The Hindu Business Line : Engineering solutions to inflation

Conventional economic theory holds that interest rates will have to be raised to reduce money supply and curb inflation. But this is a win-lose option as it will also slow down economic growth. Is there a win-win option? Yes, says P. V. Indiresan, if we take an engineering approach to economic problems.

AS A matter of interest, the characteristic curves that engineers use to study machines or transistors are similar to the supply-demand schedules economists use to analyse inflation. Therefore, it should be worthwhile to consider the suitability of engineering approach to economic problems such as inflation.

There are three causes for the present inflation:

the oil price rise;

spurt in the Chinese demand for steel; and

fears of drought due to delay on the onset of monsoon in Northern and Western parts of the country.

Increase in foreign exchange reserves is yet another cause of inflation but that is not new.

Increases in the prices of oil and steel raise production costs; they lead to cost-push inflation. The spurt in prices of vegetables has nothing to do with cost of growing vegetables. Traders are taking advantage of the erratic monsoon to increase their profits at the expense of the consumer. The excess profits vegetable merchants and steel producers make put more money into their hands (and possibly in the hands of their employees) to create demand-pull inflation. Thus, these days, both types of inflation are hurting our economy.

The government is under great pressure to raise interest rates to remedy this situation. Wisely, both the Government and the Reserve Bank have resisted such pressures. Higher interest rates induce people to save more and, thereby, reduce the amount of money floating in the economy. In turn, that will force prices to come down. That is true but it is a win-lose game.

Increasing interest rates is a win-lose game because of two reasons. One, when higher interest rates cut down consumption, that reduction curtails economic growth. Ours is a developing economy, which needs to grow rapidly. Our people are poor; they have too little; we should help them to consume more, not less. Hence, increasing interest rates is like giving less food to a growing child. Second, higher interest rates increase costs of production all round, even in those sectors that are not guilty of fuelling inflation. Hence, higher interest rates will raise prices all round, and nullify the efforts to contain inflation.

The government has mitigated the problem by reducing duties on petroleum products. Politically, that is a good move because customers will pay less. Economically, this solution too is a win-lose game. The government, which is tottering under financial strain, will earn even less. Fiscal deficit will increase and that will tend to increase, not decrease, inflation. In addition, oil companies will have less money to invest; less production capacity in the future. Therefore, the government's move helps consumers to spend more now but at the expense of having less to buy in the future. This win-lose game too is not a good idea.

We need a win-win, rather a win-win-win idea by which

(a) production costs decrease;

(b) demand becomes manageable; and

(c) the government loses nothing, and may even profit a little. Communication engineering has techniques that offer multiple benefits: For example, it is possible to reduce the power of radio transmitters, and yet, get clearer signals. There is, of course a cost. It requires sophisticated technology, more time to process but it does reconcile apparently contrary requirements.

The following example illustrates how such ideas of engineering may be translated to the economic scene. Let us take the case of a consumer who earned last year Rs 120,000 and saved out of it Rs 20,000.

Then, he spent the balance amount of Rs 100,000. Suppose his earnings this year increases to Rs 140,000 and his savings to Rs 25,000, leaving Rs 115,000 for expenses. As the economy is growing, there are more goods to sell and buy.

Therefore, this consumer should be able to spend a little more than last year without causing inflation, say, Rs 105,000. Then, Rs 105,000 is acceptable expenditure; the actual one is Rs 115,000. The extra expenditure of Rs 10,000 creates inflation.

The Government can force this consumer to spend less in two ways: In the first option, the government could impose a tax on the excess money spent on buying goods that are not there. In other words, we are talking of a tax on increases of expenditure over last year's, and that too after making suitable allowances for real growth. It is not the usual expenditure tax, which taxes the whole of expenditure. This one taxes "inflationary increase in expenditure" only.

In the second option, the consumer need not pay any tax at all if he saves the excess income. Let us consider what happens if the consumer opts to save. At present, the incremental capital-to-output ratio (ICOR) is about four. That is, one rupee of fresh investment will increase GNP by a quarter of a rupee. Or, the rupee invested today would have produced one rupee worth of extra goods in four years. Hence, the saver can safely withdraw his rupee after four years and spend it with the assurance there will be an additional one-rupee worth of goods in the market. Then, expenditure matches supply; there will be no inflation.

If the consumer opts to spend and not save, he pays, ideally, 80 per cent tax. If the government is wise, it will invest the entire amount. Then, with an ICOR of four, increase in output will exactly match the balance 20 per cent he spends. Thus, there will be less deficit financing and no inflation.

When the consumer opts to save, interest rates will actually decrease, not increase. Produces have smaller bills to pay, and their costs will decrease. Prices will come down and once again, inflation will decrease.

All this may look a bit complex but not as complex as tax regulations are already. As in the case of communication systems, we use a little more sophistication, we wait a little more time, but secure multiple benefits.

A similar tax savings mechanism may be applied in the case of producers also. When they get windfall gains, producers have two options — invest or pay higher wages and dividends. If they invest, production will increase.

That is good and desirable. No action is needed in that case. When dividends and wage bills become more than last year's, there is excess expenditure. That is the same as a consumer spending more than what the economy can supply and causes inflation. Hence, increased outgo on dividends and wages may be treated on the same lines as inflationary increase in consumer's expenditure, except for one change.

In expanding production, the producer may employ more workers, and that as the Bible says, is a consummation to be devoutly desired. Therefore, in the producer's case, in calculating the tax on Inflationary Increase in Expenditure Tax, additional adjustments should be made for increases in employment also.

It is a curious fact that the government encourages business development in many ways but not for increasing employment. It gives incentives for import of equipment, for buying machinery, for acquiring land, but nothing at all for creating more jobs. Inflation tends to curtail employment. Therefore, in an inflationary atmosphere, it is important to encourage job creators. Then, consider the following suggestion: For every new job created, the employer gets a clear credit of Rs 3 lakhs (or four years' wage whichever is lower) at the Prime Lending Rate. I suggest the figure of Rs 3 lakhs because that is the average investment these days to create an extra job. I suggest four years' wage because our ICOR is four.

Admittedly, there are many simplifications in the proposals made here. In practice, many more factors will come into play. The numbers suggested are by no means accurate and are suggested only as indicative of what will be reasonable. However, it would be best to keep the method of estimating inflationary expenditure as simple as possible even if that is not perfect and does not satisfy every eventuality. We have to balance the openings that complicated regulations create for tax evasion and litigation against possible loss of tax income. On balance, it is better to forego some amount of tax income rather than invite litigation and criminalisation.

The purpose of technology is to create win-win games. Technology has succeeded in that endeavour continuously for thousands of years. It has done so in spite of the fact every new idea faced severe opposition and damaging restrictions. When the automobile was first introduced in the UK, the rule was a man should walk ahead of it with a red flag to warn unwary horse carriages. That meant no automobile could proceed faster than a man's walk. Ultimately, technology triumphed because it produced a cheaper option than horse carriages, and believe it or not, less polluting ones too. (Just imagine what the state of our roads be, how much dung they would leave on the roads, if every car were to be replaced by an animal drawn vehicle!) Here is a simple solution drawn from technological experience to an undoubtedly complex economic problem. It will require much re-working, but ultimately, it may work!

(The author is former Director, IIT, Madras. Response may be sent to: indresan@vsnl.com)

(This is 130th in the Vision 2020 series. The previous article was published on August 9.