The RBI Governor
has been quoted as saying that there is not much scope for either fiscal or
monetary expansion. Analytical pieces
and editorials in newspapers have echoed the same sentiments with respect to
fiscal expansion but have been more ambivalent about monetary easing. This
assumes that an increase in the fiscal deficit and a loosening of the monetary
policy will both be expansionary. The analysis that leads to the formulation of
this choice in this manner is flawed for India.
Since 2009, the Indian economy has been in a situation in which a sharp reduction
in the fiscal deficit will be expansionary, particularly when combined with a
loosening of monetary policy.
The economic
environment in which the USA and EU have been in since 2010-11 is fundamentally
different from that in India. Thus one has argued for the last three years at
the IMF board (as ED) that the Euro area and the EU must not cut expenditures (or
raise taxes) in the short term, and focus fundamental tax and expenditure
reform on putting fiscal deficits on a clear down-ward trajectory over the
medium-long term. In other words, our
advice to the Euro area and the UK was to eschew immediate fiscal contraction
and focus on more durable fiscal and structural reforms.
At the same time, for India one has argued for
a reversal of the expenditure expansion that was undertaken in 2008-9. Fiscal expansion was essential in 2008-9 when
global demand collapsed, but was no longer necessary once India’s growth
recovered to 8%, which one expected to happen in 2009-10. Thus the process of restoring the fiscal
deficit to 3% of GDP, attained in 2007-8 should have begun from the 2009-10
budget and been completed by 2011-12.
Though in 2009, the growth rate for 2009-10 was merely a forecast, by
the time of the 2010-11 budget, growth was restored firmly to 8%-8.5%, the
underlying or potential growth rate of the Indian economy and a sharp reduction
in the fiscal deficit in the next two years would have restored it to the
2007-8 level.
Why this
difference in advise for the EU and India.
The EU and particularly the Euro area was in the midst of the worst
financial crisis since the Great Depression.
Banks balance sheets were in chaos requiring extraordinary support from
governments and Monetary authorities, virtually zero interest rates, inflation
close to zero and threatening to turn into deflation and low or declining
current account deficits. Further the crises affected virtually all developed
countries in the world so there were no independent drivers of demand and
growth. China with one of the lowest
private consumption rates in the world and a huge surplus on the current
account was also dependent on outside drivers of demand rather than being an
independent driver. In this situation, fiscal contraction across the Euro zone
and in UK turned out to be severely deflationary as predicted by several
observers (including us), contradicting the conventional wisdom enamored of the
IMF and board members from the EU countries.
In other words, the traditional neo-Keynesian model was much more
appropriate for the EU and the Euro area than the favored monetarist model (the
conventional wisdom ).
Paradoxically
the conventional global wisdom is currently relevant to India and has been
since 2010-11. An IMF review of
pre-crisis research on Developed countries complemented by updating of findings
confirmed that historically, fiscal contraction (expansion) had stimulated (reduced)
average growth in 3-5 years following the change. This was universally true when the
contraction was the result of expenditure reduction and less so when it was the
result of tax increases. In trying to
explain the reason the researchers discovered that the successful cases were
all linked to an expansionary monetary policy.
They concluded that a reduction in government expenditure increased
allowed Central banks to loosen monetary policy and effectively stimulate
private investment and consumption. In
contrast, a rise in taxes had a negative effect on private investment and
consumption and offset much of the benefits of monetary expansion.
An analysis of
the macro-economy of India during the last 3 years shows, a rising current
account deficit, stubbornly high
inflation, rising rural and urban real wage rates, falling saving rates, a
rising gap between bank lending and deposit rates and high gold imports. All these are indicators of a mis-match
between supply and demand at different levels: sectors such as agriculture and
energy, factors such as land and skilled labor and aggregate supply and demand
for natural resource and (artificial, policy created) non-tradable. Based on this analysis one has urged for the
last two years a sharp reduction in the fiscal deficit through a reduction in
subsidies accompanied by an equally sharp easing of monetary policy. The two together would have an expansionary
effect and reverse the cyclical elements of growth decline. A restoration of the economy to its growth
potential of 8% to 8.5% would require more policy and institutional reform.
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A version of this note appeared on the Op Ed page of the Economic Times, Monday 18th February, 2013 under the banner, "The Paradox of Fiscal Tightening." http://economictimes.indiatimes.com/opinion/comments-analysis/spending-cuts-by-trimming-subsidies-will-spur-growth-in-india-but-same-wont-work-in-eu/articleshow/18551276.cms
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