There seems to be a growing chorus of opinion in favour of the government suitably amending the Fiscal Responsibility and Budget Management (FRBM) Act in order to allow direct monetisation of the government’s ballooning fiscal deficit. This view is heavily influenced by the fear that the government’s requirement of cash from the market will drive up interest rates just when private demand for cash might be expected to increase towards the latter half of the coming financial year, and that this would lead to a crowding out of economic activity. The government printing currency notes would increase money supply and prevent this from happening. Businessmen, quick to back any potential policy that will keep down interest rates, are also rooting for this kind of direct action.
This is wholly misguided enthusiasm for breaking the shackles that exist today; the FRBM as well as the formal agreement worked out in the mid-1990s between the government and the Reserve Bank of India have helped to impose a certain discipline on the government system. The framework for that discipline is worth preserving, even if the immediate economic conditions might tempt people to throw the baby out with the bathwater. At a time when virtually every political party and every other state government is going overboard with either introducing or promising more expenditure commitments (including subsidies and cash hand-outs), all of which will put an end to all fiscal discipline, the last thing anyone would want is formal sanction to go back to the habits of the bad old days.
The relevant point in this context is that monetisation (or the creation of fresh money), is taking place all the time. The disclosure that the RBI has done open market operations to the tune of Rs 1.6 lakh crore this financial year (or about 3 per cent of GDP) buttresses this point quite conclusively. The latest episode in this context was the manoeuvre with the market stabilisation securities so as to help the government complete its borrowing programme for the current financial year. If this level of accommodation can be done without amending the FRBM law, then all the better because the law remains unchanged.
The more important point, from the viewpoint of macro-economic management, is whether the government should be providing such a powerful fiscal stimulus if overall economic activity is expected to recover in the second half of 2009-10, as everyone in the government (from the Prime Minister downward) keeps assuring the country. The Interim Budget presented to Parliament a few weeks ago posited a fiscal deficit of about 5.5 per cent of GDP—a good 3 percentage points over what would have been the FRBM norm. That is well in excess of the 2 per cent stimulus being talked about as appropriate in the present global context. In other words, the issue is not whether monetary policy should adjust in quite unwise ways to the demands being made by the fisc; the correct point is that the fisc needs to be reined in if the tempo of economic activity is expected to gain momentum six or eight months down the road. If indeed there is the “crowding out” danger, as many observers have warned, it should mean re-doing the budgetary arithmetic, and taking a close look at both the tax incentives that have been given as well as the spending plans that have been announced.
