Given the prevailing economic situation in India and following the past experience of several developed countries, there is a clamour for accepting much larger fiscal deficits, and adopting unconventional monetary policy. In this post, Gurbachan Singh contends that these are relatively soft and not very effective policy options for sustainable recovery and growth. He presents a different diagnosis, and accordingly, an alternative policy prescription.
The Indian economy experienced a falling growth rate of GDP (gross domestic product) in the last few years. Now, due to Covid-19 and the consequent severe lockdown in the country, the economy is likely to see a contraction of 4.5%-12.5% in GDP in the current year. There is a clamour for adopting unconventional monetary and fiscal policy. All this is explicitly or implicitly about accepting much larger fiscal deficits, significantly expanding the balance sheet of the Reserve Bank of India (RBI), and moving towards much lower interest rates – even zero rate of interest, if required.
It is argued that, broadly speaking, unconventional macroeconomic policies have been tried in Japan (since the recession in 1989-90), in the US (since the Global Financial Crisis in 2007), and in the Eurozone (since at least 2012). These policies have been successful to an extent in helping the economies come out of a recession/crisis – without causing a fiscal crisis or high inflation. So, there is a view that policymakers in India should not hesitate to use similar policies, given the very severe economic downturn now.
This post differs with the above overall assessment. I reconsider the unconventional macroeconomic policies, and present an alternative policy prescription for Indian economy. (In what follows, I will not consider the post-Covid situation in other countries.)
Understanding the experience of the developed world
Even though unconventional macroeconomic policies had somewhat stabilised aggregate output in Japan, the US, and the Eurozone in the aftermath of their respective severe downturns in the past, these countries/regions had not returned to their earlier growth rates. Why?
An important reason is the lowered investment path. Given the low investment rate, the GDP growth rate is low. The story does not end here. The relationship holds the other way round as well. Given the low rate of growth of GDP, the private investment stayed low; this is due to the well-known but not well-appreciated ‘acceleration principle’. So, broadly speaking, low growth of GDP and low investment rate appear to have become an equilibrium in much of the developed world.
It will help to revisit the acceleration principle, which is that “the demand for capital goods is a derived demand and that changes in the demand for output lead to changes in the demand for capital stock, and, hence, lead to investment” (Junankar 2008). In this context, it is not clear if low interest rates can help much to revive investment. This is because the cost of funds is not very relevant if economic growth is low, and the additional aggregate capacity to produce more is hardly required in the first place. Hence, the emphasis on low interest rates can be misplaced (see, for example, Rogoff 2020).
Given the low investment growth, naturally, growth of private credit is small. So, the banks hold a good amount of their funds at the central banks which, in turn, invest the funds in government bonds (and some other assets). It is interesting that in this process the central banks have, in a sense, become like intermediaries between the banks and the government. The reason why banks do not invest too much in government bonds directly is that there is an interest-rate risk. In contrast, their parked funds at the central banks are in the form of cash reserves with no interest-rate risk.
Since cash reserves of banks with the central bank are included in the so-called base money, the latter has gone up massively in Japan (since 1989), in the US (since 2007), and in the Eurozone (since at least 2012). However, given that the the central banks are acting somewhat as intermediaries between banks and the government, it is not surprising that currency, and money in circulation with the public, have not deviated much from their earlier growth paths. This helps explain the absence of high inflation.
As aggregate private investment is sluggish, it is not surprising that interest rates are low. And, given that the central banks have been buying large amounts of government bonds under the quantitative easing (QE)1 programme, it is only to be expected that the yields on government bonds have fallen more than interest rates in general have. And, given the central banks’ ‘Operation Twist’2 in some places, the yields on long-term bonds have fallen more than short-term interest rates have (Fama 2013)3.
It is well-accepted that since the long-term interest rates are low, asset prices rose substantially over time in the US after the Global Financial Crisis was over. But even in Japan and Europe, it is plausible that asset prices rose compared to what they would have been in the absence of a fall in interest rates.
How did the different actors respond to the ‘new normal’? The low interest rates provided some comfort to the governments whose debts have been rising substantially due to the fiscal stimuli (Furman and Summers 2019). Also, with low interest rates many companies have borrowed huge amounts of money only to buy back their shares and raise their share prices (and raise the bonuses for their managements). The higher asset prices provided comfort to the rich and the upper middle-class investors. Low and stable inflation has been comforting for bond investors and for the poor wage-earners. The near maintenance of output and employment gave comfort to the bulk of the population. So, was everything all right then? Clearly, no.
Even though fiscal crises or high inflation have not occurred, the situation is not, to use the term popularised by Nassim Taleb, ‘anti-fragile’. There is no easy exit from the QE programme (Blinder et al. 2013). Also, given the fall in interest rates and the rise in asset prices and the already skewed distribution of assets, economic inequality increased after 2007 (Credit Suisse, 2015). The apprehensions about fiscal deficits (and QE) can be bothersome enough to keep the confidence shaky for aggregate long-term real investment (Alesina et al. 2019). And, above all, the growth rates of GDP have stayed low long enough to make the idea of secular stagnation respectable again (Hansen 1938, Summers 2018).
There is a big policy lesson in all this for India.
Policy for India
It is true that J.M. Keynes had prescribed a general fiscal boost if there is a recession due to inadequate aggregate private demand in the economy. It was argued that whether the government spending is on investment or consumption hardly mattered (assuming that production is flexible). And since, there was a humanitarian (and an electoral) concern about the poor and lower-middle class, it was natural that the focus would be, in practice, on consumption and not investment. But that is not always the right approach.
It is true that if the private demand is inadequate and the government spends primarily on consumption, then aggregate demand will be maintained, and the economy will return to full employment. However, it is not clear if in the next period(s) too, private demand will be adequate; this is particularly true for private investment demand. If it is not, then it can imply that the government needs to provide a fiscal boost to some extent in the following periods as well. With such fiscal boost now and then, if not very regularly – more in the form of consumption than investment demand – there is a creeping and subtle, but definite, compromise on economic growth, thanks to inadequate investment. In fact, there is now an economic rationale for private investment demand to be low due to the low growth of GDP, given the acceleration principle. So, we can have an equilibrium with low investment and low economic growth.
Given the critical role of investment in sustainable recovery and economic growth, it is important that the focus of government spending under Keynesian fiscal policy in India is on investment4 and not consumption. There are other ways of maintaining consumption demand, and I will come to these later.
In what way can the government increase spending on investment? One is, of course, infrastructure spending (including medical infrastructure in a big way at this juncture). But there can be other ways as well. The government can set up an investment-holding company (or a variant of sovereign wealth fund), and provide funds to it. This new institution can subscribe to issues floated by new or existing companies in the primary capital market in this recessionary environment. This has a more direct effect on investment. (If some rules are framed, then it should be possible to minimise favouritism.) The suggested policy can also be useful in preventing bankruptcies of existing firms that have weak balance sheets at present. This investment policy can complement the new credit policy that is already being implemented.
In what may seem a change of gears, do we need economic reforms at this stage? It is true that long-term structural economic reforms do not resolve the problem of inadequate aggregate demand. So, from this angle, this is not the appropriate time to consider economic reforms. However, these can have an indirect but strong effect. Economic reforms in a country like India can raise expectations of growth, which can, in turn, push private domestic and foreign investment, through the acceleration principle.
Though useful, the approach of economic reforms to increase the potential supply of goods and services is not enough. Policymakers need to worry about aggregate demand as well – not just in a recession, but also in the normal course of realising the potential growth over time. Adequate demand cannot be taken for granted. There is a need for inclusive growth so that aggregate demand can be realistically increased over time. The reason is simple. The rich tend to have a relatively low marginal propensity to consume. So, we can keep running into a demand problem if the growth does not include the poor people and the rural sector. With such a change in emphasis, the growth rates of GDP and investment may not be very high, but these can be more stable and sustainable (Ghatak et al. 2020, and the references therein).
If reasonable rate of investment is maintained, real interest rates can become higher to some extent. This can avoid a rise in asset prices (that may otherwise happen if interest rates fall). That avoidance of (excess) asset price rise will, in turn, ceteris paribus (other conditions remaining the same), keep a check on any rise in economic inequality in India. This matters in itself but it also matters, as we have seen, in the context of maintaining adequate demand in the economy.
It is true that even some rise in real interest rates will add to the interest burden on the government. However, with higher growth, tax revenues too will grow faster. So, there is a way to pay for the relatively high interest costs. Moreover, if the higher private investment materialises on a sustained basis, the need for large fiscal deficits to maintain aggregate demand in the future years can be much less. Hence, the public debt will not rise much for this reason. In any case, the objective of policy must be social welfare and not convenience for the government in managing its debt.
After the initial push by the government, if private investment is maintained by and large, the economy can be on a somewhat sustained path of full employment (and growth). This reduces, if not obviates, the need for the public authorities every now and then to intervene and try to lower interest rates, and incur larger fiscal deficits (and sell bonds in one way or another to the central banks), and thereby maintain aggregate demand.
Last but not the least, let us now come to the question of government spending on consumption. We have the humanitarian issue of dealing with the serious problems faced by the unemployed, the poor migrants, the sick, the homeless, and other such groups. This concern needs to be taken care of immediately and generously – more so as the situation is aggravated by the severe lockdown imposed by the government.
How can the government take care of the consumption demand? This is, in fact, a matter of high priority. And, because this is high priority, there is a need to use, what may be called, reallocative fiscal policy and redistributive fiscal policy. The former is about increasing expenditure on some items and reducing expenditure elsewhere. The latter is about increasing taxes for the rich and spending more on the poor. The reallocative and redistributive policies are required, if the fiscal space for carrying out Keynesian fiscal policy is limited. This may be so even after allowing for the maximum possible fiscal deficit under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, and after raising funds to the extent possible through alternative means like privatisation/disinvestment, sale of excess land held with public authorities, and reduction of excess foreign exchange reserves (Singh 2020b)5 .
But will reallocative and redistributive fiscal policies not adversely affect aggregate demand? While reallocative policy, by definition, does not affect aggregate demand, the redistributive policy may, in principle, have such an effect (Alesina et al. 2019). However, if the additional taxes are carefully selected, the effect on aggregate demand can be minimal under the present conditions in India (Singh 2020a). This is particularly true if the idea of new tax is sold as a ‘solidarity tax’ (as has been proposed in Peru already).
The Indian economy has been going through a slowdown for a while; the last straw was the arrival of Covid-19. The priority is to take care of the humanitarian and medical concerns. But there is also a need and scope for government investment spending; the government does have fiscal space (broadly defined). Equally, if not more, importantly, there is the role of a suitable policy mix that is targeted at sustained investment and inclusive economic growth. In this context, large fiscal deficits, low interest rates, and variants of the QE programmes (that have been used in the developed countries/regions in the aftermath of their earlier respective serious downturns), are relatively soft and not very effective policy options for sustainable recovery and growth.
- Quantitative easing (QE) is a policy strategy of seeking to reduce long-term interest rates by buying large quantities of financial assets when the overnight rate is zero.
- Operation Twist is the sale of shorter-term securities and purchase of equal amounts of longer-dated Treasuries; the objective is to reduce yields on longer-term bonds relative to those on shorter-term securities.
- To the extent that the central banks do control interest rates in general, the policy is typically blunt. There is a need and scope for a well-targeted interest rate policy (Singh 2020c).
- It is true that we have excess capacity, which can come in the way of fresh investment for a while. However, such capacity is in some sectors only. Moreover, the economic excess capacity is less than the physical excess capacity.
- Just in case the reallocative and redistributive fiscal policies too are constrained, then we do face a trade-off under Keynesian fiscal policy between government spending on consumption and investment in a downturn.
- Alesina, A, C Favero and F Giavazzi, (2019), Austerity: When It Works and When It Doesn’t, Princeton University Press, New Jersey.
- Blinder, A, T Jordan, D Koohn and F Miskhin (2013), ‘Exit Strategy, the 15th Geneva Report on the World Economy’, International Center for Monetary and Banking Studies, Centre for Economic Policy Research.
- Credit Suisse (2015), ‘Global Wealth Report, 2015’, Zurich, Switzerland.
- Fama, Eugene F (2013), “Does the Fed control interest rates?”, The Review of Asset Pricing Studies, 3(2):180-199.
- Furman, J and LH Summers (2019), ‘Who’s Afraid of Budget Deficits? How Washington should end its debt obsession’, LarrySummers.com, 28 January 2019.
- Ghatak, Maitreesh, Ashok Kotwal and Bharat Ramaswami (2020), ‘What Would Make Growth Sustainable?’ Forthcoming.
- Hansen, A (1938), Full Recovery or Stagnation?, Norton, New York.
- Junankar, PN (2008), ‘The Acceleration Principle’, in SN Durlauf and LE Blume (eds.), The New Palgrave Dictionary of Economics, Second edition, Volume 1, Palgrave Macmillan, 5-7.
- Rogoff, K (2020), ‘The Case for Deeply Negative Interest Rates’, Project Syndicate, 4 May 2020.
- Singh, G (2020a), ‘Covid-19: Getting the fiscal policy right’, Ideas for India, 7 May 2020.
- Singh, G (2020b), ‘Covid-19: Does the Government of India really have limited fiscal space?’, Ideas for India, 29 May 2020.
- Singh, G (2020c), ‘Covid-19, and the way to avoid a blunt interest rate policy’, Ideas for India, 16 June 2020.
- Summers, L (2018), ‘The threat of secular stagnation has not gone away’, LarrySummers.com, 6 May 2018.