When is a good time for austerity?

In general, austerity is a good trait in governments, just as thrift is a virtue for entrepreneurs, just as there is wisdom in frugality for households and individuals. Perhaps, those are the foundations of any high savings, high investment and highly productive economy. But all economies go through cycles. How governments, companies and households behave in the different phases of the cycle matters. They could either exacerbate the booms and busts or smoothen the cycles at both ends. 

It is apparent that the Indian economy has a demand problem. Three of the four major engines of the economy are stalling, certainly not revving up -- private consumption, investment demand and exports. The government has its hands on the levers of the fourth engine -- its own spending. It is hesitant to put it on full thrust primarily because it has a fiscal deficit target to meet or a fiscal deficit glide path to adhere to. The move to cut corporate taxes was bold. But given the mess in the banking and non-banking financial companies space, investment is not likely to revive immediately. There is scope for taking a bold step forward on personal income taxes. That would give an immediate boost to consumption. 

At the same time, the government must not cut its spending, particularly on infrastructure. It would be a good idea to mop up revenue through disinvestment to bridge some of the deficit but it is time to abandon the fiscal glide path to the target of 3 per cent of GDP. If there is one lesson that has been learnt from the experience of countless countries around the world over the last three decades, it is that austerity is the wrong medicine to administer when growth is low. It only makes recovery more difficult and extracts a high cost from the most vulnerable people in the economy.

There is a time for austerity — when there is a boom. Governments should aim for a minimal deficit or even surplus in a period of fast growth so that there is cushion when the downturn arrives. Unfortunately, the abundance of boom time incentivises precisely the opposite spending behaviour from governments. Redistributive spending of the unproductive kind usually peaks at that time, not just in India but elsewhere in the world as well. 

It is because of this errant behaviour of governments that austerity has become part of the economic policy orthodoxy over the years. If the reason for a serious downturn in the economy is runaway government spending in periods of high growth (the story of India in the 1980s running up to the crisis of 1990-91) then the antidote ought to be a tight curb in government expenditure. However, it is not  runaway government expenditure alone but runaway government expenditure coupled with a supply-constrained, unreformed economy that leads to a collapse in growth. In 1991, India undertook structural reforms which is why the negative effects of austerity were not felt for long. Fortunately, in 2019, there is no crisis. However, to revive the trajectory of growth, it is important for structural reforms to continue while the government runs a counter-cyclical fiscal policy.   

Interestingly enough, companies and even households mirror government spending. Companies usually acquire flab and over extend/over-leverage themselves in periods of high growth and then tighten their belts only when the downturn comes. In the process, they add a multiplier to the boom on the upside but also a negative multiplier on the downside. For households in India, at least until a decade ago, savings tended to be high irrespective of the business cycle. In a more consumption-driven economy, that rate has come down. If indeed households too are overspending in good times and cutting back sharply in bad times, they too may be aiding in exaggerating both ends of the cycle.

The economy would benefit if governments, companies and households acted counter-cyclically. Right now, in India, they are all acting cyclically which is why the economy is slowing down further instead of picking up. It is important for someone to break the cycle. In the short term, only the government can do so with a strongly counter-cyclical fiscal and monetary policy. Once growth begins to climb back, companies and households will likely loosen their purse strings.

By global standards, India is hardly an overspending, deep-in-debt economy. In fact, the debt-to-GDP ratios of households and companies is considerably lower than in most advanced economies and even China (which has switched from an export-oriented model to a leveraged-growth model in recent years). There is plenty of room to finance animal spirits. But first, the downturn must be arrested. And then, once growth has recovered, the government can return to a path of austerity as companies and households take over the task of driving the economy.

The author is chief economist, Vedanta