Sunday, May 1, 2011

Low interest rates distort the economy

Rajiv Kumar, who heads an industry association, and Surjit Bhalla ("What inflation?") joined their pens this weekend to Deepak Parekh's plea for a dovish stance on monetary policy in response to surging prices. 

I will not join with them on theoretical discussions about flaws in our price collection mechanisms, except to say that past experience doesn't suggest that official data systematically pegs price rises too high. And I will agree with them that higher interest rates run the risk of slowing down investment in our economy.

However, I do not agree that concern about the latter should trap our policy makers in getting into a cycle of higher prices, higher government spends, higher deficits, and higher inflation expectations. In its role as the nation's biggest borrower, the government could easily settle into a cosy relationship with higher prices, leading to higher nominal tax collection, combined with negative real interest rates. This reduces the cost of being fiscally indisciplined.

From the viewpoint of the real economy, though, it increases the chance of a greater misallocation of funds - going into expenditure that does not increase productivity, but drives up demand, a la NREGA; or encouraging consumption of scarce resources being distributed at prices below cost, such as food, petroleum products and fertiliser.

When all nominal prices are rising, a sensible economist should be looking at how relative price movements drive the misallocation of resources. In India, ca. 2011, low real interest rates have encouraged a 7-year boom in up-market homes in our largest urban agglomerations. Today, they have stacked up to unsold stocks worth several years of sales at peak volumes. Similarly, cheap finance and cheaper diesel have encouraged a boom in sales of diesel cars.

These are gross misallocations of resources into a still poor nation. If our economic leaders will not discipline themselves, it is the role of our columnists and free-standing economists to do so. But the two I mentioned are respectively playing their lobbying role and talking their book.


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