Here is a question for monetary-policy wonks and for the laity interested in logic puzzles. Earlier this week, when the RBI announced tough policy measures for controlling inflation, the Sensex took a tumble of over 500 points. There were complaints that this meant a loss of wealth for individuals, corporations and, hence, the nation. The question I want to ask is: is this necessarily so? After all, Sensex points are not apples and oranges. Its decline does not connote a direct loss of goods and services as happens when a building burns down or crops are damaged by floods.
To put this in sharper relief, consider a related problem. A rich man, travelling by ship, loses Rs 1 crore when his trunkload of cash is washed away in a typhoon. Clearly, he is worse off. And since no one else was involved in this, we would be tempted to conclude that society as a whole loses wealth equal to Rs 1 crore.
But, on further thought, that is not obvious. Since the total amount of apples, oranges, homes... is unchanged, it is arguable that there is no loss of real wealth in society. This man’s loss must be balanced by small, indirect gains of other individuals.
But on even further thought, this also may not be right. Most economists (I have tried this on many) would tell you that, since this person now has less cash, he will spend less on apples, oranges, homes..., which will cause the manufacturers of these goods to produce less and so there will indeed be a net shrinkage in total output.
Let us suppose this is correct. Then if, instead of a storm causing him to lose money, a fairy goddess (or the RBI, if you so prefer) gave him notes worth Rs 1 crore, freshly minted for him, then the entire society would be better off. After all, getting Rs 1 crore is no different from not losing Rs 1 crore.
If the creation of Rs 1 crore notes creates more real wealth, another Rs 1 crore printed and gifted to another person must do the same and so must another crore and another... But this, we know, is not the case. This will cause ruinous inflation and impoverish society, as happened in Germany in 1923, Hungary in 1946 and during Mohammad bin Tughlak’s reign in 14th century India. It follows that there are situations where the loss of a trunkload of cash increases total output (since there are situations where the injection of a trunkload of cash causes total output to fall).
The link between monetary assets and real wealth is evidently not a unidirectional one. The tracking of this link remains one of the big open problems of economic theory. Some of these complexities carry over to the connection between the value of shares and real wealth in a nation. The deflation of the value of stocks can, in some situations, be concomitant with an increase in aggregate prosperity.
Take the downturn of the Indian stock market following the announcement of RBI’s anti-inflationary package — the raising of the repo rate and the cash reserve ratio. First of all, it is not at all certain that the two are causally connected; some would argue that the Indian stock market was reacting to the Dow Jones. But let me leave this aside for now. The RBI intervention has been described in the press as a policy meant to curb inflation at the cost of growth. The response of the Sensex is treated as evidence that growth is being compromised.
In reality it is not at all clear that this is the right way to analyze this. It is arguable that the opposite is the case. If this inflation were left unchecked, growth in the long run would decline. In 1972 India had an inflation of 10 per cent, in 1973, 20 per cent and in 1974, 25 per cent — the highest ever in independent India.
By letting inflation rise to such a height did we get good growth? No. 1974 was one of India’s worst years. The GDP grew by only 1.2 per cent, which means per capita income declined. Hence, checks on inflation can push up aggregate growth in the future to levels that are higher than what it would be if inflation was allowed to rise unabated.
I do not say this as the final word on the subject. Monetary policy requires strange combination of engineering skills and artistry and intuition. The only rule that we can be sure of is to be wary of those who claim to know exactly what the right policy is.
Kaushik Basu is C. Marks Professor and Chairman of the Department of Economics, Cornell University.