Economy Apr 7, 2012
The movie Ironclad shows how an army of fighters led by a Knight Templar defends the Rochester Castle in Canterbury against King John who wants to reimpose his arbitrary rule on Englishmen by throwing out the Magna Carta.
The Magna Carta signed by King John granted equal rights to all Englishmen and is supposed to be the founding document of modern democracy. By defending the Rochester Castle, the Knight Templar denies King John access to the a major part of England. It's a battle that leads to the eventual downfall of King John and the flowering of democracy.
Just like the people of England placed their faith in the Magna Carta, so did the citizens of India place their faith in the Indian government and the Reserve Bank of India to protect the value of the rupee. That trust has been broken with ever-expanding money supply and rising inflation. While the public does not trust the government, they still hold the Reserve Bank in high esteem. Dr Subbarao, you are the last defence of the rupee, please stand your ground.
Rising inflation has been eating into the value of savings and salaries of Indians for a very, very long time. When is the last time India saw negative inflation? For a few fleeting months in 65 years of freedom. The rate of inflation growth has slowed sometimes, but inflation has always grown. One of the key triggers of inflation is money supply growth. When money in the system increases so do prices as there is more money chasing goods and services. And money supply has always been increasing in India from way back in 1950. (Click the chart to see money supply growth).
The nature of banking usually ends up increasing money supply, but the devil here is deficit financing of the government by the Reserve Bank. Monetising deficits in no different from printing money. Unless the Reserve Bank can say no to the government, it will be difficult to control money supply. The chart shows how serious the growth of money supply is. In the last 10 years alone money supply has jumped by 500 percent to Rs 6,499,548 crore from Rs 1,313,220 crore. That money has to go somewhere and it shows up as higher prices for everything from onions to houses.
The public gets all riled up when politicians hide money is Swiss banks. Bad as that might be, it's nothing compared to slow devaluation of the public's income and savings through deficit-driven inflation. Is it easy to chop off the ugly head of inflation? Of course not. It's a beast that has been fed with 50-years of money supply growth. But that does not mean that one should stop fighting and become a Weimar Republic, where inflation destroyed the value of the German paper currency so much so that it was burnt to keep homes warm.
As the clamour to lower interest rates in India rises, the central bank needs to keep its duty in mind -- provide sound money to the citizens of the country. The first step is to keep interest rates where they are if not increase it. The second step is to reduce money supply. And the final step is to say no to deficit financing. It seems highly unlikely that the RBI will take the final step.
If the government is starved of money from the Reserve Bank, it will have to improve tax revenues to meet its goals. Raising taxes will kill growth and reduced tax revenue. Hence the only option will be to promote growth-stimulating policies. Once the supply of goods and services increase due to economic growth, tax revenues will rise and prices fall. Dr Subbarao needs to take a page from the book of a fellow central banker, Paul Volcker of the Federal Reserve Bank, whose inflation fighting measures over several years put America back on a sound track. You can also pass on some growth policy tips from President Ronald Reagan to Prime Minister Manmohan Singh. Or should it go to Sonia Gandhi?
Dr Subbarao, as you set your monetary policy goals later this month, think of the retirees and middle class earners who lose the value of their income and savings from easy money. It may seem like a lonely fight when you deal with the political and governing class, but there is a silent majority that appreciates sound money and stable prices.
In the movie, the Knight Templar and his fighters are on the verge of defeat when the French army arrives to save the battle. For the central bank the path back to sound money is a long one. It's not a battle of swords or guns, but a battle of ideas. If the Reserve Bank really wishes for sound money, it has make the concept easy to grasp for the average citizens. Then it will see support rise for inflation fighting.
George Albert is Editor, www.capturetrends.com