Forget the fiscal deficit: Financial Express 19th January 2012

When there is limited hope and an air of despondency clouds the future prospects of any economy, it is only appropriate that we go back to the textbook for an answer. There will be solutions somewhere, as it is not for nothing that the big names like Keynes, Friedman, Sargent and Hayek are debated even outside the university today.

There are two ways of looking at the economy. There is a more positive view, which says that growth will pick up in FY13 on the back of industry, with agriculture providing normal comfort. Inflation will be under control while the government has to take a call on the deficit and RBI on interest rates. The external account will remain volatile but largely manageable, being beyond the control of internal policies. This is impressionistic art.

The other view is more ominous. Growth will falter and slip. The absence of reforms and high interest rates has brought investment to a standstill and it will not recover for some time. GDP growth of 6% looks more likely and the government does not have the stomach to take on reforms in subsidies, deficits, land, environment, FDI and so on. A weak economy with feeble opportunity typifies the bleak canvas and is a product of the expressionistic brush.

Sitting back today, both the options seem possible and, given that no one expected what happened in FY12, even soothsayers would desist from sticking their necks out. But what really can be done is to have the right approach in place. The starting point is to revive spending so that growth picks up as the backward linkages are fostered and strengthened. In FY12, we consciously chose the tradeoff with inflation and, while it is debatable whether or not we have succeeded, we are sure that nothing more can be done from Mint Street. The fact that we still have capacity means that there is actually no ideological conflict here.

When conditions are depressed and no one is spending because there is no money, Keynes would say that the government should step in and provide the stimulus. Contemporary fiscal history shows that the stimulus worked after the Lehman crisis and critics will smile when they look back over the bold decision taken by the government to roll back the same a bit too soon. In 2011, the US, UK and Japan have run fiscal deficits of 8.7%, 8.8% and 8.3%, respectively. Today, the government is the only entity that can borrow at sub-8.5% and also has free access to funds. This being the case, project expenditure should be undertaken in the infra space, which, along with certain PPP arrangements, can kickstart the economy. Keynes cannot fail and, given that food inflation is down and probably overall inflation too will remain benign, this can be compelling. If this is acceptable, we must not bother about the fiscal deficit number, which can actually go past 6%.

Monetary policy is inflationary according to Friedman, provided we have reached full employment of resources. If this is not so, as is the case today, interest rate easing, which is Keynesian in spirit, will also take a tinge of monetarism along to boost consumption. Lower rates will spur consumption based on leverage as households should be encouraged to spend on housing and auto—the two sectors that drive the economy
in a decisive manner. Friedman would not mind this easing under these circumstances.

Hayek, a believer in free markets and private enterprise, will ask for the unshackling of the economy, which will mean less interference when it comes to policy. This environment should be provided through aggressive reforms, like FDI, land reforms, GST, DTC, etc, which will provide the ground to play on. Combined with Keynesian pump-priming (here even MGNREGA will help to provide demand) and lower interest rates, growth will receive the much-needed boost. Freeing oil product prices would, however, still be a touchy issue, which can be deferred as we are still not out of the direct inflation spiral. Hopefully, with political compulsions not being in the way in FY13, this should be easy to attain.

What about the rational expectations proponents like Sargent and Wallace? How important should the surprise element be here? These economists felt that policies work only in case the market is behind you. As long as the market knows, policies do not work. This means that especially when it comes to monetary policy, we should have more surprises—which can mean larger doses of rate cuts or liquidity inflows through CRR cuts. Or from the government side, some really large schemes that attract capital as well as generate employment would help. Maybe a reorganisation of the MGNREGA to make it more productive in rural infrastructure will help.

What can be the cost of such an aggressive stimulus? Inflation should not really result from such spending as it will be adding to our productive capacity. Non-food inflation could increase, but the lower food inflation numbers as well as a declining trend in global prices would counter this to a large extent. Deficits will be high and will raise eyebrows, but it may be worth it as we need a kickstart for the private sector, which cannot come about exogenously. Besides, if investment increases and some reforms are initiated, it may just about be a win-win situation for us. As the alternative is possible stagnation, this alternative sounds good.