4 min read.Updated: 06 Oct 2020, 12:33 PM ISTAshima Goyal,Akhilesh K. Verma
Monetary and fiscal authorities need to act in tandem to achieve better outcomes on driving growth and taming inflation, write Ashima Goyal and Akhilesh K. Verma
India’s move to a rules-based macroeconomic framework was based on the global thinking that since the central bank cares more for price stability and the government for growth, giving the central bank independence will deliver price stability, leaving the government to focus on reforms to ensure sustainable growth. As each works on its objectives, social welfare is maximized while ensuring consideration of the long-run consequences of short-run actions. But certain special features of the Indian economy make monetary-fiscal coordination necessary. If rules are interpreted flexibly, they allow coordination.
Coordination in macroeconomic policy: In India’s economic structure, output is demand-determined. Monetary policy affects demand more, while fiscal policy affects supply-side costs and, therefore, inflation. Since each is more effective in achieving the other’s objective, total independence leads to a prisoners’ dilemma type of non-cooperative strategic interaction. As players follow their own interest, each is worse off in the outcome of higher inflation and lower growth.
The monetary authority (MA) keeps interest rates high since it believes the fiscal authority (FA) would not give priority to reducing inflation. But as expected growth and revenues fall and the costs of servicing debt rise, the FA cuts back on activities that could reduce inflation. Rules may restrain deficits, but the composition of expenditure matters for inflation.
A variety of mechanisms can, however, change incentives, leading to better outcomes, including making rules more flexible. For example, if there is delegation to a more pro-growth MA and less populist FA, the changed preferences reduce pay-offs from non-cooperation, making coordination (and not a prisoners’ dilemma) the self-enforcing outcome. Since the MA knows the FA will act on the supply side, it can lower interest rates.
The Indian experience suggests a simple rule alone is not effective. It could be either interpreted too strictly, as inflation targeting was in the initial years, or it could be avoided, as fiscal responsibility was after the global financial crisis (GFC). Rules need to be flexible, with additional incentive mechanisms to direct a correct use of discretion.
Policy coordination in times of covid: The output shocks due to covid have changed preferences of central bankers worldwide to give more weight to growth. This explains why there is now much more coordination of monetary and fiscal policies. The change in preferences, as the MA also values growth more, enforces coordination. In pre-GFC times, advanced economies (AEs) had moved to separate monetary policy from government debt management functions because of possible conflicts of interest. But as debts grew large, central banks again began to play an active role in facilitating government borrowing and spending.
In India, the story is complicated because markets are not as willing to finance a large expansion in government borrowing as in AEs. Since financial stability becomes a delicate issue, a pro-growth central bank still requires a conservative FA for coordination to be self-enforcing. However, rating agencies and a fear of outflows force the FA to be conservative, so the MA can be accommodative as preferences change in a crisis.
Policy choices that have generated a lot of debate can be understood as emanating from such coordination where relatively conservative fiscal policy allows monetary policy to be expansionary. The government’s strategy of channelling aid through the financial sector does not impact the fiscal deficit and market borrowing. If growth recovers, debt created moderates. Caution in expanding deficits allowed the Reserve Bank of India to take multiple measures. Government credit warranties reduced risk aversion, in turn enabling the use of liquidity created. Coordination reversed an excessive tightening of financial conditions and, therefore, improved financial stability.
Since it is difficult to induce private spending in a crisis, monetary policy is considered ineffective. There are calls for more government spending. Loss of income, contagion and rising precautionary savings translates to depressed private investment and consumption. But the lockdown created serious supply chain disruptions. Gross domestic product estimates show that in April-June, supply-side contraction exceeded demand-side reduction. A fiscal demand stimulus would have been less effective in such conditions.
Policy space: Despite a rules-based framework, there are freedoms in the implementation and timing of actions. The Fiscal Responsibility and Budget Management Act allows for monetary financing under a growth collapse. The government has space and can create more by asset and expenditure restructuring. Medical aid, preventing hunger and protecting livelihoods are priorities. But caution in the timing and sequencing of measures can make them more effective and conserve space to respond as the pandemic evolves. A moderate expansion in fiscal expenditure coinciding with the festival season and recovering supply chains could build private sector confidence and trigger spending. To some extent, deficits are self-adjusting as tax revenues recover with growth.
Even so, liquidity injections and regulatory easing were essential to tackle liquidity hoarding, stress in corporate and household balance sheets, and weakened funding as well as solvency of financial institutions—which could result in persistently lower potential output. Surplus liquidity aids government borrowing and also reduces financial sector tensions and future non-performing assets requiring more government support. Equity cushions are available for banks.
This coordinated equilibrium strategy can work in the pandemic. It avoids the dangers of high inflation and financial instability for a temporary output spike from a disequilibrium strategy of massive monetary-fiscal stimulus. It facilitates creative policy measures to ensure the alignment of demand with supply, a reduction in interest rates and spreads, and the use of system-wide liquidity support, apart from smoother credit flows and restructuring exercises with proper risk-pricing to minimize losses and aid recovery.
Ashima Goyal, professor, India Gandhi Institute of Development Research, has been appointed as an external member to the Monetary Policy Committee of the Reserve Bank of India. Akhilesh K. Verma is PhD research scholar, India Gandhi Institute of Development Research. These are the authors’ personal views.