9%+7% is better than 6%+4%

Finance Minister Chidambaram is feeling the political heat. Inflation at the wholesale level crossed 6.58% last week, the highest for over two years. The consumer price index for rural labour has risen by over 10% in three North Indian states heading for State Assembly elections.

So, concern over inflation is spoiling celebrations of record GDP growth. The latest CSO estimates put GDP growth at 9.0% last year and 9.2% this year, the highest rate ever for a two-year period. This has raised visions of India crossing the 10% barrier and possibly overtaking China in GDP growth. But inflation is now dampening those visions

What, then should Chidambaram do? Should he decide that the economy is overheated, and cool it through stringent monetary and fiscal measures that will dampen growth? Or should he decide that it is worth suffering some inflation for such rapid growth, and so take only modest anti-inflationary measures with modest impact?

I have no hesitation I saying that I would rather have 9% growth with 7% inflation than 6% growth with 4% inflation, which is roughly what we had between 1997 and 2003. We are much better off today, despite inflation. Remember that in the 1960s and 1970s India had 8-9% inflation but only 3.5% GDP growth. In the 1980s and most of the 1990s, we again had 8-9% inflation and 5-6% growth. Only in the late 1990s did inflation come down, thanks partly to monetary policy but mainly to the Asian financial crisis and global recession that followed.

So, while inflation has risen from a low of 4%, it is nowhere near the 8-9% of previous decades.

C. Rangarajan, head of the Economic Advisory Committee, strongly urges inflation control saying that price pressures will erode growth. He feels we cannot sustain 9% growth with 7% inflation. The Economist, the British weekly, suggests that sustainable GDP growth that does not cause rising inflation is around 7%.

I am less pessimistic. Inflation has positive as well as negative effects. For starters, it reduces the public debt/GDP ratio, since the debt is fixed in nominal terms. Inflation slashes the real interest rate on government debt, lowering effective government debt service and to that extent the fiscal deficit. Inflation increases government spending as well as revenue, and the net outcome is ambiguous. But media reports suggest that revenue is rising faster than spending, with the result that the central fiscal deficit will plummet to 3.0 this year, reaching the FRBM target well ahead of schedule. State fiscal deficits are also likely to be below 3% of GDP. I suspect India will have a primary budget surplus, for the first time in decades. Inflation has contributed to this happy scenario.

This will reduce the crowding out effect of past fiscal deficits, and thus boost growth. Please note that the yield on 10-year gilts has actually fallen to around 7.7%, from almost 8.5% some time ago, despite rising inflation. The real yield has fallen even more.

Inflation has helped boost corporate profits, aiding an investment boom and boosting stock market valuations (thus improving the ability of corporates to raise cheap capital). Corporate tax revenue has zoomed and may in the foreseeable future touch 4% of GDP. The Left says the rich are not taxed enough. In fact the share of corporate and personal tax in GDP looks like tripling and later quadrupling from their pre-reform level of 2% of GDP. Total central tax revenue this year should cross 11.5% of GDP, an all-time record. To this extent, inflation has soaked the rich and financed social investment on a far bigger scale than high socialist taxation ever did.

A fiscal situation is sustainable if the rate of interest on public debt is less than the rate of nominal GDP growth. At 7% inflation and 9% growth, nominal GDP will rise 16%, double the interest on government debt. Fiscally, this is good news, which will be spoiled only if the government goes on a fresh spending spree.

The conventional wisdom holds that inflation helps the rich by boosting their asset values, but hurts the poor who have only labour and no assets. The facts are otherwise. Inflationary bursts in the 1980s and again in the 1990s temporarily dented casual labour wages, but wages soon caught up with and overtook prices, so real wages rose substantially in both decades. Lesson: inflation hurts rural labour only temporarily, while rapid growth increases real wages, of casual labour as well as of BPO workers.

Let me not exaggerate. I am not saying that inflation is a blessing. I am merely saying that inflation has positive side-effects that mitigate its undesirable effects. Less inflation is better than more inflation, other things equal. But other things are not always equal. If 7% inflation can give us 9% GDP growth rather than 6%, that’s a cheap price to pay.

Unsustainable? Yes, if the global economy suddenly sinks. But I doubt if it is unsustainable on accout of overheating. The Economist feels that overheating is evident in a predicted current account deficit of 3%. I suspect the figure will be closer to 2%, but even 3% is a perfectly healthy current account deficit for an economy growing so fast. Singapore ran a current account deficit twice as large for over a decade in its fast-growth period, and so to a lesser extent did Korea, Taiwan and some South East Asian countries. Pessimists warn that this may lead at some point to a hard landing. I personally would rather have 9% growth for a decade followed by a hard landing than steady 6% growth.

However, 7% inflation may be unsustainable politically. It may oblige politicians to use really tough monetary and fiscal policies to reduce demand in rather painful ways, such as skyrocketing interest rates. Yet my guess is that, unhappy though politicians may be with 7% inflation, they will be even unhappier with the pain necessary to reduce inflation really sharply. I suspect they will limit themselves to modest anti-inflationary measures, throw in a few more subsidies, and pray for a fall in global prices.

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