Last July, I watched a big World Cup football match in a small bar in Paris. There were about 60 people there. The French were mostly drinking wine, but there were 15 or so Brits who were drinking beer.
As the match progressed, the barman kept dropping the price of beer but not wine. The effect was the same as the effect of PNs (participatory notes) on capital inflows into India -- gulp, gulp. (Two years ago, PNs accounted for less than 20 per cent of the inflows. Today the figure is 53 per cent.)
Late into the second half, match tension and bladder pressure moved in the same direction, much as liquidity and inflation do. But the bar had only one bathroom for men and women. It was what you might call a structural problem.
It was interesting to watch the dilemma on the face of the Brits: should they keep watching or go? How should they manage the exchange rate of pleasure and pain, appreciate, depreciate, or hold steady?
In the end, most Brits were queuing up, in other words, they decided to depreciate. Unstoppable inflows had eventually forced an outflow--a sort of fuller capital account convertibility, if you will.
I am reminded of that evening because it is probably the best way of understanding what the Reserve Bank of India has done in its latest monetary policy changes*. The issues are simple:
It has to tackle inflation, which is the equivalent of having to watch the match. The alternative is not worth thinking about but sometimes it happens. But its elbow room is limited in the matter of capital inflows because the finance minister will not ban PNs even though they now account for such a high proportion of total FII-related inflows.
What the finance ministry, under very poor advice, is doing is the equivalent of the barman dropping prices even though he knows he is annoying the wine drinkers. They, as it happens, were not only in a majority, but also less boisterous and vociferous, not to mention more mindful of the overall picture and the concerns of others.
The only option for the RBI, therefore, was to let out some of the dollars by liberalising the capital account. But if opportunities (like bathrooms) are scarce, what do you do? Do you just curse the barman and hope for the best or take your chances on the street (which some of the more drunk Brits did and were hauled away by the police).
The overall result, in terms of welfare, was the opposite of Pareto optimality. Not even one person gained. Instead, everyone's welfare was reduced as a consequence of the barman's greed and his pre-occupation with his personal popularity. The Brits cheered with every drop in price.
In the end, the bar lost because there were fewer people left in it after the match. Usually, that is when the big booze sales happen.
The Brits lost because when the match was in its final moments most of them were looking at the toilet door. Bladder capacity had not matched the price elasticity of beer. The fact that three of them were locked up diminished their collective welfare even further.
The French wine-drinkers felt worse off because they paid higher prices and left as soon as the match was over for the bar next door which was not as good.
So what should have been the barman's strategy? How could he have maximised welfare, even if it meant a slight loss of personal gain? By doing two things mainly:
First, he should have raised the price of beer even if it meant the Brits becoming obstreperous. They were short-term visitors (just as the holders of PNs are) and not long-term ones like the wine-drinking French were.
Second, he should have announced that he would drop all prices as soon as the match was over. That would have resulted in not just everyone staying on but also more people coming in later.
Will the FM apply this wisdom to PNs? Write in your opinion.
*Annual Policy Statement for the Year 2007-08, Reserve Bank of India
http://rbi.org.in/scripts/NotificationUser.aspx?Id=3445&Mode=0#IIstance
