Do not worry, said the Finance Minister seeking to assuage concerns sparked by the Government’s recent natural gas pricing decision. Though user industries such as power or fertilisers may have to reckon with higher raw material costs, we will protect the ultimate consumers such as households and farmers, said the Minister.

How? Through enhanced subsidies.

It all seems so easy. Indeed, if we look at the facile manner in which the concerns about high gas prices have been addressed, one would think that all the hue and cry about the pricing decision was not worth it all.

As long as the government is able to protect, through subsidies, the ultimate consumers — households and farmers — how really pertinent is any decision at any previous point in the entire production/supply chain of all goods and services (and not only natural gas) in the economy? Distinctions as to “merit” and “demerit” subsidies also will fade into the background in such a situation.

A win-win for all

Indeed, this argument can be extended to all goods and services — be it imported coal and the “concession” to pass on the higher import costs, the subsidies inherent in the food sector ( the implications of implementing national food security in the ensuing period), the user cost increases in the transport sector, and so on.

It seems a win-win situation for everyone. The primary producer gets his higher price, the intermediate producers are not squeezed by a combination of higher costs/lower revenues and the ultimate consumer is protected.

As can be seen, in all these cases, there is a clear supply-side shock operating. That is, the supply of various goods and services is going to be, or will be, available in an ensuing period only at much higher prices. In the jargon, we will say that the supply curve of the entire economy — or at least a number of key goods and services — is shifting upwards to the left. How should the aggregate demand curve of the economy react in this environment? Should it move further to the right – which will exacerbate the price level situation in the economy -- or should it move to the left or at least remain where it was?

Confronting and answering these questions is the very essence of macro-economic policy formulation and management – at least of one key institution viz, the Reserve Bank of India.

Indeed, it should be understood that the RBI can impact only the aggregate demand curve in the economy, for supply is dependent on so many factors beyond its control – for instance, climatic conditions in agriculture, the skill level of the labour force or indeed, the subterranean conditions related to gas exploration and production.

(Given that, one wonders why “real sector” players make so much fuss about low, lower and lowest interest rates. They should just ask the RBI to produce a broadly stable and predictable demand environment signified by reasonably stable price levels – and set whatever interest rates are necessary just to achieve that. That can be the RBI’s most important contribution to real output growth).

But, first we have to understand how the Government has been so confident in answering the concerns about higher gas prices.

Govt confident, but how?

The solution offered is too good to be true. To understand why it is too good to be true, we have to see if the solution offered is only a short-term panacea or make-believe solution or an enduring option offering genuine economic benefits for all economic agents.

For the three years ending March 2013, the total subsidy bill of the Government of India (GoI) – under various heads – ran up to nearly Rs. 6,00,000 crore. In the same period, the total holdings of GoI securities of the Reserve Bank of India increased by nearly the same amount – Rs. 5,50,000 crore.

It is difficult to escape the conclusion that the Reserve Bank has directly accommodated the large subsidy bill of the government by purchasing government securities. We can quibble about secondary market purchases or purchases intended to impact only the “liquidity situation” in the financial system but not the “monetary situation”.

The larger truth is that supply shocks result in large subsidy bills, and these are then accommodated by the Reserve Bank of India.

Effectively, what has happened is the government being able to bridge the vast gaps between its expenditures and its revenues by just printing it away. No wonder the government is so sanguine about managing the impact of supply-side shocks.

DEEP DISTORTION

Accommodation by the RBI as such, of course, is no evil as long as it is very temporary and is squared up in the normal course.

But, what we seem to be seeing is a deep distortion of the role of the central bank and the very integrity of the system of fiat money. It is effectively no different from a helicopter dropping Rs.6,00,000 crore of money into the government’s account and the government then issuing cheques against that money. (May be OK in Ben Bernanke’s world but here?)

What will be the result of such helicopter drops?

One cannot but quote Milton Friedman here: “A budget deficit is inflationary if, and only if, it is financed in considerable part by printing money”— that is, only if fiscal actions are accommodated by the monetary authorities. No enduring solution or win-win situation here.

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

Related Topics