Judging from our present credit policy, the Reserve Bank's view of its own role is at variance with that held by commentators. With supreme detachment the Bank points to the high fiscal deficit and in subsequent commentary claims to have "articulated" the governor's concern about the potential unsustainability of such a state of events. The Reserve Bank may be satisfied with having analysed the state of affairs but it does not admit to sharing with the government any responsibility for creating this parlous situation.
Even a casual analysis of the government's budgetary position would surely indicate that an unsustainable deficit has been caused by high interest rates for which RBI's monetary policy is responsible. Finance ministers after finance ministers have maintained that in such matters they rely on the expertise of the RBI. No doubt the RBI has to pursue conflicting objectives in that it must control inflation as well as finance the government's borrowing programme. But if the fiscal deficit is now unsustainable it is very largely because the RBI has consistently ignored arguments for a reduction in interest rates.
This may well have required greater monetisation -- that is the printing of money -- but, as Sargent and Wallace warned us long ago in their seminal article, "Some Unpleasant Monetary Arithmetic", a tight monetary policy in the face of persistent fiscal deficits can eventually lead to an uncontrollable state of affairs where the degree of monetisation will eventually need to be substantially increased. The Sargent-Wallace argument has been generalised by Nissan Liviatan of the Hebrew University. In an article entitled "Tight Money and Inflation" published in the Journal of Monetary Economics in 1984, Liviatan argues that if a government's primary deficit is constant or rising a tight money policy will increase rather than decrease inflation.
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What the RBI and the authorities in general should have foreseen is that in the Indian polity the scope for reducing or controlling the government's fiscal deficit is negligible. Taxing agriculture cannot be a serious option given the rural ability to deliver votes and therefore power, yet unless the government is willing to compensate for its deficits by raising taxes or reducing subsidies the mere financing of deficits by bonds or money will make no difference.
If the government is unable to compensate for constant deficits by higher taxation it has to take the second best course which involves deciding whether government deficits should be financed by bonds or by monetisation. In their credit policy, the Reserve Bank considers it a positive fact that the government demonetised by Rs 5,000 crore last year. All that means is that the government borrowed that much more when real interest rates were particularly high -- not, one would have thought, a matter for self congratulation.
Our entire interest rate structure needs to be reconsidered in the light of both economic theory and the facts of the Indian economy. The RBI has ignored theory in the firm belief that its sole task is to preserve price stability through monetary measures. Further it has failed to recognise the inter-temporal consequences of its policies.
It could be argued that the wiser course from 1980 would have been to finance fiscal deficits with monetisation. That this has been deliberate policy and not a consequence of market forces is self-evident. But it is greatly to the credit of deputy governor Y V Reddy that he has accepted that in India interest rates are administered. High interest rates are certainly a consequence of the monetarist doctrine adopted by the RBI. If the results are disastrous on the fiscal deficit, the Bank is to be blamed. To parody Cardinal Wolsey, had the Reserve Bank served the cause of low interest rates half as diligently as they have served the cause of high interest rates we would not have found ourselves in the pickle we are in.
Tight money has always had a fatal attraction for monetary disciplinarians. Under what was known in England in the twenties as the "Treasury view" (and is now advocated under its new pseudonym of "the Washington Consensus") it was held that all attempts to lower interest rates would fail because such a policy might artificially boost production only for the process to be painfully reversed when the business cycle turned.
Yet the validity or otherwise of this doctrine must surely depend on the state of the real economy in question. The Treasury view depended upon the assumption that economies tend towards full employment and equilibrium. All divergences from this state of affairs were assumed to be temporary, and it was thought that full capacity would again be utilised once prices had adjusted to the new conditions.
Whether one can justify such assumptions in India with its growing population and its dearth of employment opportunities is a matter of at least some doubt. There are many who hold to the view that whatever the apparent state of employment, resources in India are both scarce and fully utilised. It is therefore helpful that the RBI has acknowledged that "In India the estimates of potential output are not very firm, because of the lack of adequate information on employment, capacity utilisation etc." Perhaps such information is also unavailable beforehand in sophisticated economies.
Typically in the United States it was for long believed that unemployment could not go below 6 per cent, later 5 per cent without building up inflationary pressures. Any good Treasury or Washington Consensus economist would have slowed down the economy well before the remarkable growth that has taken place could have taken a hold. Now that that economy has demonstrated a much greater potential, the glib economist answer is that it is all due to productivity growth.
In the Indian economy we know even less of the potential. It is therefore a matter of guessing where and when real inflation will emerge. What we can be certain of is that the state of our public finance, and by that at the simplest level I mean the fiscal deficit, is a cause for considerable anxiety. The real danger is not the potential for inflation but a serious lack of confidence in our public affairs. The present deficit has been greatly enhanced by high interest rates.
It is somewhat disingenuous of Dr Reddy to have said, as if it was an accomplished fact, that the government had assured the Bank that their borrowing needs would be less this year than last. If that be so, well and good, but it is absolutely necessary for the Bank to recognise that government promises are like the promises of all princes. The real life-line will have to come from a liberal and loose monetary policy and not from optimistic promises.
It is open to the Reserve Bank to take the sensible risk of pushing down interest rates by conducting open market operations. This might create an excess of liquidity and put some pressure on the balance of payments but these economic consequences are less important than the restoration of confidence in the authorities, including the Reserve Bank, to demonstrate a sustainable and credible policy to manage deficits. The way out is to put a ceiling on government borrowing but not a ceiling on monetisation.