Do we have to live with inflation?

One issue that has been bothering people most in recent times is the persisting inflation over the past several months. We hear that inflation in India was 7.5% in the month of May. But inflation in the Indian economy is a much more longer-term phenomenon. We will be surprised to hear that historically Indian inflation rate averaged 8% from 1969 to 2012, for more than 40 years! The most common measure used to calculate inflation is the rise in Consumer Price Index.

The Prime Minister, the Finance Minister, the RBI Governor have all been vociferously arguing that they are taking all possible measures to curb inflation. They have been telling us that we have to learn to live with inflation since it is a global phenomenon caused by factors beyond the control of the Indian government. Is this true? Are we destined to live with 8% inflation for another 40 years and helplessly watch our incomes and standard of living being eroded?

Inflation generally manifests itself in a rise in prices of commodities. One would expect that with advances in technology, the socially necessary labour time to produce a commodity would decrease, thus lowering the value and hence the price of a commodity. But what we have been witnessing is the opposite.

Prices can rise due to other reasons as well. The boom and bust cycles which are inevitable in a capitalist economy can cause a temporary increase or decrease in prices. The Indian economy has been going through this boom and bust cycles. But one would expect prices to fluctuate around an average level and not continuously increase as is happening in the Indian economy.

When a few monopolies control the production of a commodity, prices can be held much above their value. But this applies only to such commodities under monopoly control and not to all commodities being traded in an economy. On the other hand government subsidies for certain commodities can keep the price lower than their value. But this again applies to only those commodities. So, all the above factors explain why prices of certain commodities go up and down but they do not explain why there has been a general rise in prices of commodities over a period of time. 
To understand the phenomenon of inflation we have to go back in time a bit. Gold was used as the standard money commodity by governments in the past. Given the level of production and trade in the given economy, the amount of gold needed as money could be estimated. This amount of gold was determined by the sum of prices of commodities purchased and sold in the economy and the velocity of circulation of money -- economic factors which are independent of the will of governments. The calculation of money required is more complex but the simple picture given here helps to understand the issue. In later times, governments replaced gold in circulation by paper money (inconvertible notes which cannot be exchanged for gold at an official rate) and metallic tokens such as rupees and coins we use today. But, the value of these tokens would also be determined by the level of production and trade in a given economy. This is true of the Indian economy also. Given the level of production and trade in the Indian economy, we need a certain amount of currency in circulation. But if the government issues more currency than required for the same level of production and trade in the economy, if it issues rupee tokens with a higher face-value than the needed amount of gold expressed in rupees, then the value of the currency will fall.  The increased face value of rupees in circulation will now represent the same quantity of gold that is needed for the particular level of the economy. A higher amount of rupees will be required to buy and sell the same amount of commodities. This general rise in prices, is inflation.

Why is the Indian government allowing more paper currency to circulate than required for the current level of the economy? Government expenditure is financed first of all by taxation, then by borrowing and finally, by issuing more inconvertible notes. In India, for many years, the expenditure has always exceeded receipts. The main reason for this is the huge amount of unproductive expenditures in defence, interest on loans to Indian and foreign financiers, and unrealized revenues such as tax waivers, handouts and subsidies to big business houses. To meet these huge unproductive expenditures and foregone revenues the government resorts to borrowing.

A major form of borrowing to finance the deficit is the sale of government bonds and interest-bearing Treasury Bills to discount houses. These Treasury Bills are repayable after a very short period, normally three months; they play a key role in the over-issue of inconvertible paper money in India. Discount houses borrow money from commercial banks to buy these treasury bills and make money by selling them later at a higher interest rate. Commercial banks lend money from the deposits they collect from the public. They use this money to lend to discount houses for a profit as well as buy government bonds to finance the excess of government expenditure over revenue. When the borrowing requirement of the government keeps increasing, then the banks and discount houses call upon the Reserve Bank of India to provide them money from its reserves. The RBI, which has the sole monopoly over printing currency notes, increases the supply of currency whenever the situation demands. The net effect is to increase the amount of currency in circulation without a corresponding increase in production and trade in the economy.

The RBI governor claims that he is taking steps to control inflation and prices through an increase of the cash reserve ratio (CRR) and the prime lending rate (PLR).  This is nothing but a tightening of credit availability and slight moderation in the growth of cash available for transactions.  However, such minor tightening of money supply is more than offset by the ever-increasing amounts of unproductive expenditures of the government, such as on “defence”, the annual drain on account of servicing the public debt, and the revenue foregone due to tax breaks offered to private corporations.
Production of goods and services for domestic use is slowing down more severely than the growth in money supply.  Hence it is not safe to believe the RBI’s claim that the measures it is taking will curb inflation.  It has not succeeded in recent years.  There is no reason to believe that its track record will be any better in the coming months.  

The root of the problem lies in the very orientation of the economy and government policy, whose solution needs a more radical change in our political and economic systems.  It is not a matter that can be fixed merely by tinkering with the CRR and the PLR.  As long as the need for reorientation through systemic change is not addressed, it is tragic but true that we will be saddled with this permanent disease called inflation.


Posted In: Economy    RBI    consumer price index. standard money commodity    paper money    fiscal policy    CRR    PLR