Is it possible for the economy to be “overstimulated”? How would we know.
With the state elections out of the way (and with a surprisingly favourable outcome for Congress revealed by Monday’s results), the central government was free to proceed with its two-part economic stimulus package. Monetary policy measures (including fairly significant acts of regulatory forbearance) were announced on Saturday (December 7), and “real” side measures, primarily fiscal, on Sunday. These measures were taken against the background of a deteriorating growth picture in the advanced industrial economies, and a sharp slowdown in certain key sectors, such as labour-intensive exports, automotive and real estate.
If a rising tide lifts all boats, a falling tide brings out all lobbies. There have been plenty of voices arguing that what has been presented is “too little, too late”, in respect of both monetary and fiscal policy. Many of these critics cite the US; there, the emerging professional consensus is that policy has been irresolute and reactive, and that well-timed anticipatory action would have significantly reduced the growth and fiscal costs of financial deleveraging. Others cite the resolution passed by the heads of government of the G-20 in Washington last month, where all countries pledged to stimulate domestic demand (and to avoid protection). Here, the poster-child is the dramatic package announced by China well before the G-20 meetings, followed closely by the public works programme announced recently by the Obama administration.
Professional opinion In India is more sharply divided: in recent columns in this space, both Govinda Rao and Shankar Acharya have cautioned against excessive fiscal adventurism. Based on the supplementary budget recently passed by Parliament, they both argue that substantial incremental fiscal stimulus has already been applied. By contrast, Abheek Barua and Surjit Bhalla are of the view that matters are sufficiently dire, even in India, that no restraint is called for, and that, as in the case of the United States, forceful pre-emptive action now will actually prove cost-effective in the medium run. While these observations primarily apply to fiscal policy, voices from industry are arguing for continued aggressive monetary easing, in line, once again, with what we are seeing in the advanced economies.
I accept that these are extraordinary times for the global economy. But as I argued in my column last month, I also believe that there are significant risks involved in developing policy “on the hoof”, without a clearly articulated framework. These risks are of at least two kinds: first, as already mentioned, the risk that government will be pressured by special interests; and second, that poor communication in the present environment could lead to unnecessary panic, uncertainty, or even a speculative attack.
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For all the imperfections in its implementation, the macro framework in place until the Budget in February 2008 was a stool with three legs. These were the targets of the Fiscal Responsibility and Budget Management (FRBM) Act; a flexible but managed nominal exchange rate with a medium-term target for some measure of the real exchange rate; and sterilised intervention designed to deliver steady growth in some composite measure of monetary conditions.
Over the past two years this framework was used to accommodate two major, partially offsetting shocks to the economy. These shocks were, first, the large and rising inflow of capital (until the end of last year); and second the large terms of trade shock symbolised by the rise in the price of many commodities, particularly oil. These shocks were in effect accommodated by the twin mechanisms of an appreciation of the real exchange rate, and its counterpart on the “real” side, namely a widening current account deficit.
Today, these shocks are being reversed. While capital is certainly exiting, it is more difficult to be sure what is happening to the terms of trade. While commodity prices are sharply down, the deep deterioration in foreign demand for labour-intensive tradable goods will undoubtedly have an impact on their world price. Perhaps the best assumption would be that the terms of trade would improve slightly, if at all. The question for macroeconomic policy is what elements of the above framework, if any, now need modification, to what degree and through what mix of policies.
To my mind, this is where the local and the global can should fit together. I believe that policy over the next twelve months should be driven by the goal of targeting a pre-announced level of the current account deficit on the balance of payments, somewhere in the range of 2-3 per cent of targeted GDP. This would help India make an explicit commitment to sustaining global demand, without prejudging whether this contribution is to be made by boosting public investment or supporting private investment. It would also be a target sufficiently concrete to reassure those concerned about India’s financing risk, while being flexible enough to allow public investment to replace private investment should the need arise, without taking actions (such as excessive fiscal stimulus) which might crowd out private investment, either by flooding the banks with too many safe government bonds.
Judged by this yardstick how might one assess the adequacy of last weekend’s measures, and whether there is likely to be a need for additional action? It is clear that the government is right to give primacy to easing monetary policy, as that is the tool most likely to stimulate investment and to help households and corporations build up liquidity. Here, the question is whether we need to be worried about any lower limit in terms of the speed or amount of easing. Our approach so far, once the inflation threat had receded, has been to “cross the river by feeling the stones”. The main reason for taking incremental steps is to leave some reserve for future shocks. But in general the risks of more rapid easing seem to me to be relatively low, despite the high measured inflation rate.
As against this, I find myself siding with those who urge caution on the fiscal side. I say this not just because of our high debt stock and concerns of debt sustainability at the lower growth rates that now seem more probable, nor particularly because our government spends less well than the private sector. I say this mainly because I think there is greater risk of crowding out than crowding in private investment through aggressive public investment, and for me maintaining a helpful climate for private investment remains the highest priority.
The author is Director-General, National Council of Applied Economic Research, New Delhi. Views expressed are personal