Monetary targeting, which is the RBI’s way, is quite unsuitable in today’s environment of vastly asymmetric growth and capital flows. The belief that money supply determines the inflation rate was never quite true in the linear fashion that seems to be the RBI’s (and IMF’s) assumption when it keeps mopping up ‘excess’ liquidity. In hyper inflationary situations though the monetary brakes have to be applied. But once inflation is in line, all economies respond to variations in money supply by adjusting — increasing or decreasing the growth rate in real GDP, as long as money supply in some manner determines expenditures especially investment through fall in the nominal rate of interest.
Inflation happens only after as much as 16 quarters and that too if the additional capacity of productive assets that results over these quarters is not adequate or is inefficient. Thus expansionary fiscal and monetary policy provided they result in efficient capital accumulation need not be inflationary even in the medium and long term. The East Asian story was a controlled ride on this path. And today China’s central bank and finance ministry is engaged in a glorious exploitation of this ride to development.
For the advanced countries, though, this option is not there since the rate of efficient investment cannot be forced, being dependent upon technological change in the economy (the timing of which is exogenous). Having no under-utilised manpower, the inflationary potential of such high investment strategy is large, and hence it does not make sense to ‘force’ growth.
Nevertheless, even here it is worth noting that the shift from monetary targeting to interest rate targeting and a looser control over money during the Clinton years ensured higher growth. For non-diversified LDCs there is no option here for the obvious reason that the supply si not elastic over the range of goods and services that is GDP.
In the advancing countries, though, the matter is radically different. Herein, the rate of growth is only limited by the rate of investment, since there is always a shelf of technologies to choose from, and most important of all, the vast under-utilised labour means there is little or no aggregate cost to additional employment that ‘forced’ growth at high rates entails. Hence the inflationary potential is muted as long as the ‘forced’ expenditures are in the nature of efficient investments. There is, of course, a direct and immediate emergency instrument that can be, and was used in the East Asian economies when inflation tended to rise above levels considered as tolerable.
An incomes policy that varied the proportion of income kept aside as compulsory savings (earning at real interest rates of around 2%) could always be used to curb spending when investment tended to rise beyond savings capacity by suddenly increasing the share of income being so placed in compulsory savings. Empirically, this was necessary only at very high rates of investment, typically in the range of 35-40% in the case of East Asia and China, respectively. But the comfort it provided to the conduct of macroeconomic fiscal and monetary policy is important. Would that not be an anathema to the notion of consumer sovereignty? Not at all: which consumer would not postpone his sovereignty as between the choice of savings and consumption by a few years if high rise in wages, often amounting to as much as 10% per year, was contingent on this ‘sacrifice’? Indeed, with such high rise in wages, consumption would anyway significantly lag income growth, so that except in a very rare situation, the ordinary income would not feel it to be a sacrifice.
What about the current account in such ‘high speed’ growth? That, for the East Asian economies and for China today, has been a simple matter of keeping ‘real effective realised exchange rates’ low, so that foreign sales profitability was always hugely higher than domestic sales profitability, giving rise to a large elastic response to external markets. So the current account remains well in line. If such economies are also open only one way on the capital account, then the response of the world to the high growth results in capital account inflows. And, hence to large reserve growth, about which I had talked earlier in these columns.
Even assuming a monetary targeting approach, we would argue that the call the RBI has been making on the real growth possible is much too conservative. Recall that public investments, which used to be as high as 50% of gross capital formation (GCF) in India, are now, barely 24%. Public investments had huge time and cost overruns. So, with their decline, the assumed upper bound on growth must go up. Private corporate investments had reached as high as 38% of GCF at the high point of our growth post reform (in 1997). But are now as low as 23%, much of the decline being due to monetary conservatism knocking down growth runs, and regulatory and policy anomie in many infrastructural areas keeping private investment shy. So, targeting with an 8% growth and an inflation of about 7% to have a medium- term money target of 16% (8+7+1 (for increased monetisation)) would be necessary, even by the logic of monetary targeting.
Recognising other potential efficiency gains arising out of tax reform, delicensing, falling tariffs and tariffisation of quotas should further push up the upper bound on the growth. Then the probability of smothering a run of good growth from the money supply side would be much reduced.
It is only investments by the household sector, largely house construction, which has kept the investment rate at a decent looking 25%. Strange that when capital flows are so large, the manufacturing and productive investment rate should not rise. But not so strange, when one realises monetary policy that sterilises (more than necessary) the inflows can only lead to displacement of domestic by foreign investments, at best. And, in all probability, to decline in investments since foreign investment may be risk-barred from making the physical investments even as portfolio surges take place.
Hopefully, the recent attempt to stall the runaway investments in housing would be followed by measures to improve productive and especially manufacturing investments (lower interest rates and fall in the rupee value). Otherwise manufacturing would continue to race headlong into being hollowed out and would not even have the benefit of spending on construction.