Conflict and inflation: Indian realities

Policymakers must be wary of using frameworks tailored by rich countries to address rich country problems when crafting India's inflation-control strategy

Eminent economist Olivier Blanchard recently sparked a lively discussion when he stated that “inflation is fundamentally the outcome of the distributional conflict between firms, workers and taxpayers.” The conflict Dr Blanchard refers to happens in a steady state, i.e. an economic situation in which all resources are fully employed and growth only occurs due to improvements in productivity, working-age population growth, or inward migration. But the drivers and impact of inflation are very different in developing countries.
 

The main thing to note about inflation in developing countries is that it is highly segmented, much more than in rich countries, because of a multiplicity of economic and social dualisms. Uttar Pradesh is poorer than Nepal, Delhi wealthier than Indonesia. Dalits consume less and earn worse than upper caste people. These dualisms have many consequences. First, given that the impact of inflation is differentially distributed, attempts at uniform macroeconomic control using the orthodox toolkit serve, at best, a small section of Indian society —organised capital and labour largely resident in urban areas. Public sector workers are a significant chunk of organised labour. The dearness allowance system acts as boilerplate protection against inflation for them. The private sector organised workers’ real wages trail the public sector, but not by much.
 

Second, for the poor, and for poor geographies, what matters is wage good inflation. Wage goods are things that are essential to survival. Thanks to a legacy of heterodox analytical attention paid to this problem in India, this is ameliorated, clumsily, but in substantial measure. This is done through fiscal, not monetary, policy, using social protection measures, such as  MGNREGS, mid-day meal schemes, cash transfers, and food and fuel subsidies. As long as the government is able to absorb price effects in the provision of these wage goods (for example, by regularly increasing MGNREGS wages and making adequate budgetary provision for inflationary increases in costs of provision) the impact of wage good inflation is, in effect, transferred to the government budget. Given boilerplate protection to the organised sector, this should be compensated by freezing direct tax thresholds and even increasing rates. Indirect taxes, especially on discretionary goods and services, will automatically see a rise in buoyancy. But if this does not countervail the expenditure increases there are fiscal difficulties, compounded by the central bank raising interest rates in response to a rise in the consumer price index, thereby making government borrowing more expensive.
 

Third, inflation was always less of a problem for the poor Indian than affordability. It does not matter what happens to the price of an ice cream if it is unaffordable. However, rising prosperity is changing this as many things have become affordable, but only at the margin. Mobile phones and data are a good example. Two-wheelers are another, as their recent slump in demand, relative to automobiles, indicates. Tariff barriers on Chinese goods may be a necessary national security measure, but the often uncounted consequence is that things that the less well off have begun to afford become more expensive. The inflation impact of trade policy therefore needs to be carefully assessed.
 

These (and other) dualisms mean that the impact of inflation and its transmission is not uniform. This has to be factored into an inflation impact control strategy. But that requires an analytical apparatus that the authorities simply do not possess — and will not, for they do not see the inflation problem as I have outlined. For the Indian macro-policymaker, inflation is something that impacts the volume and profitability of public investment, the cost of government debt, the exchange rate, and export competitiveness.
 

For these things there is monetary and exchange rate policy. The impact of inflation on people’s lives is what fiscal policy has to pick up — and does, for it is the most politically sensitive macroeconomic instrument. This has actually protected the poor and vulnerable as the fear of electoral punishment led to the maintenance and development of supportive programmes. Tough choices (such as pass-through of oil price increases) were made when it was realised that interventions to moderate oil prices actually benefited the rich. But the unwillingness or inability — it does not matter which — to make those protected from inflation pay for these measures has weakened the fisc, reflected in the fact that over two-thirds of central government borrowing finances consumption.
 

The conflict-inflation link is relevant, even crucial, in India but we must be wary of falling into the same analytically empty, empiricist, trap of the “output gap” economists. The historical, social and structural conditions of rich countries are very different from those in developing countries. India in particular is a country with complex dualisms, which are macroeconomic in nature given the sheer size of the country. Each dual represents a theatre of conflict.
 

The clarion call across the world is for crafting inflation control policy with citizen welfare, rather than some abstract notion of macroeconomic stabilisation, in mind. Orthodox inflation theory is in tatters, which is why Dr Blanchard said what he did. In India we would do well to build our policy analysis and solutions around the conflict areas that the dualisms present, when we craft macroeconomic policy. We must not, yet again, borrow a conflict framework tailored by rich country economists to address rich country problems.

The writer is managing director, ODI, London. r.roy@odi.org. The views are personal