In praise of countercyclical policy
If it’s smartly done and addresses the related problems of growth and employment, it can reap quick rewards
If there’s one lesson that the great financial crisis (GFC) of 2007-2008 taught us it is that economics is not rocket science. Reams of intensely mathematical and utterly incomprehensible papers may have been written over the last few decades in frontline journals such as the Journal of Economic Theory or Econometrica. However, when economists were actually asked to take a call on what should be done when the real global economy was collapsing like a house of cards, the debate did not transcend the level of an undergraduate economics textbook.
It all boiled down to a very simple question: Would pump priming the economy through expanded government spending be the answer (the US chose this route successfully) or whether cleaning up the fiscal books and more austerity be the best way out? The ever thrifty Germans imposed this model on Europe, with somewhat unfavourable consequences.
Indian policymakers face a similar choice today. With the growth rate for the first quarter of the year printing at a dismal 5.7 per cent and the prospect of an annual growth rate for 2017-18 of well below 7 per cent seeming real, the government seems ready (if newspapers are to be believed) to prime the economy with a fiscal stimulus. Newspaper editorials and a large section of the economics community – particularly those who work with foreign institutions – have warned against this and exhorted the government to face this slowdown with a Teutonic stoicism, sticking to fiscal targets and focus on “reform” to do the trick While a decision has to be taken on which of these paths to walk down, it will not be be simple. For one, things in India are not the same as in the US; the latter prints the principal reserve currency of the global system and enjoys “exorbitant privilege”. India is also at the mercy of international rating agencies that places its sovereign rating on the lowest rung of the investment grade. Despite the fact that this rating is quite clearly undeserved, a number of institutional investors go by this.
All this is important since there is a growing apprehension that India is straying off its path of consolidation and compromising macroeconomic stability. While the farm loan waiver by states is seen (perhaps legitimately) as gross violation of fiscal discipline, projections for the central government’s tax collections and the likely shortfall on divestments and spectrum auction receipts raise the prospect of an overrun in the central government’s deficit. This could, among other things, drive a large flight of capital and the recent sell-off in the stock-markets is perhaps a warning signal. (I must emphasise that any sensible calculation or comparison with other economies would show that we are far from a fiscal cliff.)
However, can we afford to twiddle our thumbs and hope that the warm and fuzzy thing called reforms will dig us out of the hole? Here’s my answer. I am a great believer in the analogy of the “stall speed” of an aeroplane to describe an economy’s dynamics. If a plane goes below its stall speed it goes into free fall. Ditto for an economy. I don’t think we have decelerated to a point where we have hit the stall speed but we must make sure that we don’t get there. This requires quick counter-cyclical action
The problem with reform is the fact that ironically enough, the initial impact could be negative for the economy. Reform is by definition about structural change and this quite naturally breeds teething troubles. Just think of the goods and services tax (GST) that is arguably the biggest reform since the early nineties. Reforms are also known to work with a lag. I can bet that even the most radical restructuring of the banking system will not drive a revival in credit disbursal. To make a simplistic generalisation, reforms typically work on the supply side and ease constraints. The problem today is one of weak demand, not supply.
Where does monetary policy fit into all this? Contrary to a somewhat naïve view that prevails – the monetary authority must always act as a check on the fiscal side – it’s about time that we got some coordinated action. Fiscal efforts are unlikely to be fruitful if the RBI cries bloody murder and tries to stifle any fiscally driven demand expansion with tighter monetary policy.
So what’s the best way to put some juice back into the economy without risking damage to the picture of macro-stability? For one it’s best to announce a stimulus package alongside a significant reform initiative. I am certain that a “bold” step towards the consolidation of public sector banks would be welcome at this stage and could offset whatever negative PR a small reversal in fiscal consolidation will create.
However, before actually letting the deficit slip and turning to the bond market, the government must show that it has tried and exhausted all avenues of raising funds. Take the divestment programme for instance where only ~8,500 crore have been raised of the ~72,000 crore budgeted. How much more can it get if it really pushes the envelope? What about the plan to monetise land, particularly that owned by the railways? If expenditure needs to be pruned, can we ensure that capital spending does not get the chop?
Thus we need counter-cyclical action at this stage? If it’s smartly done and addresses the related problems of growth and employment, it can reap quick rewards. However it is important to ensure that it is not viewed as a callous acceptance of fiscal waywardness. It is just as important to signal that the business of “reform” is alive.