Finance minister Arun Jaitley portrayed the Rs 2,11,000 crore recapitalisation of public sector banks that he announced last week as the first essential step to reviving the economy. He is right: bank credit has stopped growing because all but a handful of public sector banks are so mired in ‘stressed assets’ – or irrecoverable debt – that they have lost the capacity to lend. But even this gargantuan bailout will not revive the banking system, let alone the economy, if it is not accompanied by measures that will address the root causes of the ‘stress’.

Jaitley believes that the fault lies entirely with the bank managers, who have lent ‘excessively’ in a ‘non-transparent manner’, and then ‘hidden’ their actions ‘under the carpet’. What is non-transparent is the meaning he attaches to these words. Is he saying that the fault lies entirely with public sector bank managers, who have been corrupt, inefficient or both, and have then hidden their misdeeds? The answer seems to be yes, because he has skilfully laced this with a justification of demonetisation. Both reforms, he claims, were necessary because ‘you cannot have an economy where the size of the shadow economy is much bigger than the apparent economy’. The cleaning out process that his government has bravely undertaken will revive growth in the long run all by itself.

The most charitable way of describing this reassurance is that Jaitley is whistling in the dark to keep the demons away. One look at the sheer volume of bad loans and its composition shows that the problem is far too pervasive to be attributable to the misdeeds of public sector bank managers, and has to be one that afflicts the entire economic system. In December 2016, this had reached the mind-boggling figure of Rs 9,60,000 crore. Of this, Rs 8,75,000 crore consisted of ‘restructured’ loans, whose repayment schedules had been changed to give the companies respite and allow them to become solvent. But till April 2017, this has allowed the banks to recover only Rs 46,245 crore of loans. Inefficiency and corruption, not to mention political pressure, may therefore have exacerbated the problem, but cannot be its cause.

Unrelenting high real rates of interest

The affliction from which the economy has been suffering for most of the past 10 years is the unrelenting regime of very high real rates of interest that the Reserve Bank of India (RBI) has imposed upon the country.

Its origins are to be found in the UPA government’s sudden shift of economic objectives, at the end of 2006, from promoting ‘inclusive growth’ to controlling inflation, and its ceding this task to the RBI. The only way that a central bank can do this is by squeezing credit and raising the real rate of interest. But this stratagem works only when the inflation has been caused by an excess of demand in the economy. When the price rise has been caused by a sudden shortage of supply, such as one caused by untimely rains or a poor monsoon, or by a sharp rise in global commodity prices, there is little that squeezing credit to domestic industry can do.

In such ‘supply side’ inflation, curbing credit and pushing up the interest rate depresses production, without bringing down prices. Persisting with a high interest rate policy therefore leads to ‘stagflation’. That is what India has been suffering from for the past seven years.

In January 2007, when then RBI governor Y.V Reddy first began raising interest rates, inflation (measured as it had always been by the wholesale price index or WPI) had only risen 2% over the previous ten-year average, to 6.6%. Reddy ascribed this to an ‘overheating of the economy’ caused by increased social spending on the Mahatma Gandhi National Rural Employment Guarantee Act and other welfare programmes, and took measures that raised the lending rates of commercial banks by a full 3% in the next nine months.

His diagnosis proved wrong. The proof of this came in the January-March quarter of 2008, when WPI inflation rose from 6.7% to 7.7%.

Where the rise in prices had come from was apparent, because in the same 12 months, the rise in prices of basic metals, alloys and metal products accelerated from 12.6% to 19%. Quite obviously, credit curbs were doing nothing to restrain an inflation that was coming from a sharp rise in global commodity prices that was being fuelled by a six-year-long investment boom in China.

When the world economy went into recession in 2008, Reddy’s successor, D. Subbarao, brought interest rates down sharply at Prime Minister Manmohan Singh’s urging. For the next two years, industry enjoyed the highest growth rate it has ever achieved. And it did so without triggering inflation, for wholesale prices rose only by 0.8% in 2009-10 because global oil and commodity prices had fallen by 50-60%.

This again underlined the newly-formed connection between global and domestic inflation, but Subbarao did not see it. So when global commodity prices rose sharply once again on the back of China’s $586-billion fiscal stimulus programme, and WPI inflation shot up to 10.3% in March 2010, he promptly repeated Reddy’s mistake and raised interest rates once more.

Also read: Even the Optimism of Official Economists Cannot Ignore the Warning Signs

Subbarao also made a second, and possibly more serious, mistake: he used the pretext provided by the Central Statistical Office’s introduction of an updated cost of living index in 2012 to change the yardstick for the measurement of inflation from the WPI to the revamped Consumer Price index (CPI).

This shift brought the full impact of the growing shortages of infrastructure into the calculation of the cost of living, because almost half of the cost of living index is based upon the cost of health, travel, education and housing, all of which have been in short supply for years and have therefore been responding to the rise in demand caused by industrialisation and urbanisation only by becoming more expensive.

To sum up, therefore, while the WPI has become more and more sensitive to changes in global supply and demand in the past decade, the CPI has become more and more sensitive to entrenched domestic shortages caused by the country’s abysmal failure to develop its infrastructure and social services. This is the root cause of the puzzling, and much discussed, divergence between the and price indices that has emerged during the past decade.

The fact that the CPI had begun to reflect shortages surfaced in 2012 when the WPI began to ease, but CPI inflation moved the other way. In the next two years, the gap widened rapidly as wholesale prices began to reflect the end of China’s investment spree and the consequent fall in global commodity prices, but the CPI failed to respond. The gap between the two peaked at 7.8% in October 2015 when WPI inflation fell to minus 3.5%, but the CPI still showed an inflation rate of plus 4.8%. In 2016, the WPI remained more than 2% below its 2014 level, but CPI inflation did not react to this decline even with a time lag. Instead it rose marginally to 4.97%.

As the rise in wholesale prices slowed in 2012, the UPA began to seriously consider lowering the cost of borrowing to revive the economy. To assuage the RBI’s worry that this might touch off an inflationary spiral, it also made changes in diesel and gasoline prices that would cut subsidies on petroleum products by more than Rs 50,000 crore in a full year and unveiled an ambitious programme to eliminate the Rs 1,90,000 crore of deficits accumulated by the state electricity boards, and bring the fiscal deficit down to 3% from 5.3%, over five years. But Subbarao remained unmoved and, citing vague inflationary threats in the future, marginally raised policy interest rates.

The only way to end this conflict was for the government to assert its constitutionally-mandated authority and force the RBI to lower rates. But the party was split between ministers who wanted growth and a party organisation that was morbidly afraid of the political fallout of inflation. It therefore did nothing and sealed its own fate.

Enter inflation targeting

The Narendra Modi government came to power with the full intention of restoring rapid growth. In his first ten months in office, Jaitley referred to the need to lower interest rates several times, but somehow lost sight of this goal at the precise moment when inflation disappeared from the economy. How did this happen? The only explanation is that he succumbed to Raghuram Rajan’s advocacy of “inflation targeting”.

Inflation targeting is the use of monetary policy to maintain credit and deposit rates in the economy that are higher than the actual or anticipated rate of inflation. Its purpose, as the name implies, is to keep inflation at a level that society can live with comfortably. The reliance on positive real rates of interest – or rates higher than the prevailing rate of inflation – developed in the 1950s and ’60s out of the failure of import-substituting models of growth in the first post-war generation of industrialising countries, notably including Taiwan, South Korea, Brazil, Argentina, Chile, Mexico and Turkey.

In all of these, and others, the import-substituting model of growth led to huge trade deficits that could only be contained by devaluation. But devaluation made imports more expensive and therefore fed back into inflation. This rapidly became a never-ending vicious circle. Positive interest rates therefore became the first essential step towards their transition into open, export-led economies.

Positive interest rates played a similar role in the transition of the socialist countries of the Warsaw Pact into market economies in the ’80s. However, the purpose in both sets of countries was only to check runaway inflation and stabilise the exchange rate in order to open the road to foreign investment and sustained growth. In all these countries, high real rates of interest were seen as a temporary weapon, to be dispensed with as soon as the inflation-devaluation-inflation cycle was broken.

All the governments knew that growth required an increase in capital formation, and that this would create inflationary pressures till the resulting stream of products and services entered the market. Managing these pressures required a constant, delicate balancing of interest rates, exchange rates and fiscal restraint.

Inflation targeting attained the status of a doctrine – a one-stop cure for all developmental ailments – only when it was adopted by the industrialised countries in the 1990s. For them it did prove a boon, but not for the reason that is now being peddled by monetary economists to the developing countries. For the rich nations with fully convertible currencies – the dollar, the euro, the pound and the yen – it was a way to continue living way beyond their means long after their industrial bases had withered away under the Asian onslaught.

The rationale for this developed out of Britain’s exchange rate crisis in 1992. Britain had been living way beyond its means, with very high inflation and large deficits in its balance of payments, since the early ’70s. Initially, the pound depreciated steadily against the dollar till it hit a low of $1.10 in 1976. Then North Sea oil hit the market and the pound recovered till it was once more worth well over $2 by the end of 1978. As was pointed out in a seminal book titled De-industrialisation and Foreign Trade by Robert Rowthorn and J.R. Wells, this rapid appreciation rang the death knell of British industry.

When oil prices crashed in 1986, this underpinning of the pound disappeared. But for six years, the Margaret Thatcher government resisted pressure to devalue the pound by informally linking it to the Deutsche mark, and later joining the European Exchange Rate Mechanism (ERM) and raising interest rates to keep attracting foreign savings. This house of cards collapsed on ‘Black Wednesday’ in 1992, when the UK was forced to leave the ERM and massively devalue the pound. At that point, inflation had been running at 11% for 20 years, and the balance of payments deficit was 8% of the GDP.

Devaluation stemmed the outflow and eventually helped to revive British industry, but, in its immediate aftermath, left Britain facing the task of reviving confidence in the future stability of the pound. Inflation targeting was the policy forged by the Bank of England to do this. It was, in effect a declaration to the rest of the world that it could park its money safely in pounds sterling, because the British government would never allow inflation to threaten its stability again.

Not surprisingly, inflation targeting has become the Bible of industrialised countries, all of whom are facing de-industrialisation, shrinking tax bases and rising welfare bills because of their ageing population. And it has worked, for Britain has continued to run a balance of payments deficit of 7% of GDP, and has run up a national debt amounting to 90% of its GDP. The US has similarly been financing a half-trillion-dollar annual balance of payments deficit from foreign savings and now has a national debt verging on $20 trillion, well over twice its GDP.

With the exception of China, no other country’s currency can ever become a haven for foreign savings. Inflation targeting has therefore been sold to them on the grounds that it will not only control inflation but foster economic growth. The support for this hypothesis first came from a landmark regression study by two IMF economists in 1985. A number of subsequent studies heavily qualified their conclusion, but a broad consensus emerged that while high rates of inflation do hinder economic growth, low rates actually stimulate it.

The catch lies in defining high and low. No one has been able to do this with any degree of precision because no one had been able to describe how one leads to the other. The terms ‘low’ and ‘high’ have therefore remained vague, with the dividing line between them stretching from 1% inflation for industrialised countries to 10% for the industrialising countries.

By this standard, India has never been a high inflation country. WPI inflation averaged 7% during the ’60s, ’70s and ’80s, and has averaged barely 5% since 1993. By contrast, when Taiwan adopted ‘positive’ interest rates in 1957, its inflation had been running at 60% a year. Latin American inflation had been even higher. India did not therefore need to adopt inflation targeting. What is more, it did not need to adopt the cost of living, an index of supply shortages more than of excess demand, as the base from which to determine the ‘positive’ real rate of interest.

Between 2014 and the present date, demand inflation, which is imperfectly reflected by the WPI, has been very close to zero. But lending rates to industry have remained above 11%. The real rate of interest is therefore probably the highest anywhere in the world today.

At such high rates, investing in infrastructure projects is suicide, for interest payments can double capital costs in as little as seven years – long before they start yielding returns. That is why India is now saddled with Rs 11,40,000 crore worth of abandoned projects, and why 40 of its largest companies – the cream of its new entrepreneurial class – are facing ruin.

Prem Shankar Jha is a senior journalist and the author of several books including Crouching Dragon, Hidden Tiger: Can China and India Dominate the West?