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Opinion | India should give up the fear of inflation and monetize its deficit

A failure to do so right now might result in long-term damage to the country’s private capital stock

Nearly 50 years ago, Richard Nixon said, “We are all Keynesians now." The next decade witnessed the downfall of Keynesian ideas amid soaring inflation. At present, the flavour of the day is Modern Monetary Theory (MMT), which essentially argues that a fixation with government deficits is misguided and that in the absence of rising inflation and real resource constraints, the government should just print money, if necessary, to revive the economy. Governments the world over are paying scant regard to their fiscal deficits and central banks are playing handmaiden by buying up government and private paper. Just as in 1970, many analysts worry that the utter disregard for the purported inflationary consequences of deficits will come to haunt us sooner or later. Indian policymakers seem to hew toward the latter camp because the inflationary episode earlier in the past decade is still fresh in their minds. Yet, the time has come for Indian policymakers to throw off the shackles imposed by misguided fears of high inflation.

Long before “MMT" was coined, one of us had argued that since the 1980s, India has effectively adopted the MMT framework with Indian characteristics. While much of the discussion on India’s growth take-off since 1980 has been about supply-side reforms, equally important were the bigger deficits we have sustained since 1980. These deficits arguably helped propel an economy that was demand-constrained towards one that was growing closer to its full potential. As a result, India was one of the few countries to sustain a 7% average annual growth for 25 years. While the 2008-09 global crisis and India’s subsequent banking problems dealt the country a major blow, the importance of the quasi-MMT framework is more relevant now than ever before.

Even before covid-19, India’s economy was struggling with sluggish demand and falling inflation. Covid-19 has exacerbated the problems. While the initial impact of this is a shutdown in supply, the destruction of income and an increase in indebtedness means that private demand will be impaired well after covid is behind us. Thus, the relevant constraint on growth now is demand rather than supply. Paradoxically, persistent weak demand and economic growth will worsen India’s deficit and debt problem, leading to the feared inflationary consequences. They will eventually attenuate supply by destroying capacity. Also, because of weak growth, debt and deficit ratios would be higher, setting up a temptation to inflate them away.

Given the inevitability of large deficits, should India be monetizing part of its deficit and would this release the genie of inflation? The answer is yes to the first question, and no to the second. India used to routinely monetize a part of its deficit prior to 1997. In fact, what used to be called the budget deficit was the monetized portion of the overall fiscal deficit. That monetization reflected the limitations of bond financing, where investor demand for bonds was narrow. Today, limitations on bond financing are once again a constraint—both low investor demand and the threat of downgrades by rating agencies constrain the extent of bond issuance—and argue for deficit monetization.

The domestic and global conditions today strongly argue against any danger of sustained inflation. The relationship among deficits, money supply and inflation is not straightforward, and is contingent upon the broader macro-economic context. In 2010-11, oil prices were surging, global food prices were soaring, the current account deficit was alarming, the rupee was overvalued, and short-term external debt was rising sharply. Today, oil is about a third of its peak in July 2008, food prices domestically and globally are subdued, and India’s monsoon seems normal. The current account is in surplus, in contrast to the yawning deficit earlier in the decade. The real exchange rate of the rupee has declined over the past year and is largely trendless. The danger of a sudden devaluation of the rupee, which could stoke inflation, is low.

The question then is whether deficit monetization will compromise the central bank’s long-term ability to manage inflation. Its concern might be that, once a line is crossed, there is no return to the status quo ante. Pronab Sen has argued forcefully (‘The Covid-19 Shock: Learnings from the Past, Addressing the Present’, June 2020) that excess money supply growth (over economic growth) might be higher under India’s current policy setting than if deficit monetization were to facilitate higher government spending and spur private consumption and investment. In the latter, excess money supply growth will decline, lowering the risk of an acceleration in inflation.

The more important risk is that India’s private capital stock would suffer long-term damage in the absence of deficit monetization and outright fiscal support. That in itself puts India at the risk of a multi-year loss in output, and the government at risk of losing tax revenues. It is possible to design a limited, coordinated fiscal-monetary intervention, with defined end-uses for the fiscal resources/money created, and a clear exit for the central bank. It can and should be done.

V. Anantha Nageswaran and Srinivas Thiruvadanthai are, respectively, member of the Economic Advisory Council to the Prime Minister and director of research at Jerome Levy Forecasting Center. These are the authors’ personal views.

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