Chasing a mirage

RBI chief Raghuram Rajan’s reasoning has so many flaws that one does not know where to start pointing these out.

After pushing up interest rates yet again by another quarter percent our flamboyant governor of the Reserve Bank, Raghuram Rajan said, “We are vigilant owls, not hawks or doves.” Owls he pointed out were wise. The RBI he said was doing what was necessary for the economy. This was to control inflation. When asked whether the hike would not further impair economic growth, he said, “The juxtaposition of growth and inflation is not correct ... Higher levels of inflation cut into household budgets and constrict the purchasing power of individuals. This discourages investment and weakens growth. Therefore inflation has to be brought down first, in order to create the environment for growth”. 

Rajan’s reasoning has so many flaws that one does not know where to start pointing these out. Inflation does constrict consumption as he claims, but only if the consumers’ money income remains unchanged. Rajan therefore starts by assuming that purchasing power in the economy will remain static. This means that he starts by assuming that there will be no growth in the economy. Since high interest rates reduce consumer spending on durables and Capital expenditure, they inevitably slow down growth.

 Raising interest rates to curb inflation therefore automatically ensures that consumers’ money incomes will remain unchanged. This turns Rajan’s policy into a self fulfilling prophecy.

The truth is that it is the RBI’s policy since March 2010 of ‘targeting inflation’ without regard for growth that has created the conditions that are ‘constricting the purchasing power of individuals’. That is why industrial growth has turned negative in the past seven months after having been nearly static during the previous two years. 

The most Rajan should have claimed was that price stability creates a better environment for sustained industrial growth and that he was prepared to sacrifice short term but unsustainable growth for long term, sustainable growth. But to be valid, this argument needed to show that high interest rates were indeed curbing inflation. But data for the last seven, and not just four years show that raising interest rates has had absolutely zero effect on prices. 

But just suppose, for the moment that he might prove right this time – that conditions now exist in which high interest rates can indeed bring down consumer cost of living. Then why has Manmohan Singh set up the 7th pay commission exactly one week after Rajan tightened the reinson credit? For another pay commission means another Rs 100,000 crore added to the centre’s non-development expenditure and another huge surge of purchasing power in the economy two years hence. Therefore, if Rajan’s reasoning is right, to another jump in consumer price inflation. 

Adverse shock

The havoc that former pay commissions have wreaked on the Indian economy has been documented over and over again. The fifth Pay commission increased the combined Central and state government expenditures between 1997 and 2,000 by 80 per cent to the then colossal sum of Rs1,33,381 crore. This wrecked the finances of the state governments and brought all maintenance expenditure, on roads power transmission lines, dams and canals to a grinding halt. The World  Bank called this the single most adverse shock to the Indian economy. 

When the Left front, then a UPA partner, raised the demand for a sixth pay commission in 2004 Manmohan Singh set up a committee under the cabinet secretary to study it. The committee turned down the proposal stating that the Centre might not be able to bear the additional burden. The 12th  finance commission went a step further and recommended that the government should stop appointing Pay commissions every ten years. 

Inspite of this Manmohan Singh succumbed to the pressure of the Left ( and populists in his own party , and appointed the 6th consolidated fiscal deficit of one percent over the 1.5 percent caused by the fifth Pay commission. This time, undaunted by the huge fiscal deficit and the faltering of revenue growth because of industrial stagnation, Dr Singh has announced another Pay commission, and he has not waited even 10 years to do so! It does not take a genius to figure out why. The Congress is in a panic: every opinion poll taken so far, not to mention its disastrous showing in the December state elections, shows that it is on its way out. The more optimistic predictions suggest that it will win around a hundred seats. The setting up of yet another Pay Commission only seven and a half years after the last one is its desperate bid to woo the votes of its 80 lakh central government and public sector employees. It has done so now because in about six weeks the election code will come into operation and the time for handing out candy to the voters at the taxpayers’ expense will run out. 

This raises an important question: does the left hand of government know what the right is doing? Did Rajan know when he raised interest rates last week that the government was going to announce a measure that would shortly put another 1.5 per cent of GDP worth of purchasing power into the hands of its central and state employees barely two years hence. And if he did know then how, last week, could he claim with a straight face that he was raising interest rates to control inflation? 

Now that Rajan knows, and since he will still be around what will he do when the Pay commission releases another flood of money into the economy? Will he ratchet up the interest rates again and again to control “inflationary expectations?” The plain truth is that while Rajan may consider himself to be an owl, Manmohan Singh has turned him into a jackass. 

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