Sudhir Mulji: The bullionist controversy

Consequences of sterilisation by selling domestic bonds have only been analysed cursorily

In a characteristically equivocal comment, the Prime Minister is reported to have told Business Standard that the use of foreign exchange reserves for funding infrastructure will have an impact on the fiscal deficit.

That raises issues of confidence, which will have to be assessed (Business Standard, November 29).

In a quick response Subir Gokarn has argued that "the past few years have seen a moderate inflationary scenario with falling interest rates whereas the use of Reserves will impact either interest rates or inflation," presumably adversely, and he feels that these must be deemed serious consequences, particularly now when the inflationary impact is a big issue.

It would seem that Gokarn reflects an orthodox opinion in the country, which has considerable general support. Ever since the bullionist controversy in the first two decades of the 19th century, economists led by David Ricardo have argued that an excessive issue of Bank notes or paper money by the Bank of England caused depreciation of the currency and inflation.

The over-issue at that time was caused by the need to provide convertible money for fighting Napoleon. But the consequences of adding money are as familiar to the modern economist as they were to the bullionist.

The rationale of Ricardo and his bullionist contemporaries is worth repeating in their own language. First, it was argued that the quantity of money supplied determined domestic prices; then that domestic prices affect the exchange rate adversely; and thirdly, that the exchange rate between inconvertible paper and gold determines the premium for gold, or its equivalent, the depreciation of the domestic currency.

These basic propositions are so ingrained into orthodoxy that Subir Gokarn does not need to pursue logic or facts further to argue his case.

Yet not all the modern Indian facts do fit into this analysis. First, in Ricardo's argument the value of the domestic currency will tend to devalue against gold when money supply is increased not as a consequence of inflow in specie but by an over-issue of bank notes without a corresponding inflow of convertible currency.

But if the quantity of money grows as a consequence of specie inflow, the classical argument does not follow. It was no part of the bullionist theory that the Bank of England should sterilise the additional funds.

If we substitute freely convertible currencies for gold, there is no clear evidence that the domestic currency (the rupee) is losing its value against foreign exchange.

On the contrary, such is the inflow of foreign exchange that at present rates of accumulation of reserves will touch $175 billion by the end of December 2005. We cannot add a billion dollars a week without expecting such figures.

Since the classical argument did not consider either the sterilisation of excess money supply or revaluation of the exchange rate, it made sense that an increase in money supply through specie inflow would lead to growth in domestic money supply with the familiar consequences for domestic prices.

It was no part of the classical or indeed the pre-classical argument that this inflow of money could be prevented or neutralised. Indeed it has been argued that:

"The economic history of Spain in the latter part of the fifteenth and sixteenth centuries provides an example of a country whose foreign trade was destroyed by the effect on the wage-unit of an excessive abundance of precious metals" (Keynes, General Theory).

It would seem therefore that a profusion of foreign exchange is not necessarily a panacea. There are of course plenty who believe that the inflow of foreign exchange is merely a temporary phenomenon""an aberration that will soon vanish.

Yet that argument can only convince those who have not examined investment opportunities in other parts of the world. There is no obvious alternative where the wage level is as low and minimal skills are readily available.

There is every possibility""speculative as this opinion may seem""that India and China will be favoured targets for investment.

The technical problem for orthodoxy is to ask what they propose if foreign inflows continue at the present level. Classical economics or bullionists had no clear answer, for, as we have said, a revaluation of the domestic currency was not part of the scheme of things.

Bullionists were concerned with an excessive issue of notes but not of an excessive specie flow into the country. Logically since sterilisation had not been contemplated, the conclusion would be to let domestic prices rise, with the obvious danger to foreign trade as happened to Spain with that considerable influx of precious metals.

One traditional answer is to allow tariffs to fall and thereby increase imports. No one could disagree with that, but it would be a grave error to believe that there is necessarily a suppressed demand for imports in the economy.

There may well be an existing unfulfilled demand in the economy, and in the next stage of reforms this should certainly be explored, but if there is not we shall still be confronted with the paradox of having to restrict domestic demand by sterilisation, or its equivalent, lending abroad to the United States and other richer nations.

The logic of the orthodox in applying the quantity theory of money is understandable.

It has evolved over many decades, but if I have chosen to go back to its origins it is because there is merit in the economic historian Humphrey's proposition: "To some extent this evolution has been illusory. Despite the apparent growing sophistication and complexity of the theory, there has been no radical change in its basic tenets since the early 19th century" (Humphrey, Money Banking and Inflation, 1993, published by Edward Elgar).

The original tenets, at least as explained by Ricardo, were concerned with an excessive supply of paper money or bank notes relative to the specie flow into an economy.

He had not examined the consequences of an excess specie flow; the only example of that in Europe then being the inflow of gold taken from Incas by the Spanish Empire.

In examining the economic issues, commentators have assumed that the problem is essentially one of an excess issue of bank notes or borrowing by the government, not the consequence of specie or foreign exchange flows.

Sterilisation by selling domestic bonds has been an adequate temporary response, but the theoretical consequences of this form of savings have only been analysed cursorily, presumably in the belief that these specie surpluses will eventually reverse.

Yet the issue before Manmohan Singh's government is one of determining how to use these flows.

If the logic of the Ricardian argument is that exchange deficits are caused by an excessive supply of bank notes, then it follows that the consequence of surpluses is an insufficient supply of domestic money, both on the assumption that a revaluation of the domestic currency cannot be effected and that sterilisation as a policy is inefficient.

Whether this mode of reasoning is justified when those alternatives are readily available to a modern government is a matter to be considered. Suffice it to say that Ricardo at least does not seem to have examined these possibilities.

sjmulji@aol.com