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People first, economy later

The existence of a mechanism of protection against a sudden increase in the cost of essential goods should be regarded as an indispensable component of public policy. Arjun Sengupta examines...

india Updated: Apr 24, 2008 21:39 IST

Rising inflation in the last few weeks — not so much the level of inflation as the trend of increase — poses a major challenge to the government.

The Indian economy in the past has withstood higher rates of inflation and a 7.5 per cent inflation today would not be a great problem if it did not threaten to precipitate an even higher rate of inflation tomorrow.

There is no time for bickering about who is responsible for this situation and who must accept the blame. Politicisation is no solution to the problem. The cost of this inflation may turn out to be extremely damaging to the country’s growth and common man’s welfare.

We must prevent the rise in inflation into generating wide-spread inflationary expectations that would in turn raise the level of inflation further. This could precipitate a serious crisis with loss of confidence in the domestic currency and both foreign and domestic savers moving out of domestic assets and investments.

The crisis can go out of hand very soon, unless measures are taken to reverse the expectations about continuing inflation, raising confidence among investors and asset-holders about the ability of the government to control inflation.

For that, nothing can be more effective than the stringent measures by the Reserve Bank of India (RBI) to control liquidity and suppress demand.

Even if the proximate cause is constrained supply, controlling liquidity and managing demand would always bring down the prices. The cost of that may sometimes be too high when suppressing demand leads to not just fall in prices but also in growth of output and employment.

An early intervention before inflationary expectations grip the situation, a modest reduction of liquidity may be sufficient to reverse this process. So the RBI’s attempt to squeeze liquidity is a policy in the right direction. Raising the cash reserve ratio (CRR) may unnecessarily affect the profitability of the banks, having cash without returns.

When the aim is to reduce expenditure, a straight forward increase in the rate of interest could be a preferred option, provided complementary policies are taken to neutralise its effects of increasing inflow of foreign capital, in search of higher return. If the RBI does not intervene to buy up dollars, the rupee would appreciate reducing exports and through that, the growth of output of employment, in addition to the negative effect of raising interest rates.

But that is the cost that may have to be accepted. Otherwise the RBI’s interventions to prevent such appreciation could only increase the liquidity further. A preferred policy may be to control inflows of such foreign funds either by imposing a Tobin-type tax by raising taxes on short-term capital gains.

The fine-tuning of reducing liquidity at the minimum possible cost of output and employment is the art of financial management. However, controlling the cost-push effects of inflation depends entirely upon the political economy. India has been substantially globalised not to be able to insulate itself from the cost-push of steeply rising global prices of petroleum, metals, raw materials and essential items of consumption.

However much we may control imports and exports through taxes and administrative procedures, the prices of all tradable products will rise with rising world prices. It is not just smuggling along the long international borders of our country, but also through traders’ behaviour and market arbitrage accompanied by movement of finance, the international inflation will keep impacting on domestic prices.

Strong administrative measures may demonstrate the determination of the government to control inflation, affecting inflationary expectations. The more dramatic a step taken (such as a blanket ban on all forward trading or banning exports of essential products or physical raids on hoarders and stock-holders), the greater will be the effect. But care has to be taken to clearly signal to the market forces that these measures are short-term devices for six to nine months, after which the markets would be allowed to play their normal roles of balancing supply and demand.

There are two aspects of such cost-push inflation when the prices of intermediate inputs are rising because of external factors and through that pushing up the prices of final products. One, that affects the spread of inflation to activities using these inputs, and the other that impacts the welfare of the users.

The cost-push inflation due to rising price of crude oil is serious as petroleum, used in many activities, has a substantial impact on the general level of inflation. But their effect on the welfare of the users may not be that significant — except for kerosene or LPG that are consumed by the poor. There is very little case for protecting middle and higher income people’s consumption of petroleum products like diesel and motor spirit, except in a very short period, again to prevent a rise in inflationary expectation. The only policy option for a permanent rise in their prices would be to adjust the domestic behaviour of production and consumption to such rising cost and allow prices to pass through the domestic users.

The cost-push inflation of the essential products, or wage goods, is of a different nature. Their impact on spreading inflation would be limited. In India, increasing cost of wage goods does not reflect in increasing money wages, at least in the short- term. On the other hand, the welfare effect of wage goods inflation is very substantial especially when they affect the essential commodities of mass consumption. Any government that derives its legitimacy from protecting the welfare of the common people has to control inflation of essential goods as a top priority.

For a globalised economy like ours, the existence of a mechanism of protection against a sudden increase in the cost of essential goods should be regarded as an indispensable component of public policy. This is the logic behind food security and universal public distribution system (PDS). It is often possible to raise production even in a short-run through supplying fertilisers, seeds extension services and through water management in selected areas in an emergency mission-mode programme.

In addition, a buffer stock policy should assure supplies to the PDS that should be capable of expanding without delay through ration shops covering all essential items. But until such mechanisms are worked out, the immediate response has to be expanding the existing PDS by increasing the supply of essential mass consumption goods by importing them from abroad and subsidising them.

This might become very costly as we have not yet built a system that responds to the buffer stock norms and enters into purchasing arrangements in the world market throughout the year like any other trading operation — and not just at the time of crises when global prices reach a stratospheric level. That is the cost that the economy must bear, for not doing the elementary planning exercise of protecting our people from the inflation of mass consumption products.

(Arjun Sengupta is Chairman, Centre for Development and Human Rights, New Delhi, and former Economic Advisor to the Prime Minister of India)