The Governor of the Reserve Bank of India reportedly stated that the inflation rate would be brought to its target level of 4% within 24 months. It had been above this level for 34 consecutive months already. If the prognosis is correct, by 2024 it would have remained off target for close to five years. In the United States and the United Kingdom, the inflation rate has been off target for a lesser period, but it has lately run at rates close to four times the target. What credibility do the world’s central banks have if they fail so egregiously in delivering on their mandate? Though the characteristics of India’s economy vary substantially when compared to those of the industrialised West, their governments follow the same approach to inflation control, termed ‘inflation targeting’ and implemented by their central banks. It would be reasonable to surmise then that the approach is ineffectual because it is flawed in its imagination.
A particular problem
The approach to inflation currently favoured in Anglo-American economics is the result of an evolution lasting close to a century. In the 1930s, the world faced an unprecedented crisis with the capitalist economies plunging into depression. We can now see that this was a particular problem of such economies, for the Soviet Union was unaffected. The Great Depression was as much a crisis for the economics profession, for it was expected to come up with ideas on how the global economy could be lifted out of the morass it had sunk into. The central banks were rendered helpless, for monetary policy, the preferred macroeconomic instrument, proved to be impotent under the circumstances. The profession responded momentously, through the publication by J.M. Keynes of The General Theory of Employment, Interest and Money. It provided the insight that at times, capitalist economies would require “the socialisation of investment”, by which he meant that the state would have to shoulder the burden of maintaining demand in the economy through its fiscal policy.
At some level, the message that when private investment was depressed public investment must take over, is no more than an application of economic accounting, but the proposal triggered an ideological backlash. Not all economists of the time were well disposed to the government intervention and larger public deficits, even when temporary, that was being advocated. However, confirmation of the validity of Keynesian economics came from an unexpected source. Hitler, through greater public spending on roads and armaments, showed that a market economy would respond to a Keynesian stimuli, and nothing like the hyperinflation of the Weimar Republic followed.
Impact of ‘oil shocks’
The Keynesian principle continued to work after the war, when the reconstruction of Europe meant that aggregate demand was maintained by public spending on the infrastructure that had been destroyed. The consequent unprecedented rise in living standards came to an abrupt end, though, with the two ‘oil shocks’ of the 1970s, when the petroleum exporting countries combined to hike the price of oil. This both sucked demand out of the oil importing countries and gave rise to inflation in them. Stagflation, a combination of inflation and stagnant output, followed. It is indeed correct that The General Theory was unprepared for this phenomenon, but a complete explanation of it was quickly provided by the Keynesian economist Nicholas Kaldor, and possible solutions identified. This did not receive wide enough acknowledgement, however, and a revival of pre-Keynesian economics, with its assumption of a self-regulating economy, occurred. Its leader, Milton Friedman, argued that in an unfettered market economy, unemployment would tend towards the ‘natural’ level, where presumably everyone who wishes to work would be working.
Accordingly, public policy should not target unemployment, attempting which could destabilise the economy, and focus on inflation alone. And, inflation was solely a function of money supply growth which must always be controlled. Friedman’s assertion of the optimality of the market gained impetus after the collapse of the former Soviet Union. His diagnosis of inflation led to a clamour for central banks to be made independent of politicians and given an exclusive mandate to target inflation. The arrangement came to be known as inflation targeting, with the claim that the central bank can fine tune inflation by moving the interest rate. The Anglo-American orientation of India’s policy makers meant that this view of inflation control came to be adopted in this country too.
The allure of inflation targeting is the implicit premise that the authorities, in this case the central bank of a country, will now be both devoted to and capable of controlling inflation. Nothing demonstrates that the latter is make-believe more than the runaway inflation presently on view across the world. Inflation in the U.S. and the U.K., the epicentres of the Friedmanite revolution in economics, is far higher than the targets set for their central banks by their governments.
The question is whether this reflects a lack of commitment on the part of the central banks of these countries or their inability to do anything in the face of an inflation sparked off by a rise in commodity prices, notably the price of oil and food, as is the case today. Obviously, it is the latter. Nothing else can explain inflation rates that are over four times the announced target. Faced with high inflation, Europe’s policymakers exhort that central banks should raise the interest rate further, even if it means triggering a recession. But we can now see that this is no permanent solution to a supply-side driven inflation as the present one is. Even if it were to be granted that the global inflation of the 1970s was contained by the policies advocated by Friedman, we see the problem is back four decades later, driven this time by the disruption of global supply chains due to the war in Ukraine. A recession works to lower inflation when it does by lowering output, and thereby demand; it cannot increase supply, a shortfall in which had caused the inflation to start with.
In the face of the evident failure of monetary policy in controlling inflation globally today, central bankers concerned with retaining their relevance make a renewed case for it by arguing that by pursuing a high-interest-rate policy, central banks can ‘anchor’ the expectation of inflation, and thereby inflation itself.
But why would economic agents harbour such an illusion when forming expectations of inflation? “How,” they are bound to ask, “can a central bank ever achieve this?” A central bank can dampen expectations of a depreciation of its national currency so long as it holds sufficient reserves of the dollar. However, would it have any leverage when it comes to commodity price expectations? No central bank holds stocks of petroleum or wheat. Therefore, it can never directly influence commodity prices, and the public knows this only too well. Having established itself by arguing that Keynesian economics has no explanation of stagflation, the challenge to it finds its own remedy for inflation discredited.
Coming back to India, there exists published research demonstrating that household expectation of inflation, based on data released by the Reserve Bank of India, is not a determinant of it. This makes it difficult to claim that inflation targeting, which is supposed to work via the central bank’s ‘anchoring’ of expectations, works in India. We have long known what needs to be done to control inflation in India, but the agencies responsible for macroeconomic policy ignore this knowledge when they hitch their wagon to the ideology of Anglo-American economics. The consequences are there to see.
Pulapre Balakrishnan teaches economics at Ashoka University, Sonipat