The Indian economy is going through an economic slowdown. Several economists have made a case for an expansionary fiscal policy to deal with the slowdown. In this post, Gurbachan Singh argues that it is not advisable to use fiscal policy now. He further contends that part of the fall in demand is rooted in the long-term supply-side reforms that the government and Reserve Bank of India have been undertaking.
The GDP (gross domestic product) growth rate in India has fallen over time since the heydays of the boom that ended in 2008. It fell to 5% last quarter. So, several economists have made a case for an expansionary fiscal policy to deal with the slowdown. This column presents a different view.
In 1936, John Maynard Keynes provided the theoretical justification for fiscal policy for macroeconomic stabilisation (Keynes 1936). However, it is important to remember the context in which he advocated fiscal policy. First, per capita income had fallen by a third from 1929 to 1933 in the US. This was a massive negative growth. Second, the situation in the 1930s in many advanced economies seemed to be one of equilibrium (this is implicit in the basic textbook Keynesian cross diagram and in the IS-LM model). In other words, if nothing was done about it, the output and employment could get stuck there for very long, if not forever. Third, there was fiscal space for the government to carry out an expansionary policy. If the government were to incur a deficit, even a large deficit, there was hardly any risk of a fiscal crisis in future.
Now let us see if these three conditions are met in India at present.
First, the GDP has not fallen in India. It is only the growth rate which has fallen, and even this growth rate has touched a ‘low’ of plus 5%. So, the situation is not at all comparable to what it was in the 1930s in many advanced countries.
Many have argued that fiscal policy should not be confined to a desperate situation like the one in the 1930s in advanced countries; instead, it should be used more generally. In fact, the US and many other countries started using fiscal policy more generally to deal with any significant slowdown that occurred after World War II. However, based on the experience of macroeconomic management over the previous two decades or so in the US and elsewhere, Milton Friedman (the Nobel Prize winner in 1976) had famously argued against fine-tuning of aggregate output in the economy; instead, he advised that the emphasis should be on monetary and banking stability (Friedman 1968). If we are to apply that advice to the current situation in India, it is not clear that we need a fiscal boost. Let us look at some data.
It is by and large agreed that the main reason for the slowdown over the last decade or so is the fall in investment growth (Kotwal and Sen 2019). While this is indeed true when the comparison is with the period 2003-08, it is important to note that the rates of growth of gross capital formation (GCF) at constant prices are as follows: -5.25% (2013-14), 6.13% (2014-15), 7.04% (2015-16), 5.84% (2016-17), and 12.87% (2017-18); these are based on the data on GCF. Observe that there is a somewhat upward trend in the period covered. We have moved from minus 5.25% to plus 12.87%. It would have given a clearer picture if we had the figure for 2018-19 but this is not available as yet.
It is true that there are some doubts now about the official GDP and related figures (Subramanian 2019). There are good reasons to take this critique seriously. However, even if we accept Dr. Arvind Subramanian's claim that the actual GDP growth rate is lower than the official figure by as much as 2.5 percentage points, it still does not follow that we have a very dismal story. The growth rate for this fiscal year as a whole is expected to be 6.1% (International Monetary Fund (IMF), 2019). Taking into account Dr. Subramanian's claim, we have a range of 3.6% to 6.1% for the growth rate of GDP. This does not suggest that the first condition for an expansionary fiscal policy discussed above is met.
Second, I do not think that anyone is arguing that the growth rate of 3.6-6.1% is going on to becoming a situation of equilibrium in the Indian economy, if a fiscal boost is not provided. In other words, it is not as if we are getting stuck at this ‘low’ growth rate. There is hardly any indication to this effect. So, the second condition for applying economic advice by Keynes for using fiscal policy hardly holds.
Third, there is hardly any fiscal space for the Government of India (GOI) at present after considering the large borrowings by the public sector undertakings (PSUs), the contingent liabilities, and the state governments' deficits. The lack of fiscal space is clearer to see if we use the metric deficit-to-taxes rather than the metric deficit-to-GDP, as suggested in Reinhart and Rogoff (2009). It is also important to remember that we have inflation targeting in place since 2016. So, the route to dealing with debt through tolerating – if not engineering – high inflation from time to time is no longer present. It is true that most of the debt is denominated in terms of rupees and it is held internally. However, considerable borrowing by the government from banks and insurance firms becomes a case of costly financial repression. We see now that the third condition under which Keynes advocated use of an expansionary fiscal policy too is not met in India at present.
For future there is an important lesson. When there is a big boom in India, there is a need to use countercyclical fiscal policy (this is what was not done during the previous big boom over the period 2003-08). This will serve two purposes. First, it will curb the unhealthy boom and reduce its adverse after-effects. Second, it will help create fiscal space, which may be needed if a serious crisis were to occur in future.
Let us return to the present situation. If it is not advisable to use fiscal policy now, then what else can we do? For this, let us understand better why the demand slowdown has happened in the first place. It is interesting and even ironic that a part of the fall in demand is rooted in the long-term supply side reforms that the GOI and the Reserve Bank of India (RBI) have been undertaking.
Asset Quality Review (AQR) and the provisioning for non-performing assets (NPAs), inflation targeting, Insolvency and Bankruptcy Code (IBC), demonetisation, and the launch of goods and service tax (GST) are what can only be classified as supply-side reforms; we may even include the Supreme Court judgements in 2012 and 2014 on the allotment of 2G spectrum and coal. All these have acted as shocks to the economy in the short run. The effects of AQR and NPAs, IBC, demonetisation, GST, and Supreme Court judgements are quite familiar; the short-run adverse effect of inflation targeting is relatively less well known. So, let me explain this.
Though inflation targeting was formally adopted in August 2016, the RBI had already started using a contractionary monetary policy to control inflation, which had reached high rates. The rate of growth of reserve money fell substantially over a short period of time from 21.50% (2010-11) and 14.06% (2011-12) to just 5.99% (2012-13) and 8.80% (2013-14). This was a case of applying the brakes too hard too fast. This acted as a shock to the macroeconomy. The rate of growth of money and credit fell. This adversely affected investment.
Now the various supply-side shocks have adversely affected GDP in general and profits in particular. This is to be expected as profits are the residual left after making pre-committed payments for wages, interest, rent, and other input costs. The significance of this is that profits are an important source of financing investment. When profits are low, investment is low.
One may have thought that when internal funding from profits is low, external funding could fill the gap. However, this does not happen even in developed economies (Blanchard, Figure 16-3, p. 369). In India, it is even more difficult. This is the case even in normal times. In relatively abnormal economic times like the last so many years, it has become much more difficult – thanks to the AQR and provisioning for NPAs. In the last one year, ever since the crisis at Infrastructure Leasing & Financial Services (IL&FS), lending from non-bank finance companies (NBFCs) too has been affected.
At this stage, there is not much that can be done about the supply side reforms which have already brought in various shocks to the demand in the economy except that there is an important lesson. In future, there is, of course, a need to pay more attention to the nature, pace, and timing of the supply-side reforms.
Though we cannot undo the adverse effects of supply-side reforms, we can improve the situation insofar as lending is concerned. With greater lending, the demand can go up. There is scope for using banking policy (Singh 2018a, 2019). There is also scope for an improvement in interest rate policy (Singh 2018b). In any case, it is better to use these policies rather than the fiscal policy because the banking policy and interest rate policy get to the roots of the problem; fiscal policy does not. The latter is more of a palliative than a cure.
All this is not to say that the public authorities should not do anything about those who are in difficulty whether temporarily or on a more long-term basis – due to the slowdown or for other reasons. That is, of course, needed. But that can be done by prioritising some expenditures over others instead of increasing the aggregate government spending.
- Blanchard, O and DR Johnson (2013), Macroeconomics, Pearson Education, 6th edition, Global edition, Kindle.
- Friedman, Milton (1968), “The Role of Monetary Policy”, The American Economic Review, 58(1):1-17.
- International Monetary Fund (2019), ‘World Economic Outlook’, October.
- Keynes, JM (1936), The General Theory of Employment, Interest and Money, Macmillan.
- Kotwal, A and P Sen (2019), ‘What Should We Do about the Indian Economy? A wide-angled perspective (Part I-IV)’, Ideas for India, September 27-29.
- Reinhart, CM and KS Rogoff (2009), This Time Is Different – Eight Centuries of Financial Folly, Princeton University Press.
- Singh, G (2018a), ‘Huge Bank Losses, Frauds, and Economic Risks’, Ideas for India, and HT Mint, 9 March.
- Singh, G (2018b), ‘How Can We Discourage IL&FS and Other Shadow Banks from Relying on Short-Term Funding?’, The Wire, 17 October.
- Singh, G (2019), ‘The Slowdown: Going beyond Monetary Policy and Fiscal Policy’, Financial Express, 11 October.
- Subramanian, A (2019), ‘India's GDP Mis-estimation: Likelihood, Magnitudes, Mechanisms, and Implications’, Centre for International Development (CID) Faculty Working Paper No. 354, Harvard University, June.