In what is otherwise a thoughtful piece, Jayati Ghosh’s “A case against market reforms” (27 May, Mint) confuses medium-term development goals with short-term fiscal incentives. Development goals help design policies that create appropriate incentives for players and remove the obstacles faced by the underprivileged in participating fully in society. Thus, goals such as better social security are laudable because, in the long run, they improve people’s ability to participate in the economy. But it takes a long time for the effects of such policies to show in the form of economic output.
A fiscal stimulus, however, has a very different objective. In the context of the current global financial turmoil, a fiscal stimulus would aim to counter the recessionary impact of decreased demand arising from three sources. First, global demand for Indian goods and services has decreased. Second, decline in asset prices has reduced the wealth of Indian consumers, lowering domestic demand. Third, financial institutions’ tendency for pro-cyclical lending policies has reduced credit just when the economy needs it most. In these circumstances, any fiscal policy has to aim to stimulate domestic demand and reduce the pessimism that often accompanies an exogenous fall in external demand and a recessionary psychology.
What would be the correct fiscal policy in this situation? A recent International Monetary Fund (IMF) study on fiscal policy may be of some help here. A study of business cycles over the past six decades concludes: No one seems to know the answer to that question.
The safe approach seems to be to follow a diversified portfolio of policies. This portfolio should include subsidies, increased public expenditure (infrastructure projects, education, research and development and higher public sector wages), tax incentives (where tax systems are effective and when conditions are such that tax beneficiaries will spend the tax windfall and not use it to reduce their debt) and improved credit for the economy.
The subsidies recommended by Ghosh would be one part of an effective fiscal package that the current government has to consider. The problem with subsidies is that they create vested interests which make it difficult to remove the subsidies when they are no longer needed. Thanks to this institutionalization of subsidies, the final cost to the economy may exceed benefits.
The most suitable fiscal stimulus may be heavy expenditure on infrastructure. If successful, such expenditure will reduce gross inefficiencies caused by the unreliability of public infrastructure. Inefficient infrastructure requires investment in unnecessary capital equipment (generators and inverters), excess capacity for transportation, storage and inventories due to unreliability of transportation and shipping networks, higher maintenance expenditure than would be otherwise necessary, not to mention the effects of poor health on the economy.
From the point of view of fiscal stimulus, infrastructure expenditure creates domestic employment and usually tends not to be spent in the form of increased imports (that would otherwise detract from increasing gross domestic product). Thus, much of infrastructure expenditure stimulates the domestic economy. It is a public good that has been in short supply.
Finally, lower interest rates to farmers would help, unless this easy-money policy, too, becomes institutionalized and creates a pool of beneficiaries who will find it difficult to give up the benefits when they are no longer necessary.
While market reform may sound like a bad word, there are fewer deadweight costs (inefficiencies which reduce the welfare of some without increasing that of others) associated with market transactions than with the extensive discretionary participation of the government in the economy (think corruption). Any fiscal stimulus should then create demand in the economy without making it a permanent feature.
Arvind K. Jain is an associate professor of international business and finance at Concordia University, Canada. Comments are welcome at email@example.com