Economy Jun 25, 2012
All of us are aware of India's inflation crisis. It is very disappointing, how we lost our grip on stable 4-to-5 percent inflation which was prevailing earlier. From February 2006 onwards, in every single month, the y-o-y Consumer Price Index (Industrial Workers) inflation has exceeded the upper bound of 5 percent.
All of us agree that there is something insidious when 10 percent inflation effectively steals 10 percent of the value of my wallet or fixed income investments. In India, however, we often hear the argument "Yes, this is bad, but if high inflation is the way to get to high GDP growth, let's get on with it". It is, then, important to ask: Why is low inflation valuable?
Nominal contracting is very important
The complex organisation of economic life involves myriad written and unwritten contracts involving households and firms. The vast majority of these contracts are written in nominal terms, i.e. in rupee values that are not adjusted for inflation.
Every society needs to adjust all the time, in response to changes in tastes and technology. When tastes or technology change, the structure of production needs to change, which involves renegotiation of (written or unwritten) contracts. These adjustments are costly. Contracting is costly, and renegotiating contracts is costly.
It is useful to think of a finite supply of adjustment as being available in the country. We should devote that full power of adjustment to the beneficial adjustments associated with changes in tastes and technology. In a place like India, where GDP doubles every decade, the requirement for adjustment is (in any case) large.
Inflation is an acid that corrodes all nominal contracts. Two people may have agreed on a contract two years ago at Rs 100, but that contract is thrown out of whack because of 10 percent inflation per annum. That contract has to be renegotiated. Bigger values of inflation corrode personal relationships also, given that there are many financial ties within friends and family.
Contracting is costly. Almost everything that senior managers do is to arrive at complex deals that create and sustain complex structures of production. This work is continually torn down by high inflation which makes the deals of last year break down today. Managers are able to build sophisticated edifices of contractual arrangements under low and stable inflation. These webs of contracting are harder to build and hold up when the acid rain of inflation is continually tearing these down.
Inflation messes up information processing
To continue on the theme of adjustment, the essence of a market economy is adjustments to relative prices, reflecting changes in tastes and technology. Firms learn about the viability of alternative investments by watching relative prices change. Inflation messes up this information processing. It increases the "background noise" by making a large number of prices change at once. This makes it harder to discern which price change is fundamentally driven, and merits a response in terms of increased or decreased production.
Building a sophisticated market economy is all about making long-term plans. When a firm decides to build an airport or a highway, this involves making NPV (net present values) assessments over the next 20-40 years. This requires having a fair idea about future inflation. If inflation will fluctuate in the future, then firms will err on the side of caution when making plans about the future, i.e. investment will be reduced.
I will stress that long-term investment in projects such as infrastructure or heavy industry relies critically not just on a long-term bond market (which, in turn, critically requires low and stable inflation) but also on the calculations happening in a spreadsheet about the NPV of the investment project, which involves projecting all revenues and all expenses for the next 20-40 years (which also critically requires low and stable inflation).
Impact upon pre-existing nominal savings
For a person at age 60 who expects to live to age 85 or 95, fixed income investments are absolutely crucial in the financial planning of these 25-35 years. These calculations can be destroyed by a short bout of inflation.
A civilised society is one in which people can make plans for the deep future, and trust in financial instruments. It is simply cruel on the elderly to inflate away their nominal assets. The possibility of even one bout of high inflation over the coming 25-35 years forces people to drop back to other mechanisms of protecting themselves in old age. What is needed is not just inflation control right now. What is needed is the environment of mature market economies, where outbursts of inflation are fully ruled out for decades to come.
Impact upon relationship with banks
In India, banks pay very low interest rates. While many interest rates have been deregulated, the interest rates paid by banks are held back by factors such as low competition and financial repression (ie forced purchases of government bonds).
When households expect inflation will be 12 percent, they will see a 4 percent interest rate paid by the bank as yielding -8 percent. This has many consequences. On the one hand, households and firms expend excessive (wasteful) effort on minimising their holdings of low-yield cash. In addition, households tend to shift away from fixed income contracting with the formal financial system. Both these distortions are caused by inflation, and exacerbated by flaws in the financial system.
If the financial system were regulated sensibly, then with high inflation we would immediately get higher nominal interest rates since buyers of 90-day treasury bills would demand higher interest rates to pay for inflation. This would reduce the damage caused by high inflation. In India, we suffer from bigger negative effects because of a faulty financial system.
These may seem to be small things but they actually are fairly large effects. Towards an understanding of the costs of inflation - II, by Stan Fischer, 1981, argues that perfectly anticipated 10 percent inflation induces a cost of 0.3 percent of GDP on account of only one factor: excessive efforts by households and firms to hold less cash.
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