The Hindu Business Line : Inflation: The unusual suspects

Dr Y. V. Reddy started his stint with the aim of cutting down the CRR to 3 per cent, though rising commodities inflation has forced him to increase it now to 6.5 per cent. But even this 6.5 per cent is way below what will truly contain inflation and it is almost certain that he, and other central bankers, will be chasing the inflation curve for the next decade or so, says SHANMUGANATHAN N.

The greatest trick the devil ever pulled was convincing the world he didn't exist.

— Keyser Soze, in The Usual Suspects

These days, when prices go up, the blame is usually laid at the doorstep of greedy corporates, the weather and supply constraints. But the only reason for prices going up is the central bank's creation of excess money. It is not that the prices of goods and services are going up — rather, the price of money is going down — and yet, in spite of the overwhelming objective evidence, central banks are seen as the guardians against inflation rather than the perpetrators.

Whatever their failure in maintaining purchasing power, the central bankers can genuinely claim that what Keyser Soze merely attempted in the film The Usual Suspects, they have truly achieved.

But how did the central bankers manage this? There are three fallacies in the way apex banks calculate inflation and, unless we force them to change their orientation, the ultra-loose monetary policies will continue to destroy the purchasing power of money and, indeed, the country's industrial base itself. The three fundamental flaws are:

Using the wrong definition of inflation

Using a limited asset class to mask the true spill-over effects

Using wrong weightage to arrive at a lower Consumer Price Index number

Of course, central bankers would say that the above are not bugs, but features of monetary policy.

The Wrong Definition

Inflation, as any economics book would define, is "the supply of excess money and credit relative to the goods and services produced, resulting in increased prices". We should understand that increased prices are the result of inflation and not the definition of inflation itself and what central bankers are reporting through the CPI/WPI/Core Rate is the outcome of inflation.

The measurement of outcomes rather than causes offers a two-fold benefit: Shifting the blame away from government mismanagement. As soon as we understand the fact that it is expansion of credit that is causing prices to rise, it is easy to see who is causing it. Instead, when the Government defines inflation as rising prices, this allows it to put the blame on greedy corporates, or OPEC or supply constraints. It is indeed ironic because the only commodity where citizens do not have any control over the price is money. With regard to all other commodities, such as cement and steel, we make conscious decisions and, excepting in cases of a monopoly or a cartel, make voluntary purchases based on free will.

So governments blaming the market for rising prices, instead of looking at their own printing presses where currencies continue to be debased, is confusing the cause and effect. The cause is debasement of the currency and the effect is increased prices.

The measurement of outcomes can be made very subjective, thereby masking the true picture of inflation. Instead when the cause is reported, then the measurements are not subject to misrepresentations.

Masking the Spillover Effects

There are three asset classes — financial assets (stocks, bonds), real-estate (houses, farmland) and commodities. What the central banks usually measure in the inflation definition is only a limited set of the commodities asset class.

If they were to measure a weighted basket that comprises all three asset classes, the results in measurement of outcomes (price increases) and causes (money supply) would be the same. Ignoring the other two asset classes, as India does today, makes no economic sense whatsoever, though it makes great political sense to paint a lower inflation number that the truncated calculation allows. For example, real-estate prices in most parts of the world have gone through the roof over the last few years and in omitting this, central banks have been able to paint a more benign picture of inflation.

Even apart from puritan economic principles, it should be recognised that every human individual aspires to have a house of his own while also investing in some financial assets. And in ignoring these asset classes, the inflation numbers do not really reflect the cost of living of an individual.

Who benefits from inflation?

In spite of claims by politicians and central bankers around the world, the only constituency that stands to benefit by inflation is the government. The reasons are fairly straightforward:

Playing Santa Claus: Governments around the world like to indulge in all kinds of populist socialist programmes and the only way this can be funded is by printing money. Using taxation to raise resources has limits and so governments choose the route of inflation, which is really invisible taxation.

Biggest debtor: Any debtor would really stand to gain during inflationary times and, today, government is the biggest debtor and issuer of bonds. Therefore, using inflation, these debts can be easily paid off while the creditor would receive just nominal gains.

In fact, it can be said that inflation is truly "of the government, by the government and for the government".

Central bankers have meekly subjected their economic judgment on monetary issues to the whims of politicians over the last two decades and for a true guardian of the purchasing power, one has really to go back to the days of Paul Volcker. However, the asset inflation of the 1990s has transitioned into the commodities inflation since 2001 and very few central bankers even understand what is happening.

Central bankers around the world have managed a gigantic hoax on the true cause for inflation, and that too for an extended period of time.

The Goebbelian maxim of "if you tell a lie big enough and keep repeating it, people will eventually come to believe it" seems to have worked. In fact, it has worked so well that even central bankers do not really understand what is happening.

As Warren Buffett puts it: "A person who misleads others in public will eventually mislead himself in private."

Nobody demonstrates this better than the Reserve Bank of India Governor. Dr Y. V. Reddy started his stint with the aim of cutting down the Cash Reserve Ratio to 3 per cent (from the then 4.5 per cent) but rising commodities inflation has forced him to raise it now to 6.5 per cent.

But even this 6.5 per cent is way below what would truly contain inflation and it is almost certain that he (and other central bankers around the world, for that matter) will be chasing the inflation curve for the next decade or so.

(The author is a Chennai-based financial adviser.)