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India’s money illusion problem

LiveMint logoLiveMint 20-06-2017 Niranjan Rajadhyaksha

The recent farmer protests in some parts of the country throw fresh light on an old economic problem. People think in nominal rather than real terms. Price changes matter. The paradox of farmer protests when farm output is at record levels is less puzzling once we take falling food prices into account. It is the nominal rather than the real trend that is hurting farmers. It is useful to remember that two of the biggest movements launched by M.K. Gandhi were timed with the deflation in farm prices after World War I and the Great Depression across the world.

The fact that it is lower prices that have brought farmers to the streets seems to have got widespread acceptance in recent weeks. This is a good cue to extend the discussion to some broader economic issues, especially about why the Indian economy does not “feel” like it is growing at 7%. Is it because too many people are not taking a closer look at what has happened to prices in recent quarters? More on that later.

The sharp fall in inflation in recent years has pulled down the growth in nominal gross domestic product (GDP). Many analytical muddles have followed.

First, expectations continue to be set according to what people experienced during the years of high inflation after 2006. In other words, inflation expectations in India continue to be adaptive rather than rational. Employees who are used to large increases in nominal pay during episodes of high inflation feel cheated with the more modest pay hikes we see in these years of low inflation. They extrapolate from their past experience with inflation. That is also why inflation expectations in general have lagged the decline in actual inflation, a telling comment on the credibility of the Reserve Bank of India.

Second, several analysts have tripped because of the unfortunate habit of comparing nominal values with real values. So, ratios such as bank credit growth to real GDP growth or corporate sales growth to real GDP growth can give extremely wrong signals. The numerators are nominal while the denominators are real. The issue of lags is another blind spot in many popular analyses. The problems may seem less dramatic when nominal GDP is considered as the base. This is not to say that there are no problems with bank credit growth or corporate sales growth, but that catchy headlines about how bank credit growth is at 50-year lows can be misleading.

Third, the tax base of the government is the nominal GDP. People pay taxes on what they actually earn rather than on their real earnings after inflation. This column has previously pointed out how the sharp drop in nominal GDP growth creates budgeting problems for the government. The United Progressive Alliance government managed to inflate away public debt. In other words, the ratio of public debt to nominal GDP (the key parameter to assess fiscal sustainability over the medium term) stayed manageable despite fiscal profligacy after 2009. The current government does not have that option.

The underlying point is that more analysts should take nominal values into consideration, especially in times when there is a sharp change in the trajectory of inflation.

The Economic Survey written by the economists in the Union finance ministry did well to make a similar point when it comes to assessing the impact of demonetisation. In a box that was presciently titled, “Clarifying In Advance Possible Misinterpretations in GDP–Demonetization Effects”, the government economists wrote: “After all, demonetisation is mostly a nominal demand shock, so its effect in the first instance will be on nominal magnitudes… The most appropriate gauge of demonetisation would be to compare the actual nominal GDP growth with the counterfactual nominal GDP growth without demonetisation.” The farmer protests—to the extent that the drop in food prices is because of demonetisation rather than higher output—is one resonant example of why the point made in the Economic Survey was correct.

Economists have struggled with how to deal with nominal changes in an economy. There have been debates galore, which are outside the scope of this column. Irving Fisher coined the term money illusion nearly a century ago. The notion that nominal prices can be sticky undermined the classical assumption that money was neutral, a mere veil with no impact on real economic activity. James Tobin said in 1972 that an economist can commit no greater crime than assume the money illusion. Behavioural economists have shown in their experiments that people do fall prey to the money illusion.

The recent drop in Indian inflation provides an excellent opportunity to think more clearly on the old problem of nominal versus real variables in an economy. It can also offer some clues about why this does not “feel” to be an economy growing at around 7%. This has been a common complaint

The answer could be that human psychology—or feeling of confidence or pessimism—is deeply affected by the trend in prices rather than in output alone. Indian workers, companies, investors, savers are so used to high inflation that lower nominal numbers because of the drop in inflation is a fact that they have psychologically not adjusted to. The Indian economy is not yet out of the woods but the money illusion is making the situation seem worse than it is. Think about it.

Niranjan Rajadhyaksha is executive editor of Mint.

Comments are welcome at Read Niranjan’s previous Mint columns at

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