The Reserve Bank of India (RBI) was faced with a challenging job in preparing its first review of monetary policy for the current financial year. One outcome of increasing globalisation is the irrelevance of the size of an economy in having an impact on the world.

Look at the volume of writings on the financial crises in small countries like Greece or Ireland. The crises are illustrative of the chaos theory in economics that studies the behaviour of physical systems which are highly sensitive to initial conditions — popularly referred to as the ‘butterfly effect'. It was propounded in a seminal paper by Edward Lorenz in 1972 titled Predictability: Does the Flap of a Butterfly's Wings in Brazil set off a Tornado in Texas?

GLOBAL VARIABLES

Small differences in initial conditions yield widely diverging outcomes for chaotic systems, rendering long-term prediction impossible in general. This happens even though these systems are deterministic, meaning that their future behaviour is fully determined by their initial conditions, with no random elements involved. In other words, the deterministic nature of these systems does not make them predictable. This behaviour is known as deterministic chaos, or simply chaos. We have, of course, seen the dramatic cascading impact of the failure of a single firm, the Lehman Brothers, ushering in a recession.

Considering that economic systems are not deterministic and data suffer from limitations, the results of monetary policies based on predictions are in the realm of uncertainty. The two major international sources of anxiety have been the likely outcomes of the debt crisis – one in Europe and the other in US. Either could derail the international monetary system, more so the latter. One can only imagine the chilling consequences of a downgrading of the US rating. What type of contingency planning can the central bank in India do in that context?

Since there is no point worrying too much about the international scene characterised by uncertainty, the RBI has done well in concentrating on the domestic situation, the facts of which are known except for the unreliability of data (to which the Governor referred in a recent speech), the performance of the monsoon and the trend in oil prices.

TAKING ON INFLATION

While the rate of increase in growth or prices may be subject to periodical revisions, there is some certainty about the direction.

The economy is growing, though at a decelerated rate, and prices are on a roller coaster ride. Takeaway or add a few percentage or decimal points to the rates, and it should not be a deterrent in policymaking.

A consensus is emerging that growth may be sacrificed, if need be, in the interest of price stability. Fortunately for the central bank, the Government has also veered round to this view, which has given it a free hand in formulating its policy to subserve the one and only overriding objective laid down in the Preamble to the Reserve Bank of India Act, namely, monetary stability.

The RBI has done well in revising the policy rates upward by a stiff 50 basis points to contain the growth in credit demand. The process of credit creation is the process of money creation.

In the press release on macroeconomic review the Bank says: “Breaking inertial dynamics of wage and food price rise is important for arresting inflation.” Inertial inflation was evident all along from the price expectation surveys. What it required to be dealt with was a shock that has now been administered.

The crying need is for deceleration in the growth of money supply. Despite all that has been written on the failure of monetarism, the fact remains that money is at the core of all economic systems. If monetarism lost the battle it was because it was not operated in the manner prescribed by its founders.

MONEY SUPPLY GROWTH

Can we argue that, if money supply has no relation to prices, we can solve all problems of growth and distribution by just making the printing presses work overtime? Of course, it is an example of reductio ad absurdum .

The blame for the high inflation in the country, particularly in the case of food articles, has to be laid at the door of excess money supply without any commensurate increase in the availability of the basic necessities of life. During the quarter century from 1984-85, the annual increase of broad money was about 10 percentage points higher than the real GDP growth rate.

Under a liberal assumption of the income elasticity of demand for money at 2, M3 should have been Rs 17,34,000 crore, at the end of March 2009, instead of Rs 47,94,000 crore. No wonder we have seen an exponential price rise in all articles of consumption, be they necessities or luxuries or durable assets (including houses), over the period.

It renders saving meaningless. Perhaps for the first time in recent years, the RBI has lowered the indicated money supply growth to 15.5 per cent from 16 per cent.

It has also brought down the projection for the increase in non-food bank credit from 19.0 per cent to 18.0 per cent. These measures have come not a day too soon. They should be a cause for celebration for the card-carrying monetarists and inflation hawks like this writer.

(The author is a Mumbai-based economic consultant. >blfeedback@thehindu.co.in )

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