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There is an eternal cycle in Indian economic policy. Governments habitually pursue fiscal profligacy in a bid to buy votes. There is the optimistic hope that inflation will remain under control despite the economy growing more rapidly than its potential. The Reserve Bank of India (RBI) comes under immense pressure to keep real interest rates in the negative zone. Then comes a jolt after inflation runs out of control, fiscal stress appears and the rupee gets hammered because of capital flight.

Sobriety sinks in. The finance minister of the day gets political backing to bring the budget back on track. The central bank is grudgingly allowed to raise interest rates. There is a lot of pious talk about how India needs to become more fiscally disciplined. Inflation comes down. The rupee stabilizes. Confidence rises. Then the premature calls for an easier fiscal policy begin. The monetary policymakers come under pressure for keeping interest rates too high. And India gets back to its bad old ways.

We are seeing some of this happening right now. The second Manmohan Singh government could never get public finances back on track even though the economy had recovered from the immediate effects of the global financial crisis.

Inflation climbed into the double digits. RBI was too cautious in responding to the inflation shock. It did not raise interest rates on time. It was only the run on the rupee in July 2013—when there were fears whether there would be enough foreign currency to fund a record current account deficit—that Indian policymakers moved to stabilize the economy.

The fiscal deficit was reined in. Interest rates were increased. The trio of P. Chidambaram, Arun Jaitley and Raghuram Rajan deserve a lot of credit for not allowing India to go the way of Brazil. A run on the currency was not allowed to grow into a full-blown macroeconomic crisis. The fiscal deficit has narrowed. The current account deficit is modest. Inflation has halved. Economic growth is picking up.

It is now very important that the Narendra Modi government not succumb to the siren calls for an easier fiscal deficit target or a higher inflation target. Remember that India still does far worse than its Asian peers on these two parameters. More work needs to be done so that the Indian economy does not face periodic scares as a result of structurally high fiscal deficits and inflation.

There are two immediate issues that require attention. The Modi government has appointed a committee chaired by veteran bureaucrat N.K. Singh to see whether there could be a new fiscal rule to replace the landmark Fiscal Responsibility and Budget Management Act of 2003. Such first-generation fiscal rules have been deemed too inflexible across the world.

It is possible that India too could move to either a deficit band or a more sophisticated measure such as the cyclically adjusted fiscal deficit, but the resetting of the legal fiscal target should not be used as a cover for an expansionary fiscal policy even when the economy is recovering.

There is also the inflation target to consider. There is suddenly a lot of talk of the central bank being too aggressive in setting the consumer price inflation target at 4%. Could it be a percentage point higher? Could the output loss be too high in the last stage of the battle against inflation? There have been some suggestions that the government write in a higher inflation target into its monetary policy agreement with RBI.

These are slippery slopes. The underlying political economy in India skews policy towards fiscal profligacy as well as high inflation. That is why a fiscal law and a formal inflation target is necessary, to balance discretion with some rules.

But what is written into those rules is also important. The government should avoid the temptations of a higher fiscal deficit target and a higher inflation target. The lessons of July 2013 hopefully still linger in some memories.

Should India go for higher fiscal deficit and inflation targets? Tell us at views@livemint.com

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