Hold the line on the fisc
It’s about that time in the life of a government: the economy appears to be losing its sheen and elections are fast approaching. The first law of political economy, which the politicians understand better than the economists, is to spend your way out of trouble. In more technical terms, the danger is that of the political business cycle—the use of (very frequently) fiscal, monetary, and (less frequently) regulatory policy to attempt to pep up the economy in advance of an election. It may make political sense, but, unfortunately, it only adds a further layer of volatility to the fundamentals of the economic business cycle.
As the growth numbers continue to be lacklustre, with inflation ticking up, and with literally no room for manoeuvre on the fiscal consolidation road map, the Union government of Prime Minister Narendra Modi faces its sternest test as steward of the macroeconomy.
If luck may be said to have been on Modi’s side for the first few years of his premiership, with low crude oil prices providing crucial breathing room, we may instead be heading into a perfect storm of (an emerging economy version of) stagflation—flagging growth and rising inflation—at a time when next year’s general election, and a clutch of state elections this year, are already looming large.
Will Modi choose to stick to the road of fiscal rectitude or, instead, give finance minister Arun Jaitley the nod to open the spigots of government spending in the forthcoming Union budget?
After all, this budget will be the last full-year budget in the life of the current Lok Sabha, and, therefore, the last opportunity to ply the electorate—in particular, poorer, rural voters—with fiscal largesse. In India, unlike in Anglo-American advanced economies, such largesse always manifests itself as increased government spending, rather than as tax cuts, because, of course, so few people pay direct taxes. And, with the formalization and digitization drive progressing, but still incomplete, the only sure fire way to put money in the pockets of the rural poor is through further intervention in already heavily distorted agricultural markets— through minimum support prices and related policies, in particular.
The consequences of considerable politically driven fiscal slippage will not be pretty to behold. For it is sure to unleash—and legitimately so—further monetary tightening to ensure that inflation stays on target, in order to counteract the putative inflationary impacts of a larger fiscal deficit.
The unorthodox combination of loosening fiscal policy and tightening monetary policy—sometimes called the Mundell-Laffer policy mix—made sense in the context of Reaganomics or “supply side” economics, because it was crucially married to regulatory reform—accelerated deregulation to unshackle entrepreneurship, in particular.
Let us not also forget that fiscal loosening of the Mundell-Laffer type involved both large tax cuts and increased government spending. The Indian variety, by contrast, is unlikely to feature much if any further regulatory reform, and fiscal loosening delivered only via increased spending, not tax cuts, as already noted, and coupled with probable monetary tightening by the monetary policy committee (MPC) of the Reserve Bank of India (RBI).
Well, folks, we have seen this movie before, and we know that it doesn’t have a happy ending. Prime Minister Modi and his economic advisers know this too, of course, and it is my belief, or at any rate my hope, that Modi will choose to stay on the high road of fiscal consolidation rather than take the low road of fiscal profligacy.
There is more than hope involved, since Modi has shown a remarkable resolve to take tough decisions which he believes are right, even if they impose a short-run economic or political cost. Whatever the merits of demonetization or the goods and services tax (GST), it was clear that both would impose short-term costs on the economy for the prospect of medium and longer term gains.
We can debate how the cost-benefit calculus stacks up and we can agree or disagree with one or the other move, but what cannot be gainsaid is that Modi spent political capital on both, as, indeed, he had earlier spent on what ultimately proved to be an unsuccessful and unpopular attempt to reform the land acquisition law, the latter being one of several poisoned chalices left behind by the Manmohan Singh-led United Progressive Alliance government that was swept out of office in 2014 (the most important of these is the problem of bad corporate and bank balance sheets—the “twin balance sheets” problem—on the rectifying of which, RBI governor Urjit Patel, with the blessings of the prime minister, has already achieved considerable success).
In sum, my own assessment of the political economy is that Modi has the resolve to hold the line on the fiscal deficit, and that he and his political advisers reckon that the electorate will give him credit for doing the right thing, even if it imposes some short-term costs.
The Modi government has already done more to push forward the reforms agenda in less than four years than the Singh government could muster in a decade. If I were a betting man, I would wager that, when all is said and done, Modi will show himself a better macroeconomic manager than Singh.
Vivek Dehejia is a Mint columnist and resident senior fellow at IDFC Institute, Mumbai. Read Vivek’s Mint columns at www.livemint.com/vivekdehejia
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