Running a ‘project finance economy’
It is time to question neo-classical economic precepts on deficit and inflation for an economy of India’s nature
Every country seeks growth in its Gross Domestic Product (GDP) to meet the needs of its citizens. A growth in GDP is a function of the amount of labour utilised in a country, the amount of capital deployed, and the increase in the country’s productivity. Any nation that seeks to accelerate its GDP growth must employ more people, use more capital or increase its productivity.
In a set of brilliant Reith lectures last year, Mark Carney discusses how the economic theoretician tries to paint the discipline of economics, as a neutral technical discipline, with immutable laws that provide good and bad answers. But are their answers good for developing countries in general, and India, in particular? In a developed economy, the level of per capita income of the population is high, the levels of unemployment are typically low, the tax base is broad, and governments can meet their expenditure from tax revenues. The need to borrow arises primarily to smoothen the timing of revenue and expenditure flows. These countries have reasonably robust soft and hard infrastructure.
It is not that everything is perfect in terms of access or even in the quality of infrastructure, but life chances for people are much better than in other parts of the world. It is true that sometimes these countries start to trail in some areas of innovation by falling behind in research and development (R&D) investment, but essentially, they have high per capita incomes and governments have the resources to meet their current expenditures. In normal periods, these economies can be said to be in a steady state and like low inflation with balanced budgets. If they run fiscal deficits, it is on account of unanticipated shocks or by political choice.
I would like to call these economies “working capital economies”.
In contrast, developing economies are those that have low per capita income and high unemployment or disguised unemployment (very low productivity jobs). They are not in a steady state. They often lag in their soft infrastructure — reasonable schooling, decent health care, and levels of malnutrition in children. They have gaps in their hard infrastructure in respect to the availability of drinking water, power, public transport, roads, rail, airports and ports. Typically, they have lower spending on R&D and technology.
Therefore, these economies operate at low-productivity levels. Often, these economies have access to cheap labour, but it is mostly unskilled, they typically exhibit a shortage of capital and struggle to grow sustainably. Revenue is not enough for the desperately needed capital expenditures. They need to borrow and invest in infrastructure to break out of their low productivity trap to be able to raise their per capita incomes and get close to full employment. I term these economies “project finance economies”.
Project finance economies have different imperatives from “working capital economies”. They need investment to fill the gaps in their infrastructure and lack the resources to do so. They need to run fiscal deficits, tolerate higher inflation, and keep interest rates lower relative to their level of inflation so that they may raise the resources to build the needed infrastructure. Only by improving their soft and hard infrastructure can they raise economic productivity, which creates the ability for them to put their economies on a sustainable growth path and allow them to service their loans.
Inflation around 7% creates some money illusion and increases consumer expenditure and makes employees feel an improvement in their situation. Lower interest rates spur capital investment and if the money is well spent, raise the productivity of the economy and increase per capita incomes. The important requirement is that the borrowing is used to fund capital and not current expenditure.
The passage of the Fiscal Responsibility and Budget Management Act (FRBM) in 2003 in India was to restrict the ability of governments to run fiscal deficits. This was done with a view to constrain them from being irresponsible and taking on more debt than it could service. The question is should the Act have constrained the ability of the government to borrow or should it have ensured that if the government borrowed, it was for capital expenditures that would raise our productivity.
Further, in 2016, India decided to establish an inflation target that is to be monitored through a monetary policy committee. The inflation target has been set at a 4% with a 2% band on either side. The question is should a “project finance economy” set a low 4% target, when for most of India’s independent history it had an average inflation of 7% with a few spikes without major problems? South Korea did the same during the 20-year period of its rapid GDP growth between 1980-95. To kill inflation, the Reserve Bank of India kept interest rates higher than in most parts of the world between 2014-2018, making us the haven of the carry trade by over-estimating inflation consistently. This discouraged capital investments and led to a slowdown in exports because of an overvalued currency.
We need a reset away from simple neo-classical dogma to create the right policies for sustainable employment-generating growth in India by improving our productivity. As Confucius said, “When it is obvious that the goals cannot be reached, don’t adjust the goals, adjust the action steps.”