Sunday, February 17, 2013

Paradox of Fiscal Tightening: Expenditure Cut is Expansionary (Deflationary) in India (EU)

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. 
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."

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