The Indian economy has been experiencing a slowdown in growth of GDP in general and investment in particular, with the Covid-19 crisis being the last (big) straw. In this post, Gurbachan Singh presents an internally consistent 10-point programme for economic recovery, which includes a novel package of well-targeted policies for macroeconomic and financial stability, and self-sustaining growth.
“Insanity is doing the same thing over and over again and expecting different results.” (Frequently attributed to Albert Einstein)
India’s gross domestic product (GDP) fell by 23.9% in the April-June quarter of 2020-21. It is expected to contract by 9-14.8% for the financial year as a whole. This is, of course, a large contraction for the current period but economic growth has been slowing down for some time now – Covid-19 was just the last (big) straw. How can we have a meaningful recovery? In this post, I present a 10-point policy plan.
Much of this post is based on my recent work, and some earlier work as well. All that work considered different aspects somewhat in isolation and this post provides an integrated and comprehensive perspective. There is value addition here, as Aristotle stated, to the effect that the whole is greater than the sum of parts. However, the post is not ambitious in the sense that the objective is not to present a perfect plan. Instead, the aim is to have a reasonably good plan. In the words of Karl von Clausewitz (1832), “The enemy of a good plan is the dream of a perfect plan”. For reasons of space, the theoretical foundations of policy, the empirical evidence, and the references to others’ writings are minimised here. I will abstract from political, legislative and operational aspects – the focus is on the economics involved and more specifically, on policy for macroeconomic and financial stability.
I will consider economic growth only to the extent that it relates to macroeconomic and financial stability. The latter is a broad term that includes banking stability, monetary stability, fiscal stability, and asset-price stability. The last is difficult to achieve but an attempt can be made to ensure that at least macroeconomic policy itself does not end up as a big cause of excess asset-price volatility. I will consider financial stability that can be maintained with minimal financial repression, bailouts, and jumps in inflation rate (Singh 2012). I will consider policy for macro-financial stability that does not have an increase in economic inequality as a side effect. Though the suggested policies are in the context of India, the policy proposals draw their lessons from the developed world as well (Singh 2020e). Furthermore, the policies suggested here are not just centred on the current situation related to Covid-19; these are for recovery from the more general slowdown that the economy has been experiencing for a while.
The ten-point policy programme
First, we have a serious issue of inadequate aggregate demand in the economy. Monetary policy is not very useful here (more on this when we come to the interest rate policy later). So, there is a need for the Government of India to spend more. This is the standard Keynesian fiscal policy.
On account of Covid-19, there just might be a need for lockdowns in different forms over a long period of time. If so, the Keynesian fiscal policy will have to be scaled down for a while. Such a policy has a less important role in what can primarily become a supply-side rather than a demand-side problem (Singh 2020b).
Second, the main and somewhat autonomous fall in aggregate demand relates to investment. Accordingly, the fiscal stimulus needs to be directed primarily at greater investment spending. This is treating the problem at its source. It is true that consumption demand was also affected over time but that is, broadly speaking, induced by a fall in income growth, which is, in turn, primarily due to a fall in the rate of investment. So, it is important that the focus is on investment here – this is consistent with the approach in the Economic Survey of 2020. I will discuss the humanitarian issue and the related consumption spending at a later point in the post.
Third, besides investing in infrastructure (including health infrastructure), it is important for the government to invest in projects which produce goods that will have adequate demand in the future. There are two ways of dealing with this issue. First, we can use knowledge in the market (Hayek 1945). Though unconventional, the central government can invest in the primary market in issues floated by private-sector companies that would like to invest in some projects. Why? The companies would have done their homework regarding demand for the output before launching the issues and they would have ‘skin in the game’ (Taleb 2017). The government can make selective investments in this context. Second, the policymakers can identify causes (like lack of inclusive growth) that play an important role in explaining why we have inadequate growth of aggregate demand and do something about the same (Ghatak et al. 2020). In fact, it can also be a mix of the two approaches (more on the possible demand problem later when we discuss the ‘feedback loop’).
Fourth, there were huge dollar inflows into the country in the last few months. These would have led to a major appreciation of the rupee, which would have, in turn, adversely affected exports. But the Reserve Bank of India (RBI) prevented this. However, it did so by increasing its foreign exchange reserves on the asset side of the balance sheet; these have been already very high for a while (Singh 2017b). The RBI also had to increase base money substantially on the liabilities side of its balance sheet. It is true that the RBI could have opted for sterilisation1 but that warrants reabsorbing the excess base money by selling government bonds. This raises yields on bonds, which is contrary to the policy of keeping interest rates low during periods of recession. So, there is a difficulty with the prevailing policy which has side effects or after-effects.
An alternative policy could be a (Pigouvian2) tax imposed by the government to discourage the sudden capital inflows, which can cause externalities in the economy. This proposed policy can stabilise capital flows and the exchange rate (Jeanne and Korinek 2010, Singh 2020f). This obviates the need for the RBI to increase its foreign exchange reserves – a policy that has adverse effects as discussed above.
Fifth, the food-price inflation has been high for several months in India. This has pushed up the general inflation rate in the economy. It is difficult for the RBI to tackle this for two reasons. First, it naturally cannot do anything about food prices. Second, though it can, in principle, do something about the general inflation, in practice, it is constrained due to the well-known trade-off between the different objectives that it faces under the prevailing policy regime that is based on flexible inflation targeting.
Under the proposed policy regime, these two issues do not arise, if it is not the RBI but the government that intervenes. It can do so by reducing taxes (or even giving subsidies) on food when food prices get much higher. A similar policy can be used to stabilise the price of an important commodity like oil within the economy (Singh 2018b). Food and oil prices are very important in the Indian economy. But it is possible with government intervention to deal with, what would otherwise have been a case of, cost-push inflation in an effective way (there have hardly been any signs of wage push by labour unions, etc., in India for a while).
Sixth, in a recession, investment is low even though the market interest rates tend to be low. Under the prevailing policy of the RBI (or any other central bank), the interest rates are kept even lower for encouraging borrowing and spending in a recession. This policy includes a quasi-subsidy for borrowers, which can be useful. However, as the then RBI Governor Raghuram G. Rajan observed in September 2013 in Frankfurt, this interest rate policy “… is very, very blunt ... targeted fiscal policy may be better…” But he did not specify how.
In past research I have shown how this is possible (Singh 2014b, Singh 2015, Singh 2020d). The government (or a somewhat independent and new wing associated with the government) can give an explicit subsidy on interest cost on borrowings for the purpose of financing real investment in a recession – this is effectively a reduction in interest rate. The subsidy pushes up the demand curve for funds. In the new equilibrium, the borrowing for real investment is higher.
In the process, the market interest rate, as it applies for other participants (such as those who borrow to invest in the stock market), goes up towards the more normal rates. Now we know that prices of many assets are inversely related to interest rates. Accordingly, all else equal, under the proposed policy the asset prices stay closer to normal levels (and do not go up, which is what happens under the prevailing interest rate policy). Also, economic inequality does not go up as prices of assets that are held primarily by the rich do not go up. As is clear, the proposed policy is well-targeted. This is very different from what happens under the prevailing policy which affects - among other things – interest incomes of pensioners and others.
The interest-rate policy for the purpose of giving a push to investment is included here primarily for completeness. In practice, investment can be interest-inelastic in which case (prevailing or proposed) interest-rate policy may not be very useful for giving a push to investment. Hence, in the context of the current situation I began the 10-point programme with the need for the government to spend more.
Seventh, we have seen in the previous three points that under the proposed policy regime the government can (a) reduce volatility in exchange rate due to international capital flows, (b) take care of any cost-push inflation, and (c) if required, bring about effective reduction in interest rates for borrowers for financing real investment and thereby stabilise aggregate demand in a recession. All this reduces the issue of a trade-off for the RBI and paves the way for it to meaningfully target core inflation3 (and not headline inflation) and do so with only a small leeway (Singh 2014, Singh 2017a).
In fact, the RBI can do better; it can target the path of the general price level. This is also the new policy that the Federal Reserve announced in the US on 27 August 2020, though their reasons are somewhat different.
Besides providing more price stability, such a policy is useful in so far as real long-term returns on debt instruments are concerned. It can also be useful for participants in the currency market, given that the price of one currency in terms of another is, fundamentally speaking, a function of the ratio of the price levels (and not inflation rates) in the two countries; this is using the theory of purchasing power parity (PPP).
Eighth, we had a quasi-banking crisis in India even before the Covid-19 crisis hit us (Singh 2020a). The situation has worsened thereafter. This is true not just for the public sector banks (PSBs) but also in many cooperative banks (as also non-bank financial companies). In fact, an important reason why we have had the problem of low aggregate demand is because of inadequate flow of funds through the financial intermediaries. So, there is a need for an effective banking policy as it relates to macroeconomic stability. We are familiar with the policy of a minimum cash reserve ratio (CRR)4 and statutory liquidity ratio (SLR)5. There is a need to also have a maximum CRR and SLR to ensure stable flow of credit (Dasgupta 2009).
Given the large non-performing assets (NPAs), the PSBs need to have more capital so that they can lend, given the Basel capital adequacy norms6. One route is that the government recapitalises these banks. This is, however, more palliative than a cure. There is a need for a long-term solution. This can include privatisation of banks in a phased manner, and greater and more meaningful regulation of banks to achieve social objectives. This is likely to result in less NPAs, less losses and thus, less need to recapitalise the banks now and then (Singh 2016, Singh 2018a, Singh 2019).
Ninth, instead of fiscal deficit to GDP ratio, an appropriate metric to measure the fiscal position is the ratio of fiscal deficits to tax revenues (Reinhart and Rogoff 2009). This ratio has been very high for a while. Now the fiscal deficits have increased further due to the fall in GDP and the related substantial fall in tax revenues.
So, it is not advisable to finance the net additional government expenditures through additional borrowing. Instead, such expenditures can be financed through disinvestment/privatisation of some public sector units including public-sector banks, sale of excess government land, and reduction of excess foreign exchange reserves. Such sales are warranted anyway for a variety of reasons. The effect on aggregate demand is the same whether the fiscal stimulus is financed by borrowing or by sale of assets (Singh 2020c).
Since no additional fiscal deficit in envisaged here, the question of ‘persuading’ commercial banks or the RBI to increase investment in government bonds does not arise. In other words, we can avoid (additional) financial repression, or monetisation of debt. All this is consistent with the proposed policy of a maximum CRR and SLR that I considered earlier for the purpose of smooth and stable flow of credit for industry.
Tenth, and above all, given the poverty, unemployment, plight of migrant labour, and healthcare requirements due to Covid-19 and the related lockdowns, there is an urgent need for more humanitarian spending by the government. This is a high priority (Gandhi 1927). And for this very reason, there is a need for reallocative fiscal policy – to cut government spending on less important items and increase spending on higher priority areas. This policy does not affect aggregate spending, but it is useful for obvious reasons. There is also a need for a redistributive fiscal policy, which is to raise taxes for the affluent and to pass on various benefits to the less well-off. With a proper choice of new or additional (solidarity) taxes, its effect on aggregate spending can be minimised, if not reduced to zero. The redistributive policy, like the reallocative policy, does not add to the fiscal deficit but both policies are important (Singh 2020e).
This concludes the tenpoint policy programme and we will now consider an important feedback loop.
A feedback loop
With the policy plan above, it is expected that macro-financial stability will be restored meaningfully. An important part of this plan is higher investment. With higher suitable public spending on investment for a while, it is also expected that the economy will return to a reasonably high growth path. At this stage, higher and somewhat sustained growth will, in turn, provide a rationale and incentive for greater private investment sooner or later – thanks to the acceleration principle (Junankar 2008). We have two important implications.
Firstly, the government often offers special exemptions, concessions, or pep talks to ‘revive animal spirits’ and push investment. These efforts are inessential. In any case, the role of animal spirits in real investment is often exaggerated – animal spirits (or sentiments) are important primarily in financial investment (Singh 2020g).
Secondly, under the prevailing policy the focus is, in principle, on maintaining aggregate demand regardless of whether the additional government spending is on investment or consumption. In practice, the focus is more on consumption due to humanitarian (and electoral) concerns. In such an approach, the economy does move towards full employment. However, it does not return to a reasonably high growth path, which can sustain adequate private investment on its own based on the acceleration principle. The result is that policymakers need to repeatedly intervene with some stimulus. This is not the case under the proposed policy.
- Sterilization is a form of monetary action in which a central bank seeks to limit the effect of inflows and outflows of capital on the money supply. Sterilization most frequently involves the purchase or sale of financial assets by a central bank and is designed to offset the effect of foreign exchange intervention.
- A Pigouvian tax is a tax assessed against individuals or businesses for engaging in activities that create adverse side effects for society. Adverse side effects are those costs that are not included as a part of the product's market price. This notion of Pigouvian tax in Microeconomics may be extended to the field of Macroeconomics.
- Core inflation is general inflation except that it does not include price changes from the food and energy sectors. This measure of inflation excludes these items because their prices can be very volatile.
- Cash Reserve Ratio (CRR) is the percentage of a commercial bank’s deposits that are required to be maintained in the form of cash as mandated by the central bank.
- Statutory Liquidity Ratio (SLR) is the term used for reserves that commercial banks in India are required to maintain in the form of RBI-approved securities before providing credit to customers.
- The international norms for maintaining minimum capital in banks are referred to as Basel capital adequacy norms.
- Dasgupta, Swapan (2009), “Comment on Luigi Zingales: Why not Consider Maximum Reserve Ratios?”, The Economists’ Voice, 6(4).
- Government of India (2020), ‘Economic Survey 2019-20’, Ministry of Finance, Department of Economic Affairs, New Delhi.
- Gandhi, MK, (1927/Reprint:2018), The Story of my Experiments with Truth - An Autobiography, Penguin, India. Reprinted in 2018.
- Ghatak, M, Ashok K, Bharat R (2020), ‘What would make India’s growth sustainable?’, Ideas for India and The India Forum, 14 August 2020.
- Hayek, Friedrich (1945), “The Use of knowledge in society”, The American Economic Review, 35 (4): 519–530. Available here.
- Jeanne, Olivier, Anton Korinek (2010), “Excessive volatility in capital flows: A Pigouvian taxation approach”, American Economic Review: Papers & Proceedings, 100(2), 403-407.
- Junankar, PN (2008), ‘The acceleration principle’, in Steven N. Durlauf and Lawrence E. Blume (ed.), The New Palgrave Dictionary of Economics 2e.
- Reinhart, CM, KS Rogoff (2009), This Time Is Different – Eight Centuries of Financial Folly, Princeton University Press.
- Singh, G (2012), “A review of Mohan, Rakesh (2011), Growth with financial stability – central banking in an emerging economy”, Margin -The Journal of Applied Economic Research, 6(3): 407-414.
- Singh, G (2014a), ‘Inflation targeting in India: Right and wrong’, Ideas for India, 31 January 2014.
- Singh, G (2014b), “Overcoming zero lower bound on interest rate without any inflation or inflationary expectation”, South Asian Journal of Macroeconomics and Public Finance, 3(1): 1-38.
- Singh, G (2015), “Thinking afresh about central bank's interest rate policy”, Journal of Financial Economic Policy, 7(3): 221-232.
- Singh, G (2016), ‘Public sector banks: the more things change, the more they stay the same’, Ideas for India, 21 July 2016.
- Singh, G (2017a), ‘Reconsidering the 4% inflation target’, Ideas for India, 16 January 2017.
- Singh, G (2017b), ‘Should India hold US$400 billion dollars of reserves?’, Ideas for India, 3 October 2017.
- Singh, G (2018a), ‘Huge bank losses, frauds, and economic risks’, Ideas for India, and Mint, 9 March 2018.
- Singh, G (2018b), ‘Making oil prices less taxing: Under the prevailing policy, it is the oil price that fluctuates’, Financial Express, 4 December 2018.
- Singh, G (2019), How bank denationalisation can be a solution to tackle slowdown woes, Financial Express, 11 October 2019.
- Singh, G (2020a), ‘Banking crisis is not over yet, but recapitalisation hiding the truth’, Financial Express, 13 January 2020.
- Singh, G (2020b), ‘Covid-19: Getting the fiscal policy right’, Ideas for India, 7 May 2020.
- Singh, G (2020c), ‘Covid-19: Does the Government of India really have limited fiscal space? Ideas for India, 29 May 2020.
- Singh, G (2020d), ‘Covid-19: and the way to avoid a blunt interest rate policy’, Ideas for India, 16 June 2020.
- Singh, G (2020e), ‘Covid-19: Recession in India, and policy lessons from other countries’, Ideas for India, 27 July 2020.
- Singh, G (2020f),’Handling the dollar rush’, Business Standard, 19 August 2020.
- Singh, G (2020g), ‘Animal spirits: Right and wrong’, Business Standard, 16 September 2020.
- Taleb, Nassim Nicholas (2017), Skin in the Game, Penguin - Random House.