BackFiscal policy must play a bigger role to keep our economy going
The spectre of demand destruction hasn’t gone and monetary tools may not spur consumption much
PremiumDiwali is just around the corner. The most recent economic data is heartening—even though India is not out of the woods as yet. Here are some straws in the wind. Collections of goods and services tax (GST) in October crossed the ₹1 trillion mark for the first time since the pandemic struck; and it was more than thrice the low point of April. The strong rise in integrated GST component—levied on interstate trade—suggests that national supply chains are recovering. The GST collected in any particular month is an indicator of economic activity in the previous month.
The purchasing managers’ index (PMI) in October came in at its highest level in 13 years. This survey of companies is an indication of what lies ahead. The intermediate goods component grew particularly strongly. The monthly inflation expectations survey of enterprises conducted by economists at the Indian Institute of Management Ahmedabad shows a decline in inflation expectations and greater confidence in output normalization.
There are signs that India’s overall labour market is improving. Monthly estimates by the Centre for Monitoring Indian Economy (CMIE) say that the national unemployment rate in October was below the level seen in February. More than a fifth of the Indian labour force was unemployed in April and May, the months of a severe national lockdown. However, Mahesh Vyas of CMIE has written in Business Standard this week that there are signs of incipient stress in the labour market.
A job market recovery is more likely to be led by informal than formal firms. PMI data shows that employment in large enterprises is perhaps still below February levels. Anecdotal evidence suggests there are still labour shortages in some parts of the urban economy. A gradual decline in rural wages growth could spur people back to the cities.
All this positive data is backed by more micro data such as electricity production, mobility and car sales. There are many qualifiers as well—a low base, inventory restocking, pent-up demand, higher demand for goods rather than services, a shift in buying from the informal to the formal sector. This column had earlier mentioned the risk of a demand shock that could follow the supply shock, as households deleverage and precautionary savings rise. The spectre of demand destruction has not yet gone away.
Despite these qualifiers, there is reason to believe that the initial recovery is stronger than many had earlier assumed. It is significant that economic activity has recovered to around 85% of its pre-covid levels without a significant push in fiscal spending. Most of the expansion in the fiscal deficit since April has come from lower tax collections rather than higher discretionary spending.
In fact, a sharp annualized fall in spending by the central government in September has ensured that the spending in the first half of this financial year was lower than in the same period of 2019-20, in the midst of the sharpest contraction in many decades. The three-month moving average of central government spending is near its lowest since 2006, according to a recent note by Credit Suisse. The weekly monetary data released by the Reserve Bank of India (RBI) also shows that net RBI credit to the government began to fall after July.
The latest fiscal numbers—though September is likely to be an outlier—show that monetary policy continues to do much of the heavy lifting, despite persistently high inflation. Fiscal policy has so far focused largely on protecting the supply side of the economy, with credit guarantees, food distribution, and basic income support.
India is still one of the rare economies where price pressures have increased since the pandemic began, though they should ease next year. Real interest rates continue to be negative. In September, the yield on the benchmark 10-year government bond was 1.4 percentage points below inflation in India. This is similar to the situation in many large advanced economies such as the US, UK, Japan, France and Spain. On the other hand, most large emerging markets have positive real interest rates—China, Russia, South Korea, Indonesia, Mexico, Taiwan, Thailand and the Philippines.
The balance between fiscal policy and monetary policy—as well as the coordination between the two—is a tricky issue. Much depends on the situation. Here is a general point. Most of the theoretical insights as well as policy attitudes on monetary policy were developed in response to an inflation crisis in advanced economies in the 1970s. For example, average US inflation between 1971 and 1980 was 7.86%, including three years of double-digit growth in consumer prices. The average inflation rate in the past 10 years has been 1.76%.
Much of today’s monetary policy practice was built around the 1970s challenge of curbing aggregate demand to bring inflation under control. It is an open question whether the same tools are as effective in pushing up aggregate demand, especially when there are large shocks such as the one the world economy experienced this year. That is why fiscal policy will have to play a more important role in case the ongoing economic recovery runs out of steam.
Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics
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