India's conundrum - High Growth and High Inflation

This speech by Dr Subir Gokarn (Deputy Governor, Reserve Bank of India ) is fairly typical. Take for instance the following statement:
I will begin by discussing the current inflationary scenario in India, which, as we have been saying in our recent assessments, is not very reassuring. I will then place this scenario in a broad historical context, with the intention of demonstrating that India has a good record of reining inflation in, regardless of what has driven it.
Anyone who doesn't know that inflation in India has always run rampant is either lying, or deluding himself with false statistics. All he is doing in his speech is to talk on about the components of inflation and a brief history of how it occurred.

To me this speech is the equivalent of a layman standing beside a volcano talking about the what happened during an eruption. He is describing the ash, smoke and fire. However he has no understanding of the geology behind volcanic eruptions or how to predict them.

So, what really explains the unusually high inflation in India? To understand inflation you have to understand the most important thing about inflation. And that is the following statement by Milton Friedman and Anna Schwartz, made in their influential book, A Monetary History of the United States, 1867-1960:

Inflation is always and everywhere a monetary phenomenon

"Friedman advocated a central bank policy aimed at keeping the supply and demand for money at equilibrium, as measured by growth in productivity and demand. The monetarist argument that the demand for money is a stable function gained considerable support during the late 1960s and 1970s from the work of David Laidler. The former head of the United States Federal Reserve, Alan Greenspan, is generally regarded as monetarist in his policy orientation. The European Central Bank officially bases its monetary policy on money supply targets. " - Wikipedia

The above statement provides a clear explanation and a solution to the problem of inflation in India as below:

1. Friedman says that inflation is due to money supply growth outstripping economic growth
   
2. A free-market economy has a natural DEFLATIONARY tendency due to innovation and efficiency.
   
3. Inflation is neither a precondition for, nor a consequence of sustainable growth in an economy.
   
4. When growth is accompanied by inflation it is a sure sign of a disproportionate growth in the supply of money
   
5. Inevitably this due to a DISPROPORTIONATE GROWTH in BANK CREDIT.
   
6. When banks lend short-term deposits over the long-term, it causes a growth in DEMAND DEPOSITS through the money multiplication mechanism.
   
7. These new deposits bid up the prices of goods and services because they appear in advance of an increase in production of new goods and services.
8. This MONETARY GROWTH shows up in the monetary statistics as an increase in the money multiplier.
   
9. Traditional central banking policy instruments such as tinkering with reserve requirements and raising repo-rates can not effectively restrict this credit expansion. Credit demand is a function of CONFIDENCE. The central bank can only dampen this confidence to a small extent.
   
10. Fast growing liquidity created by this credit growth fuels a high demand for a slow-growth in the quantity goods and services. This creates a feedback loop that increases CONFIDENCE further as businesses seek further bank credit to meet this demand.
    
11. This feedback loop increases the money supply further. In due course this process creates a CREDIT FUELED BOOM in the economy.
    
12. A CREDIT FUELED BOOM is typically accompanied by high inflation and assets bubbles. Witness the stock markets and property markets, wherein assets are priced above what is economically justifiable.
13. Eventually this BOOM turns to a BUST as frenzied investment in capacity outstrips real demand and highly leveraged businesses end up with no customers.
14. MISALLOCATED capital is written off. This BUST causes a disaster on the commercial banking system's balance sheet.
15. Addicted to easy credit the commercial bankers and industry will cry for bailouts and claim "NO ONE SAW THIS COMING."
16. Austrian economists will say "We did" and point to many versions of the above explanation that are ignored by the mainstream.
    
17. At this point Central Banks panic. They lower interest rates, inject liquidity, purchase distressed assets and print money.
18. Slowly, confidence will return. Low interest rates will fuel the next asset bubble and/or credit boom.
19. This time it will be worse because the entire system will expect the bailout even though they know the boom is unsustainable. This is a moral hazard which will lead to a generation of "Fed-watchers" who spout absurd things like "bad new is good because it will result in QE-II".
    

ALTERNATELY ....

1. A sustainable economic system is possible - where virtuous, sustainable growth is driven through capital markets, not bank credit.
   
2. Growth is accompanied by low inflation because money supply only increases to finance clearing of goods through self-liquidating credit, and not to finance capital expenditure.
   
3. In a sustainable system, investment of SAVINGS (deferred consumption) in capital goods and assets is NOT accompanied by any increase in DEMAND DEPOSITS.
4. In a sustainable system, BANK CREDIT only expands to satisfy demand for SELF-LIQUIDATING CREDIT. The venerable Letter of Credit system can expand bank credit efficiently to FINANCE the PRODUCTION and DISTRIBUTION of consumer goods in immediate demand. Its shrinks bank credit when this demand is satisfied.
   
5. In a sustainable system, CAPITAL INVESTMENT, including asset purchases, factors and facilities of production takes place in CAPITAL MARKETS, away from the commercial banking system.
6. Therefore, the solution to India's inflation problem is fairly simple:

Restrict COMMERCIAL BANK LENDING to financing the production and distribution of goods via self-liquidating credit.

... OR ALTERNATELY ADOPT A FREE MARKET APPROACH AS FOLLOWS ...

1. Open the mint to gold and silver. Issue the Indian Golden Rupee 100% backed by Gold and the Indian Silver Rupee 100% backed by silver. Declare them to be legal tender. There will be no further need for a central bank issued, debt-backed paper currency.
   
2. This one act will unlock India's biggest asset - the capital that is currently lying idle in India's enormous private gold hordes amounting to 25,0000 tons. A fraction of this will prove to be more than sufficient to power India's growth.
3. Dissolve the Reserve Bank of India. The absence of a lender of last resort during financial panics will automatically teach commercial banks to restrict lending to the highly marketable, self-liquidating credit that finances the production of semi-finished goods on their way to satisfy immediate consumer demand.
4. The only notes in circulation will be those issued by commercial banks, not the RBI. The market will judge the health of a bank by discounting its notes just it does for any other corporation.

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