In the short run, restrictive monetary policy negatively affects growth. In the long run, however, mainstream economic theory holds that once wealth-holders can be assured that inflation is anchored at a certain level, they will be far more confident of investing in the domestic economy.
This is the logic that underlies Raghuram Rajan’s focus on stabilising inflation: It is not enough to reduce inflation. It is essential to keep it tethered at some level.
To argue, as some within the BJP have, that the RBI governor is wilfully wrecking the economy by maintaining higher interest rates is to display a profound ignorance of the current academic consensus on monetary policy.
No doubt, the mainstream theory as outlined here is debatable.
Even if inflation rates are brought to a stable level, and even if the private sector is confident in the power of the central bank to contain inflation, investment might not be forthcoming due to a perceived lack of demand.
This could be because consumer demand is low, either because the fruits of growth have not been distributed equitably or because high prices do not allow consumers to purchase manufactured goods.
In such a situation, there is not much monetary policy can do. Fiscal policy would have to step in and focus on the factors affecting consumer demand rather than simply easing the rules for producers.
There is a good case to be made that this is the situation in India today.
Thus, for truly inclusive growth, the Modi government would do better to deal with the problems of jobless growth—which keeps demand low—and high food prices rather than making a scapegoat of monetary policy.
It is curious to note that the government is concerned about the economy when its own figures indicate that GDP growth is currently at 7.6%.
Let us accept the veracity of these figures. At this rate, national income would double in about 10 years. To argue that still higher rates of growth are required for poverty reduction is to implicitly admit that the fruits of growth are not reaching the majority of the population.
The Indian economy has been experiencing over a decade of jobless growth. This is not the Bharatiya Janata Party’s fault alone—the high growth years of the United Progressive Alliance government saw very little progress on the employment front.
Yet there are reasons to believe that the situation has worsened. A report by economists at HDFC Bank indicates that employment elasticity—the percentage of employment generated for every 1% change in GDP—stands at 0.15% over the period 2012-13 to 2015, lower than it has ever been.
The economy is losing the ability to generate suitable, well-paying jobs. This severely restricts the base of consumer demand essential for economic growth.
Moreover, the spectre of social unrest looms large. The protests by Jats in Haryana and Patidars in Gujarat, while condemnable for their violence, are an expression of the frustration of privileged groups that see the benefits of an expanding economy being restricted to an ever-smaller circle of influence.
Thus, to call for even higher growth rates misses the point. Only a more equitable distribution of the benefits of growth would lay the foundation for a healthier economy.
High food prices
The other problem that the Indian economy currently faces is one that it has perennially grappled with: high food prices.
Further rate cuts were halted by a resurgence of food price inflation, which had moderated over the first few months of 2016 (when calculated year-on-year), but saw a worrying increase in April.
While one may blame two years of consecutive drought for the high food prices, monetary policy would be able to find more room to operate if the economy were still not so dependent on monsoons.
There is a crying need for massive public investment to improve agricultural productivity and arrest years of neglect of the agricultural sector.
The government has made some moves on this front. Non-plan expenditure on agriculture and allied activities rose from around Rs2,928.34 crore in 2015 to Rs4,015.54 crore in the 2016 budget. Yet, total spending on agriculture and farmer’s welfare—Rs35,984 crore, by the government’s own estimates—still accounts for only 1.8% of total budgeted expenditure for the period 2016-17. Still, it is entirely possible that actual expenditure would fall short of budgeted amounts, given the government’s focus on maintaining the fiscal deficit.
High food prices have a negative effect on consumer spending and aggregate demand because they squeeze household budgets and leave little for spending on other goods and services.
Detractors of the RBI governor must ask themselves whether higher interest rates are hurting micro, small, and medium enterprises more or shrinking purchasing power due to high prices.
The rules of the game
At one level, policymakers are mistaken in holding monetary policy responsible for slow growth in the face of the problems of high food prices and jobless growth. There is, however, a more fundamental contradiction at play.
If the BJP wants a free-market economy, then it must maintain the strict independence of the central bank.
The BJP provides no meaningful alternative to the system. It wishes to propagate a private economy while bringing the independent institutions that undergird such a structure firmly under its thumb. Such a heavy-handed approach does not augur well for the economy.
Solving the issue of jobless growth, tackling high food prices in a sustainable way, and addressing the problem of the concentration of wealth in the hands of a few would let monetary policy work in tandem with fiscal authorities to deliver better outcomes.
Rajan’s exit is indicative of a government that does not fully grasp the nature of the economic system it is in charge of.