One is surprised that how clueless the government is in controlling the price rise in India. Equally clueless are those who are reluctant to look beyond the conventional arguments of hoarders, traders and weather, to blame for price rise, as if these are responsible for the across the boundary inflation in all emerging economies. One wonders, if the hoarders are such an organized group with excellent cold storage facilities and where they can keep significantly large perishable goods for a long period of time and in a coordinated way across the country or globe? A recent sting operation by a news channel even failed to find any hoarders or groups who can be held responsible for a general price rise across the country. While hoarders and speculators take advantage of a situation and add salt to the wounds, they are not the prime reason of price rise which is happening in all emerging economies as a result of inflationary economic policy.
The price rise is due to the systemic issues in ours and global economy which are coming to the fore everyday. When loads of money is printed and distributed to the unproductive service sector, people who are feeding the society starts turning away from production. The decreasing productive class has to compete with increasing unproductive class who have got almost all the share of this cheaply printed money to make a claim on the same amount of supplies. This results in prices to rise. It is not the prices of commodities going up but the value of currency going down because more cheaply printed money is being pumped into the economy and which is devaluing the currency. When this is being done globally, thanks to the the economic policy of globalization, we have to devalue our currency in line with dollars to keep our exports competitive. Debt based consumption combined with reckless printing of money and the fractional reserve system is the real cause of price rise.
Let us first understand what a fractional reserve system is. Owing to what is called as fractional reserve system, when government creates money, the total money that is created in the system is increased many times more. To understand, Let us say initially there is a 100 unit of new money deposited in the bank. The bank is allowed to loan all except a certain minimum percent which is called as cash reserve ratio. In India this ratio is currently 6% but for convenience let us assume this ratio is 10%. The bank will then keep 10% and loan 90 to other customer. The borrower will then make a payment to avail goods and services at the cost of this loaned amount which is a “promise to pay”. The person whom the borrower has made the payment deposits this Rs 90 to some bank thereby returning this money to the banking system. The banking system will then loan 81, and keep 9 with it. So 100 unit of new money by way of loans can create a money of 1000 unit in the economy. While the actual money is 100, the money created in the economy is all loans or promise to pay. The money was created from thin air and banks have been loaning what was actually not there, with them.
For more clarity please visit fractional reserve system video else where in my blog.
Quantitative easing or printing of money coupled with fractional reserve system creates a flood of money in the economy. Increase of money if not in proportion to supply of commodities will create prices to rise. When the supply side is taken care of, by increasing debt and importing goods from outside, inflation is controlled but trade deficit and external debt rises. Since the cheaply printed money can now buy loads of goods available in the market with low prices, it results in people believe “Wow! What a prosperous economy?”. But what we forget is that this prosperous life is at the cost of future consumption since the debt can not grow indefinitely and has to be repaid with interest. The bubble has to burst. When the continuous debt becomes difficult, supply of commodities is affected and inflation goes up. It is precisely happening in ours and many other economies now. Due to the sovereign debt crisis that we are seeing in Europe, many economies like India have become conscious of their increasing debt levels. Since they are now trying to contain the debt, the supply is affected, resulting in price rise. Note that recently our imports growth rate has reduced and was overtaken by exports growth rate. While many cheerleader journalists considered their job done by applauding the trend, few have attempted to understand the impact on supply because the government is now conscious of the debt levels and is trying to contain the imports. This will inevitably have an upward pressure on the prices as while the demand is being sustained by the availability of money, the supply is reducing.
Due to our dependence on high imports and debt, foreign exchange becomes extremely necessary. The dollars we get from our exports have been the result of same economic policy of stimulus or quantitative easing coupled with fractional reserve system. This leads to devaluation of currency. Due to devaluation of dollars, our currency appreciates and therefore exports suffers. Therefore the country need to devalue the rupee in line with the devaluation of dollars so that exports remain competitive. This is done by printing of money and increasing liquidity. So next time when we hear something like “government is injecting capital in the economy through xyz bank.”, we will know that this is devaluing the currency. The contradiction is evident in the government policy when on one hand they increase the money supply, on the other hand raises the interest rates to absorb the liquidity.
The reason for the contradiction I explained above is the shortsightedness in the leadership. When Friedrich Hayek asked John Maynard Keynes that his theory is dead in long run, he said “In the long run we all are dead”. Well that explains the chosen shortsightedness that prevailed over the world leadership after the 2nd world war. Shift in fundamental values do not necessarily show its result within a span of a few months or years but may be in decades or centuries. And this is what precisely happened here. The shift from fundamental principal such as Say’s law “supply creates demand” to Keynes’s principals of inflation or quantitative easing creates demand, helped to create a prosperous society in the west which thrived for decades, on debt based consumption until recently when their growth on debt became unsustainable. We have been simply following the west who adopted keynesian principals during and after 2nd world war. Inflation does not create demand but does a smart theft of purchasing power of common masses without them realising that they are being looted everyday thus making them poor and increase disparity in the economy. Inflation is devaluation of currency. It is printing of money and increase of money supply. Its not the price of commodities going up but the value of currency going down simply because too much cheaply created money is chasing too few available goods.
Says law of supply creates demand puts a descipline in place. It tell us that before one make a claim on goods produced by others one must meet his obligations of producing goods to pay back in return. In vedic principals this can be translated as “Ten tyakten bhunjitha” which means one should only consume after making a sacrifice. An example of supply creates demand is that if a shoe-maker wants to earn more money, he needs to produce more shoes to earn it. Money eventually is a claim to others labours by ways of commodities. We can’t just print money out of thin air and give it to a person who does not produce and spend, thus competing with those who produce. For the limited set of goods if unproductive people are made to compete with productive people, prices will rise. Today we see around us all the service sector based jobs who are getting a large share of this cheaply printed money while the poor farmers who bear the burden of this phony service sector are made to live a life of abject poverty.
In near future, I expect that eventually whether willingly or due to global events such as dollar crash, it will be difficult for the government to increase the debt to import and increase the supply. Government will put the burden of national debt on tax payers and to reduce imports bill will increase the prices of fuel. Increase in the prices of fuel has a direct bearing on prices of all commodities as transportation prices increases. At this situation, I expect that the government will try to absorb the liquidity, by exorbitant rise in taxes and interest rates. This will cause economy shrinking and GDP growth will be affected and go down significantly.
The timing may be debatable though I strongly expect it to happen in 2011 but the downward pressure of the GDP will require a stimulus to prevent a 2008 style bust. This is because a series of job losses caused by austerity or savings will result in defaults causing a crisis in the banking system. A quantitative easing on the other hand will cause massive inflation and if continued then eventually end up in zimbabwean style hyper inflation. The government will have to adopt one of the two evil choices, either to default which means liquisity crisis or to choose hyperinflation which means the paper money will loose its value. It is not just a problem limited to India but many countries including Europe and US who have been doing the same will face the same problem. Europe is still facing the same problems and many countries like PIIGS (Portugal, Ireland, Italy, Greece and spain) have been facing the same debt crisis and looking for one round of quantitative easing after another to bail them out. They have been bailed out in May 2010 by a round of quantitative easing and they are now again requiring another stimulus. Uncle sam though with unique advantage of reserve currency is leading this road but surely will be the first to fall from the cliff as it has unsustainable levels of debt. The inevitable crash of US dollar will result in the collapse of global financial system.