A V Rajwade: Demand, supply and the "sacrifice ratio"

WORLD MONEY

Cutting inflation is important but so is knowing just how many potential jobs are being sacrificed.

Inflation is always and everywhere a monetary phenomenon: Milton Friedman.

While global factors and rising demand had contributed to inflation in some sectors, supply constraints had contributed to a larger extent: Prime Minister Manmohan Singh in his remarks to the Economic Advisory Council earlier this month.

The key question is: who is right? The RBI and the finance minister seem to believe the former, as once again evidenced last Tuesday. Friedman's remark dates from an era when the world economy was far less globalised than it is now. But even in that era, his faithful disciples had started having doubts. To quote from Sir Geoffrey Howe's Conflict of Loyalty "" Sir Geoffrey was the first Chancellor under Thatcher and thus the chief implementer of her monetarist stance "" "We were already beginning to detect real difficulty in setting, sometimes even reading, the monetary compasses by which we were aiming to steer." He also derided the "monetary base control" being urged upon him by Swiss monetarists, and then being followed by Paul Volcker in the US. If Sir Geoffrey was skeptical of monetarism after starting as a true believer, the more recent experience is summarised in the Bank for International Settlements' last annual report: "the striking similarity across countries (in the fall in inflation) despite wide differences in monetary policy frameworks, exchange rate regimes and the configuration of other economic forces impinging on these economies, suggests that other common forces may also have played an important role. Globalisation is a natural candidate."

As monetary tightening continues in India, the other issue raised is the link between inflation and growth. Many have argued that high inflation does not lead to high growth. While this argument is unexceptionable, low inflation also does not necessarily lead to high growth. Consider the widely varying experience of the two lowest inflation, and largest, Asian economies: Japan has had very low to even negative inflation and very slow growth for a decade; China has had low inflation and high growth! The case of Japan also suggests that continued and egregious fiscal excesses and a very loose monetary policy, do not necessarily lead to inflation. The point I am making is that the relationships are tenuous and not necessarily cause and effect. What is undeniable, however, is the link between higher interest rates and investments: corporate or personal. For corporates, debt finance may not be available "" or costlier than the "hurdle rate" of return on investments. Individuals would find EMIs going up and unaffordable, reducing housing demand. Clearly, investment slowdown hurts growth and jobs, present and future.

But to come back to the current rate of inflation, its political sensitivity is obvious. At one time, the high price of onions led to the BJP's defeat in Delhi's local polls; will this also lead to the Congress's defeat in Punjab and Uttaranchal? We should know by next week. In any case, monetary policy can do little to curb the demand for food products "" few people consider interest rates while eating! In fact, the RBI itself had acknowledged this when, in May 2003, the WPI had gone up to almost 7 per cent, but monetary policy was eased! As Omkar Goswami recently argued in The Economic Times, "What can the Reserve Bank do to curb this phase of inflation? Actually, precious little without risking the prospects of choking the best ever growth of Indian economy." What is the "sacrifice ratio" of lower growth to reduce inflation? The ratio of jobs lost (or not created) associated with a 1 per cent reduction in inflation? Do we have any data or estimates? One BIS paper (The evolving inflation process: an overview by William Melick and Gabriele Galati) recently gave the "sacrifice ratio" for the US economy in the late 1980s and early 1990s as 2.5, "meaning that a differential of 2.5 percentage points between the (actual) unemployment rate and the natural unemployment rate would be associated with a 1 percentage point reduction in inflation." Since then, the ratio seems to have gone up to four, with the Federal Reserve Board macro-economic model having a sacrifice ratio of around six! Clearly, there are serious costs to curbing inflation, and we should be conscious and transparent about them. And if inflation is a heavy burden on the unemployed poor, so is slower growth resulting from higher interest rates: their prospects for jobs recede further in the future. But in a democracy, the protests of the urban middle class on onion prices inevitably carry more weight than the woes of the inarticulate and unorganised unemployed poor.

As the Prime Minister argued, the key is on the supply side. I suspect the RBI is fully conscious of this, and its main concern is credit growth. To be sure, reducing that would also involve sacrificing growth and employment.