The Finance Ministry is not powerless in front of the RBI, however. It has complete and undisputed command of the tax policy.
Reserve Bank of India (RBI) governor Raghuram Rajan has withdrawn his name from the candidates being considered for appointment as governor after his term comes to an end.
He had resisted pressure from the central government to reduce the interest rates. As a result, the government was unhappy with him.
Perhaps he saw the writing on the wall and chose to withdraw his candidature so that his self-esteem was not hurt.
At present, the governor of the RBI has independent charge of the amount of notes that the RBI will print.
The RBI can print more notes, lower the interest rates, encourage businesses to borrow and invest, and in the process jumpstart the economy.
However, this policy leads to inflation. Let us say there are notes of Rs.100 circulating in the economy. Now the RBI prints additional 10 notes.
These notes are borrowed by businessmen and they start establishing factories. They buy steel with this additional 10 rupees that the RBI has printed.
Previously, 100 rupees were chasing the steel that was available in the market. Now, 110 rupees are chasing the same steel. This will lead to an increase in the price of steel in the second economic cycle.
People who are making their house also have to buy this steel. They will make fewer houses because steel is expensive.
Their consumption will be reduced. At the same time businessmen will establish larger numbers of factories. The investment will increase.
The new factories, however, will lead to the generation of employment in the third economic cycle. This will lead to the benefits percolating to the people.
At present the RBI governor decides whether such stimulus will be injected into the economy or not. The finance minister wants that this decision should not be left to the discretion of the RBI governor.
The argument is that the RBI governor is not an elected official. He should not be allowed to take such vital decisions that affect the welfare of the people.
The finance ministry is not powerless in front of the RBI, however. It has complete and undisputed command of the tax policy.
It can, for example, impose an additional tax on the steel that is sold in the country. It can use that money to provide tax incentives to businessmen to establish new factories.
The imposition of such a tax will lead to a reduction in consumption. Those making their house will have to buy expensive steel. On the other hand, investment will increase.
The businessmen will get tax relief for establishing new factories. These factories will lead to the generation of employment in the second economic cycle.
The basic impact of printing of notes and imposing additional taxes is the same. It transfers income from consumption to investment.
The difference is regarding the time taken for the impacts to take place. Printing of notes has a delayed effect. The increase in price of steel takes place in the second cycle only when new factories begin to get established.
On the other hand, imposition of tax leads to the same increase in price immediately.
Both the policies will be equally ineffective if the money is used for government consumption instead of private investment.
Let us say the RBI prints large numbers of notes. The government takes more loans from the banks to pay increased salaries to its employees.
Businessmen do not take more loans to establish new factories because licensing, corruption, or other policies of the government.
The result will be increase in consumption of the government servants and reduction of consumption of the people.
Same result will take place from the imposition of tax and use of the money to pay increased salaries to government servants.
The basic issue is to reduce government consumption and increase private investment. That will determine whether we move to a faster rate of growth or not.
Another reason why the government wants to control the monetary policy is that the negative impact of printing of notes on the people is diffused, distributed and delayed.
The printing of notes lead to an increased in price after some time. The notes are printed. Then businesses borrow that money.
Then they purchase cement and steel from that money. The industries find that there is more demand for cement and steel.
Initially they meet this demand from their existing inventories. They think of increasing the price only after they find that they are not able to meet the increased demand.
The transmission of these signals may take up to six months or even a year. The impact is distributed as well. Similar increase in price takes place of other goods such as cloth, paper, and sugar.
The people of the entire country are thus affected by the printing of notes. It is like the sun sucking out water from the pond. The impact is slow and widely distributed.
The impact of an increase in taxes is, on the other hand, direct and hard. For instance, if the government increases the rates of personal income tax, it directly and immediately leads to the taxpayers being hit. Or, if the government increases the excise duty on cars, it immediately leads to an increase in the price of cars in the market.
The car manufacturing companies and buyers will be up in arms.
They will protest the increase in tax. The governments often prefer to use the route of monetary policy to shift incomes from consumption to investment because its impact is delayed and diffused.
No particular group of consumers stands up in protest when the RBI prints more notes.
The government is justified in wanting to have a greater influence on the monetary policy so that it can transfer national income from consumption to investment or from investment to consumption surreptitiously.
But this is more a matter of “how” to implement a policy. The real issue is to set the direction of the policy, that is, to decide whether to transfer national income from consumption to investment or from investment to consumption.
The tragedy of the Modi government is that it is transferring national income from investment to consumption. The issues of one rank one pension (OROP), and now the Seventh Pay Commission are increasingly throttling government investment and increasing government consumption.
The fight for the control of the monetary policy is justified insofar as this policy option should be available to the government. But the basic policy direction is bad.
In such a situation the tussle is about how to kill the economy—by an independent RBI or one controlled by the government.