Last week this newspaper published a story on its front page saying, more or less, that while the government wanted lower interest rates so that investment and growth could accelerate, the RBI said, no, inflation is still a problem so maybe it’s premature to cut rates.

This divergence of views goes back to 1935 which was the very first year of the RBI. It eventually led to the ‘resignation’ of the first governor in 1937. So these little tussles are of no great interest.

What is of interest, however, is the new dimension: the chief economic adviser’s suggestion that food inflation should be excluded while measuring inflation. But the RBI isn’t convinced.

This newspaper had written an editorial on this difference of opinion on August 14 this year. The message was — stop arguing boys and settle it quietly and quickly.

The striking thing in this debate which should never have gone public is that it’s the RBI that is more concerned about inflation than the government which gets hurt more by it because higher inflation upsets voters.

In a sense, this is par for the course because it’s the job of governments to increase investment and growth and it’s the job of the RBI to keep inflation in check because that’s what it is charged by law to do.

Also while governments focus on the short term gains from growth, the preamble is the RBI Act also makes it responsible for financial stability. This last, until 2005 or so, was taken as synonymous with price stability. But since then it has taken on a new meaning.

Hence my suggestion that we now have a new trilemma comprising growth, inflation and financial stability. As anyone will tell you, three variables mean instability. I have written often about this.

The best example of this is the Three Body Problem in physics which has no stable solution. But it’s applicable in many other cases such as the Impossible Trilemma as contained in the Taylor rule.

The new trilemma

How does this new instability arise and how does it affect policy? Growth is a function of investment. Inflation is a function of demand and supply. Financial stability, in the final analysis, is a function of fiscal policy or absence of fiscal discipline. As we know from our experience since the 1980s, fiscal indiscipline raises both interest rates and inflation.

Now if you want more investment you need lower interest rates. That’s what all governments want.

If you want lower inflation you need a tighter monetary policy, which is what all central banks want.

If you want financial stability, which both the governments and central banks want, you need both higher growth and higher interest rates. These are mutually contradictory.

This is exactly like the Three Body Problem of physics. There’s no solution and persistent instability. Or, if you want to compare it to the Taylor rule, you can control only one. The other two will be free floating variables.

In short, this new trilemma, like any trilemma, is not solvable. Economies will keep stumbling from one situation to another and governments and central banks will keep grumbling and growling at each other.

The Indian problem

India, as ever unique, has a peculiar problem: it’s a full-fledged country but, like Europe, it has many rates of inflation depending on where you measure prices. The RBI wants to aggregate all these into a single target rate.

Sounds good except for two things: it’s not possible and it’s not a meaningful endeavour because the number it conjures up is an arbitrary one. That’s why we have a range. But how useful is it to target a range? How is 4.1 per cent the same as 5.9 per cent?

The second problem is credit creation. The mechanics are simple, we learn in our first year in college: the more money that’s created, the more the credit that is created because otherwise banks would go bust.

But, while it is easy to extend credit it’s very hard to recover what’s owed. It’s this that threatens financial stability.

To make things worse, if consumption is financed by loans, stability is at real risk. This happens when incomes are not growing fast enough to meet people’s needs. It’s a global phenomenon.

The third problem is the need to pay for welfare and defence. India is very badly placed in this regard because it has to pay entirely for both. Most countries pay fully for welfare and only partly for their defence. So there goes the other leg in which financial stability rests: fiscal responsibility.

Net-net neither the finance minister nor the RBI governor have an easy job. For them it is, as the 1971 song went, ek dhund se aana hai, ek dhund mein jana hai (come through a fog and go into another fog).