First, let’s remember why manufacturing sector growth is important: it’s the only real way to move people out of agriculture, as so many want to; and India’s overall growth has been diminished and unequal thanks to the sector’s stunting. Now, let’s look at the latest figures, for June 2012, on industrial growth: the manufacturing sector that month was 3.2 per cent smaller than it had been in June 2011. This isn’t a “slowdown”, such as overall GDP is facing. This is an existential crisis. An economy with a supposed trend growth of something between six and nine per cent can’t have a manufacturing sector that doesn’t grow.
The obvious cause for this, of course, is policy paralysis, or administrative paralysis, or executive incompetence, or whatever they’re calling the UPA’s inaction today. Though if we look at the actual numbers, what appears to be most inhibiting Indian companies’ ability to invest and expand are shrinking profit margins. According to a Business Standard Research Bureau sampling of 1,500 companies that will appear in this newspaper on Monday, net profit margins have fallen from close to 10 per cent in the quarter ended March 2011 to four per cent in the quarter ended June 2012. In most sectors, this is driven by a sharp increase in interest costs, by over 30 per cent. In other words, it is the cost of borrowing that is primarily responsible.
Yet, for some reason, however, you can loudly criticise those mucking up our fiscal policy, but that part of the government that makes our monetary policy is largely insulated from such criticism. The Reserve Bank of India’s (RBI’s) air of technocratic and academic competence means that we may discreetly disagree with its actions, but we cannot really call it to account.
The free pass that we’re giving the RBI is a mistake. The “independence” of the central bank is a cherished property, but it means independence from executive interference. It does not mean a lack of accountability. In the absence of accountability, the same errors will build up at the RBI as anywhere else: errors born of a closed mind, and a sense that you know best. Such errors are dangerous anywhere, but they are particularly unacceptable in an agency that makes macroeconomic policy — because, in spite of what you’ve been told, macroeconomics is a very incomplete subject. Compared to other branches of the discipline – econometrics, say, or microeconomics – macroeconomics too often consists of a certain amount of voodoo mumbling followed by the bellowing of a pre-prepared conclusion.
This is most obvious in the question of what, exactly, the RBI’s aim is. It will act to control price inflation as well as to support growth, we are assured. (These same authorities are silent on what happens when it can do neither.) Which target takes precedence, of course, is not even discussed — we don’t need to, as there is no question that inflation comes first, as “monetary stability” is exclusively identified with “price level stability”. This is not necessarily true — but more on that later.
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Let us ask, then, what theories drive the RBI to monitor inflation so closely even as growth collapses by four per cent over four quarters, and an entire sector strangles itself. Well, the broad idea is that sustained long-term inflation is bad for growth, that it muddies price signals, and that it is redistributive. These, particularly the first, are born of theories motivated by advanced economies, and through cross-country regressions. Essentially, what that means is that, on average, we seem to see that long-term inflation is weakly associated with lower growth; and that we can explain why that is so for a few more advanced economies. That doesn’t stand up to tough questions — such as what happened in South Korea, where the manufacturing sector, and the economy, grew explosively in real terms for decades even as prices rose at inflation rates twice what India endures now. The simple truth is that nobody understands the links between high (but not hyper-) inflation and growth in a developing economy with tons of structural rigidities. Yet the RBI claims to know what’s going on, persisting with the myth that it can control inflation.
Finally, there’s the fear that price rises destabilise price signals. This is actually remarkably unsupported by theory, which actually suggests that controlling price rises is problematic. In particular, if you try to target the inflation of a price index as underlying costs change, you wind up gravely distorting relative prices — and the distortions are greater when costs change more, and the price index is worse designed.
Which take us to the final point: what index is the RBI targeting? (All of them, in India, are badly designed.) When core inflation outpaced the consumer price index, it claimed to be targeting the first. Now, when the situation is reversed, it claims the opposite. Inconsistency is a monetary authority’s greatest sin. Of course, if the RBI starts looking at headline inflation, then it is bowing to public outcry, not academic detachment. The most coherent and current model is the decade-old synthesis written out by Goodfriend and King; that suggested a second-best approach for a central bank was to target an index of core, sticky prices — weighted, ideally, by their degree of stickiness. In any such index for India, current inflation would be manageable, and far from volatile. Goodfriend and King’s first-best approach? Stabilise the mark-up available to companies, to avoid spiralling inflation. This is, of course, the exact opposite of what the RBI is doing.
If those are too difficult, surely the RBI should at least look at the GDP deflator? But that, by most calculations, has dipped from 10 per cent a year ago to close to five per cent today, so a central bank that wants to play Super-Pricebuster will want to ignore it as well. As it will ignore surveys that deny any build-up of future expectations that would fuel future inflation. As it will ignore the fact that food inflation has always been this high in India, and you’ll never change people’s expectations about it. As it will ignore the fact that wage-price spirals depend on the effect of slabs in income taxes — which almost nobody pays in India.
The simple truth is that we need much more work on the micro-foundations of the Indian macroeconomy before we can answer any questions about inflation for certain. For someone groping in the dark, the RBI is far too sure of itself. Remember: “independent” should not mean “unaccountable”.