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Economy Apr 27, 2012

Why inflation is good for the poor...and the government

By Blog

By R Jagannathan

Now that we know inflation is not going to disappear anytime soon, it is worth asking ourselves: who gains, who loses? Or can anybody be a real gainer?

Answer: yes. But we will tell you why later.

In general, we tend to believe that inflation hurts the poor more than the rich because the poor have to pay more for their daily necessities, while the rich anyway have loads of cash to see them through.

was the Reserve Bank right to cut rates to address growth even while inflation is still on the loose? AFP

So was the Reserve Bank right to cut rates to address growth even while inflation is still on the loose out there, waiting to pounce on the poor?

TT Ram Mohan, an IIM professor, raises an interesting argument in The Economic Times when he quotes economist Alan Blinder's 1980s book, Hard heads, Soft Hearts: "The meager costs that inflation imposes on the poor are dwarfed by the heavy price the poor are forced to pay whenever the nation embarks on an anti-inflation crusade...".

Ram Mohan clearly thinks we can live with 6-7 percent inflation but not with lower growth.

However, this is contentious, for it loses out on nuances. The poor are not just one broad category, just as the rich are not just one big group of moneybags.

In any elevated inflation scenario, there will be gainers and losers, and who actually gains or loses depends on the specifics of each situation. Let's take each case, one by one.

Rich versus poor: Since inflation eats into the real value of your cash, and the rich have more cash than the poor, the poor should lose less. Especially if their wages rise faster than inflation. However, this is too simplistic. A lot depends on where the inflation resides. If it is in food and wage-goods, as it was till late last year, the poor would lose more than if the inflation were to be concentrated on non-essentials. In short, both rich and poor can gain or lose.

Old versus young: In general, inflation hits the old more than the young, assuming the young borrow more (home EMIs, auto loans) while the old save more. The latter earn their pensions from fixed deposits and annuities. Inflation erodes the real value of debt, and worsens earnings from savings. When consumer inflation is at 9.5 percent (as now), what is the use of 8-9 percent return on National Savings Certificates or fixed deposits? The real returns are zero. But borrowers with fixed EMIs benefit as they keep paying in currency of lower real value. However, inflation and high rates also mean more earnings for the old. On balance, though, the old lose more than they gain. The young, vice-versa, if they are big borrowers.

Importers versus exporters: High inflation usually means a falling currency, which tends to help exporters and makes imports costlier. But this does not always happen in practice, as exchange rates depend also on capital flows. The more the inflows, the higher the value of the domestic currency - despite higher domestic inflation. A lot, therefore, depends on the mix of inflation, capital flows, and many other factors.

Bonds versus stocks: Inflation erodes the value of fixed-rate instruments, but boosts that of shares. Reason: when prices are rising, stock prices ultimately have to rise to adjust for the inflation-boosted rise in earnings of companies. A counter-point: high inflation usually comes with high rates, which is said to be a dampener to stock prices. Interest rates and stock prices are usually inversely related. But since stock prices have to be seen over the medium term, investing in stocks when interest rates are high means that when they fall you have huge gains to make. So stocks should ultimately gain from current inflation.

Government versus the rest: Does the government gain or lose from high inflation? Let's see. When we have inflation, governments that borrow hugely have to repay less in real terms when the value of the rupee falls. That's a gain. They also raise more as revenues, as tax brackets creep up and rising prices bring higher tax revenues from excise and customs. When money GDP rises, politicians can also show a larger than expected fall in fiscal deficit since the value of the deficit falls in relation to the size of the GDP growth.

If inflation falls, government can raise debt more cheaply. In case revenues too fall for some reason, governments can still print more currency and raise inflation.

So, no prizes for guessing who benefits the most from inflation.

by Blog

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