India needs lower taxes, supply side miracle - not rate hikes

The stubbornly high inflation rate in India despite the Reserve Bank of India’s (RBI’s) continued tightening of monetary policy raises the spectre of stagflation - which is a mix of high inflation and economic slowdown.

At the latest policy meeting on 16 September, the Reserve Bank again hiked rates by another 25 basis points with the goal of licking inflation. But the RBI ought to realise that at some point high interest rates will lead to high inflation. Also the time has come for the Indian government to take some action as the RBI alone cannot solve the multi-year, fiscal deficit-triggered problem of inflation.

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High inflation and a slowdown create a vicious stagflationary circle that’s difficult to break. Corporates are already complaining that the continued increase in interest rates is slowing growth. Slow growth negatively affects the supply of goods and services. This, in turn, pushes prices up, leaving inflation stubbornly high.

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In India, the interest rates on savings have dramatically gone up over the past several months. This by itself increases money supply by putting more cash in the hands of individuals, increasing demand for goods and services - which is ultimately inflationary. In a scenario where the output of goods and services slows down, higher demand only increases inflation.

The RBI has been trying to achieve price stability by targeting demand. It does this by manipulating money supply. Hence to increase demand it reduces interest rates and raises money supply. It does the opposite to reduce demand and prices.

The policy has not been hugely successful and, if one looks to the past, when have you seen prices fall and stay low for a sustained period of time? All that India has seen is rising prices year after year.

The RBI has taken a hawkish stance in its last policy review and is expected to continue to raise interest rates. That policy is going to damage growth and create crippling stagflation. But if the RBI cuts interest rates, one could once again see inflation rates jumping to 15 percent or higher - just like it did in 2010.

So what’s the solution?

Targeting prices through demand control alone will not work. The supply side too has to be targeted. An increase in the supply of goods and services will bring down prices and stubbornly high inflation. This is what the US had done in the 1980s, under President Ronald Reagan and Federal Reserve Chairman Paul Volcker.

Volcker hiked interest rates to cut inflation and Reagan, through fiscal policy, cut taxes and reduced regulations, which resulted in a spurt in fresh investments. The new investments boosted the supply of goods and services, which led to a 20-year boom in the US.

The Indian political class needs to support the Reserve Bank by facilitating the entrepreneurs of the country to invest and grow. Getting the Indian government out of the way by reducing regulations and taxes can boost Indian growth, which will lick inflation. Supply side policies are not only economically wise, but also morally right.

Playing with the value of citizens’ money through monetary policy is not right. It’s a breach of trust that citizens place in the value of the rupee. Supply side economics is moral as the government lowers taxes to give money back to the people to whom it belongs in the first place.

The Reagan-Volcker economic revolution has proven that supply side policies work. It’s time for India to take the leap.

The author is Editor, www.capturetrends.com