet the foreign exchange requirements of their projects but to replace rupee borrowing at home.

Reddy could not control the behaviour of the foreign investors, but he could control that of Indian firms. So in August he announced a cut off in external commercial borrowing to meet non-capital expenditure. Down plunged the share prices and up went the dollar. Exporters heaved a sigh of relief.
But the relief was temporary. The appreciation of the rupee had caught the eye of foreign portfolio investors. After the subprime lending crisis in the US many began to look for alternate homes for their capital. India’s well regulated stock market and its rising rupee inevitably caught their eye. So then began the space rocket lift-off of the Indian stock market.

In the month of October alone $ 8 billion of FII flowed into the stock markets, pushing the Sensex up to nearly 20,000 in three weeks. The government knew that this was “hot” money, hunting for a quick profit. Analysts began to talk of a correction of  2,000 points in the near future. Were this to happen a lot of investors, mainly small, first time, investors who did not understand the market would be the main victims. This led the government to make its second attempt to put out the bush fire.

In October it made noises that it intended putting curbs on foreign investment in the share market. Down went the Densex by more than 800 points, but the foreign capital came back strongly and pushed the index up above 19,000 yet again.

But is everything hunky dory at least in the domestic economy ? Far from it. A closer look shows that the seeming stability hides an economy that is sinking gently into a recession, like a souffle left too long on the table after it has been cooked.

The August IIP was boosted by good results in electricity and mining. At 9.8 per cent in August, manufacturing growth remained below last year’s level for the third straight month.

Even the decline in inflation rate is not Mr Reddy’s doing. Anyone who can read weekly or monthly index numbers of prices could have seen that by October this year the five per cent inflation rate would drop on its own to three per cent or less. This was because the entire bulge in 2006-07 had been caused by freakish weather and a poor monsoon in the summer of 2006, which had pushed up the price of primary products very sharply. This was a seasonal effect that would disappear on its own.

In sum, to fight an inflation caused by factors he could not control, and which was self-limiting, in any case, Mr Reddy hit India's first industrial boom in 13 years on the head with a club. To deal with the skull fracture that resulted he offered aspirin, and seeing that the victim has not regained his balance, is waiting with more capsules of aspirin in his hands. He is not willing to acknowledge the fracture so he has to keep insisting that the patient has recovered.