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Saturday, June 07, 2008

We have seen this movie before

In the 1970s, the oil shock kicked up inflation all over the world. At the time, monetary policy was poorly structured the world over, and governments did all kinds of silly things in combating inflation. This messy combination of policies helped trigger of the painful period of `stagflation'. For economists, though, it was a great period in that it triggered off new thinking about what monetary policy should do. These new ideas have reshaped monetary policy in all high-income countries. New ideas of monetary policy have helped usher in the `great moderation' where recessions are shallower and shorter. I have an article We have seen this movie before in Financial Express today where I interpret India's problems with monetary policy and inflation from this point of view.


  1. Do you believe we will see an appreciable acceleration in agricultural output this year due to inflation and the farm waiver?


  2. Ajay, thanks for that excellent piece.

    I have a few questions for you, if you have the time. I'm from Sri Lanka, and as you might know, we have a severe problem of inflation in the country with the official rate according to a slightly controversial new CPI index hovering at about about 25%, whereas according to the old index (which is no longer published) inflation is more than 30% according to estimates by some analysts.

    In Sri Lanka there is a view, subscribed to by most journalists and promoted by the central bank, that inflation here is primarily a petroleum phenomenon. The argument is basically this :

    Proposition 1 : price of oil has gone up
    proposition 2: everything is transported using oil (additionally fuel is used to generate electricity).

    Conclusion: this means cost of production of everything is increased, which affects the bottom line of companies so they raise prices. this is inflation, central banks can't do anything about it.

    Now I know "Cost Push" inflation has been addressed by many scholars, but the theory doesn't seem to go away. Central Bankers here say there is a "demand pull" and "cost push" components in inflation, and demand pull has been controlled where as the cost push can't be controlled by the central bank.

    They say the comparisons with other regional countries cannot be made since the price indexes are built differently (that's true, but can that account for the stark difference on rates is the other question)

    So my questions to you, as a student of economics, are these:

    1) In your opinion, how strictly do contemporary central bankers both here in subcontinent adhere to the Friedmanian monetarist view that inflation is "always and everywhere a monetary phenomena" ?

    2) what are your views on inflation as a petroleum phenomenon? :)

    3) Given the institutional failure of central banks to be independent, particularly in Sri Lanka (President's buddy sits as it's governor) would you recommend a currency board arrangement for countries like Sri Lanka? I know you have been a critic of RBI's dollar-pegging, but Steve Hanke most notably and others here think it's a better idea, than say legislated inflation targeting.


  3. Deane, I don't know a lot about Sri Lanka. I can see a few problems, though.

    From 1/1/02 onwards, LKR depreciation has averaged 2.2% per year. This doesn't sound very good, at a time when inflation has been high. Could this be setting the stage for trouble in the form of a speculative attack and a large depreciation?

    When inflation is at 25%, why should citizens hold currency notes or nominal bank deposits? What is the trigger at which dollarisation (or rupeeisation) takes off? When that happens, LKR money supply to GDP will drop, the revenue potential of the inflation tax will go down, and the government will then have to set about building a better fiscal system. But along the way, on this route, things could get very painful.

    Either in such a crisis, or ideally before it, the government would have to evaluate a monetary policy reform. This involves rewriting the core legislation governing the central bank, and getting it going afresh. One possibility is to run a currency board - though a currency board to the Indian rupee might make more sense to the extent that Indian GDP probably has a higher correlation with Sri Lankan GDP when compared with the correlation against US GDP.

    Are intellectuals in Sri Lanka thinking about these things? They should be. It's better to think through these things ahead of time. Crises are good times to do economic reform - provided fully articulated and well thought out reforms proposals are at hand and can be pressed into service. Else, crises can lead to all sorts of wonky ideas getting used.

    I'm totally unsympathetic when central bankers make excuses about inflation not being in their control. Look around the world: There are a lot of countries, all of which are facing the same shocks, but inflation hasn't crossed 5% in lots of them.

    There are two kinds of blunders taking place. One class of blunders is the intellectual one - of people who haven't properly figured out monetary economics being placed in roles of running central banks. The other kind of blunder is that of institutional design - of a central bank that is not properly structured to focus on the task of inflation.

  4. "...As an example, in the US, a rationing system was put into place where cars with odd numbered plates were only permitted to buy petrol on odd numbered days!..."

    Haha... I mean they really did that?
    Wow! that is innovative... I must say :)

    [I just had to post this comment, couldnt really stop myself]

  5. Thanks Ajay. There are a few people who are talking about reforms -- currency boards, inflation targeting, so on. But none of them are in a position to actually implement reforms, in the current administration anyway.

    Hopefully CBSL would have the good sense not to create a zimbabwe-type situation. I think they have tightened monetary policy recently, possibly the pressure of some local economists.


  6. Dear Mr. Shah,
    Undoubtedly you would be unsympathetic to the central bankers as it is easy to give prescriptions and comments where as it is difficult to use monetary policy tools to fight inflation especially one which is driven by supply side factors. People thought that Greenspan can do no wrong. After sub-prime he was demonised. Now the debate is on whether Bernanke was right in cutting rates. Inflation targeting is good in times of great moderation but will it stand the test of the present turbulant times? We will soon find out. Is it possible for a country like India to have a Central Bank that only focuses on inflation? the record of Filipino central bank does not inspire confidence. Surjit Bhalla asks policy makers to wait. (See the link ) So can we absolve the central bankers of the blame. I request that you should explain your remarks about people who donot know monetary economics occupying positions in the central bnaks and faulty institutional design of central bank. If you are hinting at inflation targeting central bank for India then your cure may be worse than the desease.


    Why not? What is the problem with Indians? Indians are the same as people in developed countries. They also want protection from the government confiscating their wealth secretly through inflating paper money and driving up the price of commodities and houses as compared to the value of worthless paper money.

    Anonymous, do you think Indians are less than human so as not to deserve to have money that is a 'store of value' as economists claim money to be? Are Indians a second class type of citizens not to deserve a low inflation currency? It is a human right to have good money. Are Indians animals?

    The only job of the central bank should be to give money that preserves its value and allows Indians to take it out of the India to any country they wish (full convertibility). Capital mobility is a freedom also. That central banks can create growth is a falacy. It can only create poverty through inflation.

    Paper money central banking is a fraud. Probably the best and the most complex fraud devised by humankind to date.

    Inflation targeting is also a fraud but less of a fraud than high inflation. That a low (2-3 percent) inflation is needed for 'development' is just an excuse to keep government debt costs low in face of a national debt that is never repaid and keeps constantly growing. Actually a gentle deflation (say 1-2 percent) would be better for ordinary citizens outside government. That will put the breaks on government.

    Under the gold standard (before 1971) or before the second world war to be more precise, there was no inflation except when central banks suspended gold covertibility by too much money printing. There was no inflation in India, Africa the roman civilization or wherever.

    Of course in the old days also kings used to debase coins. But through paper money central banks like RBI and the Fed the process of debasing has been given a new meaning.

    Ajay it is people like you who will ultimately save the poor. keep it up.

    To everyone who thinks RBI should not be told to do its job and issue a sound money here is food for thought.

    "It is impossible to grasp the meaning of
    the idea of sound money if one does not
    realize that it was devised as an instrument
    for the protection of civil liberties
    against despotic inroads on the part of
    governments. Ideologically it belongs in
    the same class with political constitutions
    and bills of rights. The demand for constitutional
    guarantees and for bills of
    rights was a reaction against arbitrary rule
    and the non-observance of old customs
    by kings. The postulate of sound money
    was first brought up as a response to the
    princely practice of debasing the coinage." - that was Ludwig von Mises by the way.

    Low inflation (or deflating) money is your right. It is a very reasonable right. Fight for it. If you shut up and wait and listen to 'supply push' stories you will never get it.

  8. One more thing.

    Central Banks - even inflation targeting ones - DO NOT FIGHT inflation. That is just a story they sell to gullible people who believe in cost push inflation. They CREATE inflation. Okay??


