Fiscal reform must precede the implementation of inflation targeting.
Since the history of the period is yet to be written, few people know of the valiant battle that Dr C Rangarajan, then deputy governor of the RBI, waged within the institution in the 1980s to sneak in monetary policy — the real thing, not what used to pass for it before the 1990s — into India’s economic armoury. Before that, it was the era of what is called fiscal dominance, which basically meant the government would spend as much it wanted to and everyone and everything else, including interest rates, had better adjust to that.
Yet, when it came to fishing the inflation chestnut out of the fire, it was monetary policy that was asked to come to the rescue because only it could make a difference. Thus, the credit for fiscal expansion would accrue to the government; the pain of monetary contraction to the RBI.
This paper asks a question that the UPA government has made relevant once again, especially in the last few months. The question is this: “is an aggressive monetary policy response to inflation feasible in countries that suffer from fiscal dominance, as long as monetary policy also responds to fiscal variables?”
In a recent paper* posted on the US Fed’s website, Michael Kumhof of the IMF, Ricardo Nunes of the US Fed and Irina Yakadina also of the IMF, say that “if nominal interest rates are allowed to respond to government debt, even aggressive rules that satisfy the Taylor principle can produce unique equilibria”, meaning you will get periods of relatively stable inflation. But they add, “following such rules results in extremely volatile inflation”.
This, if you ask me, lies at the heart of the harm that the UPA government has done. It has made the Indian economy vulnerable to inflationary volatility. The gains of 1994-2004 have been lost, if not forever then for a long time to come, because political instability of the kind we are about to witness is a fertile breeding ground for fiscal dominance and emasculation of monetary policy.
Much of the paper is devoted to proving the point with the help of maths. So the message comes out loud and clear: if the government will not behave itself, “the optimal response to inflation is highly negative, and more aggressive inflation fighting is inferior from a welfare point of view”. Ergo, eliminate fiscal dominance.
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Another important point which the paper makes, and which will grate on the finance ministry’s ears, is that in developing countries inflation targeting is a stupid idea. To quote:
“…when the fiscal authority is unable, or unwilling, to control tax revenues and spending, (where there are) weak taxation systems, tax evasion, banking crises or overspending… the usual prescription of the inflation targeting literature, a more than proportional interest rate response to inflation innovations known as the Taylor principle, becomes impractical and undesirable.” This, pretty much, is what the RBI has been saying.
The paper goes on to make another point of great relevance to India today. That is whatever India’s economic Taliban may say, “It has not been clear from the literature whether this situation can be rescued by a central bank that adapts itself to fiscal dominance by conditioning its actions on fiscal variables such as government spending or government debt”.
But this is something for the RBI to ponder: has it been guilty of being overly accommodative of the government? The record certainly suggests that. By being accommodative, the RBI has been rendering itself ineffective.
To quote: “…an interest rate rule that tackles fiscal dominance by responding to debt and that simultaneously satisfies the Taylor principle is not a robust solution,” meaning it doesn’t work because of a whole range of reasons.
To start with, there is the high volatility of all variables; then there is the persistent violation of the zero lower bound on nominal interest rates rule; and finally, there is the negative impact on welfare.
To sum up: “Only solid fiscal fundamentals allow for both a benign outcome in terms of welfare and for the ability to fight inflation aggressively. Fiscal reform in developing countries is therefore an indispensable step before implementing inflation targeting regimes.”
*Simple Monetary Rules Under Fiscal Dominance, International Finance Discussion Papers, Number 937, July 2008, http://www.federalreserve.gov/pubs/ifdp/2008/937/ifdp937.pdfas