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Will raising rates solve inflation, or do we need governance reforms?

Illusions & Delusions
Last Updated 13 August 2022, 19:06 IST

Inflation dominates discussions these days. The Russia-Ukraine war and the US sanctions on Russian exports have disrupted global supply chains. Supply disruptions and global shortages are being experienced in a variety of commodities – from oil/gas to semiconductor chips to wheat and food items. The US-China trade war and China’s ‘Zero Covid’ policy are further aggravating shortages. The sharp price increases across the globe is the result. Central banks in the US, UK and EU have reacted by sharply raising interest rates. The RBI has followed suit. Three increases, in as many months, aggregating 1.4% have so far occurred on a starting base of 4%. More increases are in the offing, as per the RBI Governor’s remarks. In effect, a globally coordinated policy response to the spectre of global inflation seems to be in place.

Although raising interest rates to control inflation is well-supported by traditional economic theory, it is doubtful if it will resolve inflation in India. Recall that a similarly well-coordinated policy response to the Global Financial Crisis of 2008 had created a number of subsequent problems for India. The crisis had been caused by the US sub-prime crisis and the consequent collapse of Lehman Brothers in September 2008. The US Fed and the central banks of the UK and EU had slashed policy rates to restore growth dynamics. It had worked there. However, in India, though RBI had similarly slashed repo rates from 7.75% to 5%, in less than two years it was forced to raise rates, all the way to 8.5% in the face of heightened inflation. We need to understand why this happened.

Indian inflation is not new. Its existence can be linked to centralisation of expenditure, uneven urbanisation and allied infrastructure availability that came with central planning, adopted soon after Independence. Inflation waxes and wanes periodically but usually remains on the higher side. The main losers from this are the poor and the private sector salaried, fixed-income citizenry as the purchasing power of their rupees keeps going down. Businesses and government employees are better insulated, often even benefitting in a benign inflationary environment. The RBI has thus been mandated not to eliminate inflation but to keep it in the 4-6% band, so as to minimise its adverse impacts.

Retail price inflation had crossed the 6% red line as early as June 2021, dipped marginally in July and continued to play ‘peek-a-boo’ with the red line, till Russia’s war set it off. On the other hand, the US, UK and EU were, till recently, low inflation zones. The US and UK had undergone drastic decentralisation with the reforms of Ronald Reagan and Margaret Thatcher in the 1980s in a reaction to the twin challenges of high inflation and low growth that they were facing. Decentralised decision-making, combined with widespread, evenly high-quality infrastructure, and the consequent productivity gains of WTO-led globalisation, had resulted in a period of low to near-zero inflation during the last three decades. Accordingly, low interest rates had prevailed.

India, on the other hand, has very uneven urbanisation. Though the official urban density is around 35%, World Bank estimates, based on satellite night light data, suggest a figure closer to 60% -- the gap is termed as “India’s messy urbanisation” -- the unacknowledged slum clusters that dot our otherwise pampered metro cities. In the hinterland, infrastructure availability is uneven, resulting in the non-availability of public services, post-harvest crop losses, and elongated supply lines. Thus, policies that work well in the US and EU may not yield similar results in India.

We need to ask ourselves why there are still such sharp differences in the Indian ground reality despite over seven decades of strenuous developmental effort. The answer lies in the developmental model that we adopted soon after Independence. Then, the Soviet sun had been shining bright and its centralised mode of governance was highly admired. We had, as did most newly independent countries, imitated that model. It is capable of producing remarkable results in the short term. However, it does not have long-term sustainability because centralised decision-making creates geographical cronyism and complex bureaucracies that are inherently unstable. The Soviet Union collapsed in 1991 due to the internal contradictions it developed.

China, under Mao, had initially followed the Soviet model and had a troubled trajectory. However, it changed course under Deng Xiaoping. He decentralised its economic administration and empowered its cities with simple and transparent rules of governance, creating the ‘Chinese Miracle’, though the current strong-arm management style of Xi Jinping seems to be diluting that story nowadays.

What then should be the Indian way forward? Perhaps taking a leaf out of the reform books of Thatcher and Reagan may resolve our problems. After all, both were right-wing conservatives trying to battle inflation while reviving growth in their countries. They succeeded, so why won’t we?

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(Published 13 August 2022, 18:42 IST)

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