Inflation for dummies – by a dummy

19Apr07

This post is the result of millions of hours of reading of excellent articles and books on inflation from the Austrian perspective and the Friedman perspective, millions of hours of current reading of Ajay Shah (1, 2, 3) and Ila Patnaik (1, 2, 3, 4) as well as the mistaken editorials, op-eds, columns and interviews in the Indian media. I just had to get this post out of my system. Mint, as an aside, disappoints me completely and I feel somewhat (perhaps in a silly way) cheated at being promised a libertarian publication and receiving an intellectually dishonest pro-welfare state, regulation-monger.

Here is my attempt at explaining inflation with an intuitive and hand-waving approach. I am of course hardly trained to provide a formal, rigorous approach, but as anyone who has done analog design would know, intuition and knowledge of the basic handles to turn is often more important that mathematical precision. Feel free to critique my explanation, hopefully without nitpicking on technical details. Keep in mind that this is a vast simplification of the underlying dynamics, intended for dummies from a dummy.

Inflation is entirely and only due to an increase in the money supply in the economy. In fact, if you look at the original definition of inflation before it was manipulated by media-savvy central bankers covering their behinds, inflation is the increase in the money supply. Price rise is an inevitable consequence of inflation. I think only the Austrians say this nowadays. However, the main point is: there are no such things as “cost-push” or “demand-pull” inflation as you hear in the media. Just disregard it if someone explains inflation through taxes, duties, speculators or some other kinds of “pressures”. These are theories that have already been debunked decades ago, yet they persist, mainly because politicians and central bankers – the creators of inflation – want to push the blame on abstract technical terms. A simple straining of the logical faculties of one’s mind should make the fallacy in these theories at least intuitively obvious.

If the cost-push theory is valid, then inflation should result from increase in costs of some items in the economy even when the amount of money in circulation is constant. Cost-push means that some goods and services in the economy become costlier (say food grains, petroleum, cement, wages etc as well as those that depend on these goods and services) due to various factors such as a drop in supply – say a bad year for agriculture, war in the Middle East, increased sales taxes, export subsidies causing scarcity in domestic markets, engineers exporting themselves abroad raising the wages of engineers staying back etc. If the total amount of money chasing the total amount of goods and services is constant, and some of those goods become more expensive, the total amount of money chasing the remainder should reduce. Also, since the total amount of goods and services has been simultaneously increasing in a growing economy, there must be less money chasing more goods and services, except those ones that became more expensive, making those goods and services cheaper. Thus, if money supply is constant, there cannot be a general rise in the price of everything based on a rise in costs of some things. Such a price-rise, across the board, can take place only if the total money chasing the total goods and services has increased.

Similarly, if the demand-pull theory is correct, then an increased demand for some goods and services should produce a general price rise in the economy. This is clearly impossible as well. If the total money supply in the economy is constant, then increased demand for some goods and services should mean reduced demand for certain other goods (in a growing economy which produces more goods and services per year even more so), thus leading to a drop in their prices. Again, under constant money supply, a general rise in prices of everything is impossible.

The Reserve Bank of India creates inflation. It is simultaneously a bank, bank regulator, part of the executive branch with the Ministry of Finance and a large player in the foreign currency market. It prints banknotes, tries to regulate interest rates and manipulates the rupee price.

It needs to print money for two reasons. Since it is part of the ministry of finance, whenever the government runs a large project it cannot cover with taxes, the RBI prints money. Printing more money means inflation. That is, among many others, an important reason to be wary of government projects. Many such projects are thus financed by money generated out of nothing, producing inflation. That’s why inflation is a tax which we pay equally, independent of our income, and do not even realize it as such.

The second reason why the RBI prints money (inflates, to be sure) is when it tries to keep the exchange rate of the rupee with the US dollar nearly constant. The rupee is officially a floating currency whose price is defined by the market, but the RBI intervenes heavily to manipulate the price of the rupee at regular intervals. How does it do this? By buying dollars with freshly printed rupees in order to keep the price of the rupee low (i.e. more rupees per dollar). It needs to do this because many foreign investors want to put their capital in a globally interesting economy like India, thus increasing inward dollar flows. These dollars need to be converted into rupees before they can be used, hence pushing the demand for rupees higher. This would have made the rupee more expensive (less rupees per dollar) unless the RBI bought dollars with new rupees. These new rupees “created out of nothing” find their way back into the Indian economy, since that is the only place they can be used to buy material stuff with, and result in inflation. Why would the RBI want to keep the rupee cheaper? One reason is to keep enough dollar reserves in the country (itself an artificially created necessity, whose basis is not at all obvious to me). Remember to wince the next time you hear a chest-thumping article on India’s dollar reserves that you and every citizen of India paid for them without being aware of it or understanding why they were needed (If a restaurant did that to you, you’d call it cheating). Even assuming a valid basis for maintaining dollar reserves, India has long had more of them than prescribed by experts according to all possible criteria of sufficiency. Why then is the RBI interested in keeping the rupee cheap? The reason for this comes from the deeply flawed belief that exports are the most important thing in international trade. I will come to the absurdity of the importance given to exporters shortly. Since we believe exports are crucial, we feel the need to encourage them by keeping the dollar more expensive. This increases exporters’ rupee profits. However, the fall in the prices of the rupee (more rupees per dollar) is accompanied by a fall in the purchasing power of the rupee in India, thus simultaneously increasing the costs of production of the exporters. The RBI tries to aim at an exchange price which optimizes the net gains of the exporters from the increase in their rupee profits as well as costs of production. However, the other job of the RBI – to keep prices low – conflicts with exporters’ interests. Hence the knee-jerk responses of the RBI trying to satisfy varying special interests and creating artificial boom-bust cycles. To realize how severe the currency manipulation has been, note the recent over 10% gain in the rupee price (less rupees per dollar) in three days when the RBI didn’t step in to buy dollars.

I am an exporter myself. I have exported myself abroad and earn a salary in foreign currency. When I send money to India, I benefit from the cheap rupee, since it gives me more rupees to spend in India. Several of my relatives earn salaries in dollars and have their savings tied to the exchange rate. If we returned to India for good, we stand to lose a dramatic amount of our savings if the RBI lets the rupee really be determined by market rates. So the next time you hear of India’s export successes, including the human exports of workers, remember it was you and every Indian citizen – including the poorest – that subsidized that success through inflation without even knowing it. The RBI has decided that we exporters should profit by theft. Be sure to view the next exporter’s cries of help at the doors of the RBI with utmost contempt.

The RBI should be decoupled from the executive branch of government, stop manipulating the currency and most crucially – stop printing it. Ideally, it should freeze the amount of liquid money and permanently close the printing presses and mints. I am too amateurish to think of a way to make it stop manipulating the interest rates through its fractional reserve system, but the least it can do is to end the conflicts in its mandates and the funding of inefficient government projects as well as special export interests through mass theft.

Now, an excursion to understand why exports are overrated. The importance of exports is a spurious notion perpetuated by the idea of applying national borders to economies. The standard of living of the people of a country is not decided by how much they sell to people of other countries. It is decided by what they consume. In a market, individual people produce goods and services that other individuals would like to buy and thus increase their wealth. The concept of national borders is simply absurd. When an Indian exporter sells something abroad, “India” does not benefit. The individual participants in that transaction do. Similarly when Indian individuals import something, “India” does not suffer. The individual participants in that transaction benefit. If the “export-import balance” of nations is so crucial, why not go further? Why not measure the “export-import” balance of states, or cities or households then?

Here is a simple analogy. I used to live in angalore a couple of years ago. I shared an apartment with four friends. Barring some minimal costs we shared, everyone was pretty much on his own. Each had a job and an income. Each of us sold his labor independently of the others and received an income independent of the others. We conducted transactions with the world outside our house boundaries independent of the others. Some of us had surpluses with the external world, while maybe some of us had a debt. Heck, suppose most of us had a lot of debt. Whatever our debt or surplus positions, they were individual. Does it make sense to measure the debt/surplus from the sum of our financial positions and call it a “household” debt or surplus? It is an absurd notion. Would it have made sense to cheat everyone in the house into subsidizing one person to achieve a “household surplus”? Our standard of living was individually defined and the standard of living of the household was a completely incidental sum of our individual values. The idea of optimizing our transactions conducted independently with the external world in order to achieve a surplus for the household sum would be absurd. Yet, that is exactly what export promoters wants to do in a country.

Finally, let us return to inflation. Regardless of which theory of inflation you buy and what you believe should be done to counter inflation, there is a deeper lesson we should learn from the recent discussion on inflation (which you get to learn if you came this far!). Think about it. If some remote official in the RBI changes the interest rates, issues orders to print more notes or buy and sell dollars, thus changing the money supply – without normal laypeople even knowing – why do prices rise? How do all kinds of people from the neighborhood plumber, vegetable vendor, hairdresser, grocery store to industrial houses producing cement, steel, cars, paper to service providers like banks, restaurants, tea-stalls and beauticians, sellers of carpets and haulers of garbage, producers of wheat and drivers of buses find out? How do all these people with whom we engage in meaningful economic exchange every single moment of our lives – many of whom are illiterate and supposedly helpless, while most are educated but unaware of inflation in any concrete sense – find out? How do these people know what to change in their production, how much to change and calibrate exactly how much to sell it for? If an increase in money takes place without anyone explicitly knowing it or understanding its implications, how come every single one of us acts as if we did understand them in an almost coordinated manner? The reason is, we are constantly managing and optimizing our choices and behavior in our own micro-world in our own bumbling ways. We may get it right many times, most times or all the time. But we have the greatest incentives to make the right choices given our own surroundings. The element of the economy which helps us make those choices are prices. Prices are the signals of availability and scarcity of things we want and of how much we want or value them in relation to what we already have. Prices are conveyors of deep and dispersed information. Our daily, heck hourly transactions are the choices we make about the utilization of our time, money and minds. It is futile and inconceivable that a government, even one that is truly honest and benevolent, can amass and utilize this dispersed and deep knowledge to implement policy. A corrupt one with perverse incentives even less so. It is immensely crucial to not distort the messages carried by prices through intervention, even if it benefits the majority, as it inevitably harms someone whose life depends upon reception of correct price signals. This is what we call the “market”. The insight to be gained here is the following: even in the absence of a free market, even in a severely restricted society like India’s where rules and regulations prohibit and restrict transactions, the market does not cease to work. We continue to find our local optima in our behavior and continue to use the price signals around us to make our choices and try to improve them. No amount of regulation or rules will ever be able to stop us from trying to find our micro-optima. Those rules can only restrict our freedom to find better choices than the ones allowed to us, they can only distort the signals we receive, leading us to make bad choices. Considering the futility of trying to find a centrally led global optimum, our best bet is to allow individuals the freedom to find their local optima and grow more prosperous.

Filed under: Incentives, Indian Media, Inflation, Money, Prices, RBI, Special Interests   |  30 Comments