Friday, June 8, 2018

RBI’s Interest Rate Manipulation

Finally after a gap of 4 years the Indian central bank RBI raised its interest rate – the repo rate – by mere 25 basis points to 6.25% yesterday. RBI cited a concern for rising price inflation in the form of oil price shock as a major reason for hiking the interest rate. They said, while hiking rate will combat price inflation, its policy stance remains “neutral” i.e., it is ready to lower rate again if the hike in interest rate starts to hurt economic growth.

The mainstream view of the role of the central banks in the economy and society is that they are the monetary institutions that stabilize the economy and help it grow. But the reality is exactly opposite to this mainstream view. RBI is the main source of all kinds of instabilities in India. Its policy of interest rate manipulation, via creation of money out of thin air, is the source which creates major problems like inflation, boom and bust cycles and the inequality of income and wealth.

Inflation
Modern mainstream macroeconomics defines inflation as a rise in general price level, for which they blame sometime supply shortages (cost push inflation) and sometime rise in demand (demand pull inflation). The original and correct definition of inflation was an increase in the quantity of money and credit. The modern mainstream definition focuses on the effects of inflation, which is wrong. The right way to look at inflation is to focus on its cause rather than effect. This is because only then we can truly eliminate inflation from our economy. Once we clearly see that inflation is an increase in the quantity of money and credit, the next logical question is, who is responsible for this increase? The answer is easy: RBI, the central bank which has monopoly over the supply of money and credit in India. Only RBI can create money (rupees) in India. Only they can print it. If you and I will print our rupees at home then we will go to jail. It is a crime of counterfeiting. RBI is the official counterfeiting institution! Thus only RBI can increase the quantity of money and credit, and so it is solely responsible for creating inflation. When it prints currency notes to lower the interest rate, it increases the quantity of rupees in the market. This is inflation. And this inflation lowers rupee’s purchasing power. Looking from the goods side, it looks like their prices are going up. In reality, the purchasing power of rupee is going down. What 100 rupees used to buy in 2017, it no longer buys in 2018.

Boom Bust Cycles
RBI is also the sole cause of business cycles (boom and recession) in India.

The mechanism through which RBI tries to increase or lower the supply of money is via its monetary policy of interest rate manipulation (other two ways are: CRR (cash reserve ratio) and purchase or sale of government bonds (OMO: open market operations)). Interest rate is a price of time. It is determined by the societal time preference of how much resources people want to consume today or save and invest for tomorrow. The consumption and saving  habits of people determine the supply of loanable fund, and the demand for this fund comes from the businessmen (entrepreneurs) side. This demand and supply of loanable fund is what determines the market rate of interest. If supply goes up, while demand is constant, then the interest rate will come down and vice versa. And when the demand goes up, when supply is held constant, the interest rate will rise and vice versa. Without the RBI, the supply of loanable fund (money) comes from the real saving of people. This saving in turn comes from prior production. But RBI distorts this whole mechanism by artificially creating the supply of money from thin air. When it prints money (without any prior production and saving), it increases the supply of money in the market which lowers the interest rate. This RBI determined monetary rate of interest is different from the market determined originary rate of interest. Interest rate is a price of time and it is used by entrepreneurs to make decisions about how much resources to allocate for producing goods for immediate consumption in present and how much to devote to capital projects for future production and consumption. When RBI artificially lowers the interest rate, it gives a false signal to entrepreneurs about the availability of saved resources. They start borrowing to start long term capital projects. These projects are inherently unsustainable because the real pool of savings to support these projects is not available. As they start spending the borrowed money, in the form of giving wages to their workers etc., their spending starts to lift prices of various producer and consumer goods. This is the beginning of the boom. But because this boom is unsustainable, it will end in a final bust and ensuing recession and depression. When prices will rise so much that it threatens the ruling government, for which the central bank is working as a banker, RBI will start to increase the interest rate (like what it is now doing). But this sudden increase in the interest rate creates problems for businessmen who borrowed money thinking interest rates will remain lower for long time period for them to realize profits from their long term capital projects. They suddenly find that they all made an error. And they have to suddenly stop their projects. This is the bust and beginning of a recession or long depression. This bust now results into mass unemployment and halting of production processes hurting economic growth.

Inequality of Income and Wealth
RBI also creates and increases the income and wealth inequality. Because RBI prints money, to whomsoever it will give this money he/she will become rich. Those people who get this freshly printed money from RBI first can claim and buy scarce goods at lower prices. Once they spend this printed money, it starts to slowly raise prices. Those people who receive this money last, will face higher prices, lower purchasing power and lower standard of living i.e., poverty. Now who are going to receive freshly printed money first? Obviously those who are well connected with the government and its bureaucracies. Politicians, bureaucrats, big businesses who receive big loans from commercial banks (people like Ambanis, Adanis, Tatas, Birlas, Mallayas, Modis etc.) and anyone with a political clout. Who will receive this money in the end? Common people. In this way the rich become rich and poor become poor in India.

Conclusion
RBI is not a messiah who is going to stabilize or grow the Indian economy. It is the very cause of all our miseries. If people of India want to see inflation, business cycles and inequality of income and wealth being eliminated then they must demand that the Indian central bank RBI be dismantled as soon as possible. As long as RBI is in place, it will continue to destabilize the Indian economy. It will also continue to print money for the government so that its political masters can continue to control the lives of Indian people; so that they can continue to wage bloody wars. For the cause of peace and prosperity it is necessary that RBI be dismantled.

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