Sudhir Mulji: On money supply

Printing money may cause a higher price rise for this generation, but will benefit the future

It was to be expected that my proposal to increase money supply in place of Montek's plan for using the accumulated foreign exchange reserves for infrastructural development would be criticised. In private two general arguments against it have been made to me.

The first is that if it were true that printing more money could engineer growth many countries would have employed so simple a contrivance.

The fact that this mechanism has been generally abhorred, particularly by worthy and respectable institutions like the World Bank and the Fund, is said to be a clear indication that it is not a sound idea.

The second argument is that it is a characteristically "soft" Indian solution, boding ill for the future, by setting a bad example to populist politicians who would pay no regard to the deleterious consequences of the potential inflationary impact of such measures.

Thus the proposition is dismissed without further analytic consideration, the economic argument for rejection relying upon Milton Friedman's generalisation that an increase in money supply always eventually translates itself into an increase in prices.

The origin of this argument goes back at least to Ricardo who in evidence before a House of Lords committee stated, " Reduction or Increase of the Quantity of Money always ultimately raises or lowers the Price of Commodities".

However prior to Ricardo, David Hume had analysed the problem in his classic essay "Of Money". Hume recognised, as Jean-Baptiste Say was later to elaborate, that money was

"Only the instrument that men have agreed upon to facilitate the exchange of one commodity for another.....It is evident that the greater or less plenty of money is of no consequence since the price of commodities are always proportioned to the plenty of money." .(Hume Essay "Of Money" edited by Eugene Miller Liberty Press).

In this his opening statement Hume was unequivocal that greater money supply will simply mean higher prices; but then he modified his position by recognising the fact that this proposition was not always valid. For he had observed from the outcome in some European countries that

"In every kingdom into which money begins to flow in greater abundance than formerly, every thing takes a new face: labour and industry gain life; the merchant becomes more enterprising; the manufacturer more diligent and skilful, and even the farmer follows his plough with greater alacrity and attention. This is not easily to be accounted for."

Hume's policy conclusion was, "From the whole of this reasoning we may conclude that it is no manner of consequence, with regard to the domestic happiness of a state whether money be in greater or less quantity.

The good policy of the magistrate consists only in keeping it if possible still increasing because by that means he keeps alive a spirit of industry and increases the stock of labour in which consists all real power and riches."

Thus Hume distinguished between the logical conclusion[s] that money and commodities must have only a proportional relationship so that prices will increase or decrease as these proportion change; but he then questions why an increase in money supply should stimulate activity for both industry and labour and answers that it is primarily because money integrates less monetised and primitive areas with more developed areas of the economy. He therefore concludes that

"Although the absolute quantity of money is a matter of great indifference there are only two circumstances of any importance namely the gradual increase (of money supply), and its thorough concoction and circulation through the state."

Thus a summary of Hume's argument may be stated as follows: the absolute quantity of money is irrelevant, for it can only facilitate the exchange of goods and services.

That can be achieved with less or more money; but an increase in money supply increases activity by enabling us to bring a larger proportion of society into the exchange economy; that is provided the authorities ensure that the quantity of money is widely circulated throughout the economy. Thus, whatever the quantity of money supply, the danger lies in idle accumulation without circulation.

Montek has identified in the accumulation of foreign exchange reserves a destination of idle Indian accumulations, which has done as little in stimulating economic activity as the influx of precious metals did to the Indian economy a century ago.

Montek would like to change that by using these funds for infrastructure. However, in identifying exchange reserves as an additional source of funds, he has apparently and deliberately mistaken "a collateral effect for a cause" to use the language of Hume.

For these reserves are not surplus accumulations but purchases that have already been paid for in domestic currency. Money is therefore in the hands of the public and not within the government. If portions of these accumulations are spent they have to be debited to the government account thereby increasing its overall deficit.

Montek would do better in defending such expenditure by reflecting on Hume's arguments of the need for money in societies as they develop from primitive states to more advanced ones.

Such developments require greater funds in circulation to enable isolated areas to exchange their goods and services with those of more developed areas. This has nothing to do with use of our foreign exchange reserves but simply relies upon the state's sovereign right to print money.

The relevance of our foreign exchange reserves is that the crux of the Montek plan is to expand public investment, particularly in infrastructure.

In the past any attempt to do this has simply led to a Balance of Payments crisis, but now that our foreign reserves have grown so considerably it should be possible to avoid such an outcome. The issue between Motek and myself is not foreign exchange but how to provide the rupee counterpart that any purchase of foreign exchange must involve.

In response to the criticism that if printing money was such an easy solution to development why have other countries failed to pursue such an obvious policy, my answer is that other countries are not as well placed in having such surpluses both in foreign exchange and labour simultaneously.

For eventually all demand must break down into demand for tradeable goods and demand for non- tradeable goods. Demand for non-tradeable goods eventually then breaks down into demand for land, labour or capital.

We have a surplus of land and labour and can therefore use our surplus foreign exchange in launching a policy of printing money to provide the capital needed to undertake infrastructural investments.

Finally I must conclude by answering the second set of objections to the effect that printing money is typically the "soft" option that characterises Indian populist behaviour. Here the dichotomy lies as much upon the querist as the queried.

It has often been said that iniquitous government borrowing by this generation is robbing future generations by increasing their liabilities without leaving them any assets.

In this case I am proposing to reverse that trend, because the damaging effect of printing money must surely fall upon this generation whereas the creation of infrastructural assets can only benefit the future generations.

If therefore by printing money, the consequence is a higher rise in prices for this generation this should be recognised as a noble sacrifice on their part for the benefit of the future.

sjmulji@aol.com