Reserve Bank’s progressive tightening of monetary policy is drawing blood; many businesses are feeling the pinch, and economists are beginning to fear that Venugopal Reddy is aspiring to follow in the footsteps of his distinguished predecessor, Dr C. Rangarajan. When faced with rising inflation in 1995, Rangarajan had clamped down on bank credit. Many companies that had ordered equipment could not get credit to buy it, many that had expanded capacity could not sell their goods because they could not give distributors credit, and many found their clients running short of money and cancelling orders. Businessmen are wondering if they are going to see a repetition of the bloodbath of 11 years ago.

In a speech to Bombay Chamber of Commerce on 9 April, Rangarajan defended his action. He said that the recession that followed monetary tightening was due to the meltdown in East Asia — and implicitly declared himself innocent. His defence is wrong on timing. He began to tighten credit in late 1995; there was no sign of the East Asian crisis till 1997. The troubles of Indian borrowers started in 1996, on account of credit shortage, not lack of demand; the demand slowdown spreading out from East Asia did not strike Indian shores till 1998.

Reserve Bank’s handling of the East Asian crisis was also mistaken. It maintained the Dollar-Rupee exchange rate at a time when east Asian currencies had been devalued 30-70 per cent; thereby, it gravely hurt Indian exports, and exposed Indian industry to lower prices of competing imports than it would have been if the rupee had been devalued. But that was not Rangarajan’s mistake; it was that of his successor, Bimal Jalan. Serially, they were responsible — though certainly not solely so — for the crisis of 1996 and the ensuing slowdown, which ended only in 2003. The average growth rate in those seven years was half of the 9 per cent that we have recently achieved. If we had not lost all that growth, we would have been 35 per cent richer today. That is an upper limit, for we must not assume that the path would have been smooth but for Reserve Bank’s roadblocks, or that other policy-makers would not have made other mistakes. But 20 per cent would be a reasonable estimate of the lost growth.

The errors are history since Rangarajan and Jalan ceased to be governors long ago. But Rangarajan is the Prime Minister’s most trusted economic adviser; his influence can magnify manifold the errors he now makes. This is why his defence of the current tight monetary policy is important. According to him, rising inflation, a widening current account deficit and 21per cent-plus growth in money supply are indicators of an overheated economy. He thought it important not to turn what is now a cyclical problem into a structural one; to put it in simple English, he meant that if inflation continues to be high, people will get used to it, and we will have permanently high inflation, which would entail high interest rates, a depreciating exchange rate and periodic payments crises.

Certainly, if the choice were so put to them, most people would prefer the yet unknown effects of monetary tightening to the frightening prospect Rangarajan laid out. But his question was a rhetorical one; it implied its own answer. People should ask another question: is tight monetary policy the only instrument available to the government against inflation? The answer is no; there is also fiscal policy, and it is superior under present circumstances. For one thing, tight monetary policy acts only against investment and inventories, whereas fiscal policy can work against all components of demand, including consumption. For another, monetary policy has the strongest impact on banks and their borrowers, which are mostly small businesses; taxation can impact all investors — big companies, small businesses, and personal borrowers. There is something Rangarajan has missed out in his policy prescription; and he is too good an economist to have missed it out inadvertently.

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The author is consultant editor of The Telegraph.