Monetary and fiscal policies go together
Not a day passes without news of some public interchange, at times involving significant differences, between the Ministry of Finance and the Reserve Bank of India. Many Indians are quick to take sides even as they remain uninformed of the issues at stake. These issues mainly revolve around the conduct of macroeconomic policy. How has such a situation arisen when there can be publicly expressed difference between the country’s elected government and its central bank?
Over the past three decades or so the idea has circulated globally that economic policy-making should be divorced from political influence. Though applied universally, it has been brought to bear upon macro-economic policy-making with particular force. A manifestation of this principle is the idea of an independent central bank mandated to exclusively pursue a publicly announced inflation target. It may be mentioned in passing that this goal for the central bank is premised on the assertion that the inflation rate may be controlled by it. Though this idea originated in the United States it has now spread widely. In fact it is in Europe that the principle of central bank independence is adhered to with utmost earnestness. In the context therefore, it cannot escape one’s attention that it is Europe in relation to the United States that is performing poorly after both were struck by the Global Financial Crisis. This cannot be divorced from the feature that the Federal Reserve, unlike the European Central bank, is not an inflation targetter but is mandated to aim for “maximum employment consistent with stable prices”. In 2008 when the western world was staring at the biggest collapse in output since the Great Depression the Government of the United States launched one of its biggest initiatives ever to stabilise the economy and revive growth. President Obama resorted to drawing upon fiscal policy in order to provide a stimulus to the economy. But the US Congress, dominated by conservatives, weakened this effort by confining the stimulus largely to tax breaks. Tax breaks do not serve as stimuli to the same extent as public spending on infrastructure. Nevertheless, the fiscal deficit did expand and very likely had a favourable impact despite the limited potential due to its composition. But it is the role of the United States Federal Reserve during this episode that stands out. It resorted to ‘unconventional monetary policy’ which supported the fiscal expansion. Though there were several aspects to it, its principal objective was to prevent a rise in the interest rate. This it did by a combination of buying-up the toxic assets of commercial banks and purchasing government bonds on a large scale. Money supply rose from the billions to the trillions of dollars. But, as intended, the interest rate did not rise following the Obama stimulus, the financial system remained largely solvent and, despite the fears of the monetarists, inflation was not ignited. While the branches of the United States government, in which one must include the central bank, acted not only bravely but also in concert, the near-sovereign European Central Bank stuck demurely to its goal of ‘low and predictable inflation’. The contrasting results are there for all to see. The varied recent experiences of the US and Europe have a bearing on what we are facing today in India.
Despite Europe’s lack-lustre performance, indications are that India’s policy-makers eye its financial architecture with envy! Since 1991, it has been the aspiration of central governments, irrespective of the party, to deck India in the contemporary institutional architecture of the western world irrespective of the consequences. The guiding principle of this architecture is that macroeconomic policy should be based on rules and conducted by technocrats insulated from politicians. The rules themselves are putatively based on unimpeachable technical considerations. While there is a strong case for leaving implementation of policy to technocrats unimpeded by political interference, we may query the goal of policy itself being set by technocrats acting on their own. The choice of the policy to adopt in a specified situation should be based on a deliberation of its consequences and must be made by politicians. The significance of the insistence on deliberation, including consideration of all the possible consequences, is that the reigning technocratic orthodoxy today pretends that there is one optimal policy. Actually, when it comes to macroeconomic policy, as we shall see below, this is not so.
A consequence of a reliance on a technocratic approach, allegedly due to its superiority to the deliberative one, is that the conduct of macroeconomic policy can become sequestered, robbing it of efficacy. There is evidence of it presently in this country. Narendra Modi’s government had come to power on the back of the promise to ramp-up the rate of growth of the economy. After twenty months in office, it has little to show in this department even if has made some policy moves to its credit, mainly the move to a transparent allocation of public resources ranging from telecom to mines. But there has been no restoration of the rate of growth prevalent a decade ago. And the private corporate sector which had welcomed the election of Mr. Modi has not translated its enthusiasm into outlays, despite its being governed by a party with impeccable pro-business credentials. Private investment has not revived since 2014. The sensible thing for the government to do under the circumstances would be to step up public investment. Investment in infrastructure, of which India faces a significant deficit, may be expected to have the highest multiplier across all conceivable public expenditures. Apart from a capacity of placing the economy on a higher growth path such a strategy has the potential of also triggering private investment incentivised both by improving supply conditions and increasing demand.
There is, however, the possibility of the effect of such a step-up in public investment being diminished by a rise in the rate of interest. Such a contingency can of course be averted by an easing of monetary policy. In India today this appears an unlikely scenario. With a central bank wedded to inflation targeting and conditioning its actions on the extent of fiscal consolidation we are in a world in which monetary and fiscal policy, the two arms of macroeconomic policy, are working quite independently. In its most recent monetary policy review, the RBI has virtually directed the Government of India to undertake structural reforms and to stick to a path of fiscal-deficit reduction. This would be considered outrageous even if there is reason to believe that the present situation reflects not so much a worsening of the supply side, requiring structural reforms, as much as a slackening of demand, requiring fiscal expansion. The Government of India is an elected body. There is no public body that can exhort it to act in a particular way. But Mr. Modi has only himself to blame for this state of affairs. Presenting the government’s first budget in 2014 his Finance Minister had announced that the sole objective of monetary policy would be inflation targeting. This leaves the RBI no longer responsible for growth. It has placed macroeconomic policy in silos. The arrangement can be rectified.