Return of Fiscal Activism

Japan’s fiscal stimulus, increasing of fiscal deficit targets in Eurozone economies, UK chancellor Hammond’s mulling reviewing his predecessor’s plan on budget, apparently indicate that fiscal activism is gaining currency in developed economies these days. The developed economies are mired with low or zero interest rates (negative interest rates in Japan) and monetary policy has reached its limit. These low interest rates had set up perfect ground for the fiscal policy to emerge as a powerful tool for these economies. In the liquidity trap scenario the fiscal multipliers are large and hence it is conducive to resort to fiscal activism (Strike when the iron is hot)

The genesis of fiscal activism can be traced back into Keynesian economics. The idea of welfare state was embraced during great depression of 1930s .

But Greece’s sorry tale of fiscal expansion following its adoption of the euro in 2001 is the epitome of fiscal activism gone wrong. The adverse consequences in fiscal activism have led to crises in Latin American countries, mainly in Venezuela.

A country’s fiscal space is judged not only by interest rates but also whether country’s public finances are on sustainable path . The basic equation of debt sustainability which includes factors such as country’s primary deficit , nominal GDP growth rate , nominal effective rate of interest and Debt/GDP ratio should be given prime importance. One of the criticisms against fiscal activism lies in  government’s inefficiency in understanding consumption patterns of the society. The ghost towns in China is a reminder of government’s failure to understand the demands of the people in the economy. Thus ill framed fiscal stimulus worsens the problem by increasing the number of non performing assets .

The fiscal activism should be used as a countercyclical policy i.e. an expansionary fiscal policy should be undertaken during economic slowdown and contractionary fiscal policy should be undertaken during boom. If the nature of polity acts as a straitjacket in resorting to contractionary fiscal policy then fiscal activism should be avoided because it will lead to huge fiscal deficits. The economic survey 2016-2017 highlights that the two episodes of Indian macroeconomic vulnerability in 1991 and 2013 were caused due to application of both procyclical and countercyclical policy. 

During 1980s the government increased fiscal deficits as a response to accelerating growth . The 1991 Balance of payment crisis again forced government to resort to expansionary fiscal policy. Similarly, during the 2000 growth boom government increased its spending program. But again in 2008, government had to increase its fiscal deficits due to Global Financial Crises. The combination of procyclical and countercyclical policy worsened the inflation in 2013.

The experiences of fiscal activism underscore that one-size fits all approach shouldn’t be followed. The authorities should take into account a plethora of factors and not just the interest rates while considering fiscal activism as a tool to solve economic problems.

- Tanushree Dutta

Inflation Targetting – Is India on the right track ?

Recently RBI rules have been amended and RBI has adopted inflation targeting as its monetary policy strategy. As per government notification an inflation target of 4% will be followed till March 2021. This article while revisiting the genesis of inflation targeting (IT) attempts to find out the benefits of IT for India and the challenges that India face in making IT successful.

Genesis of Inflation Targetting

Milton Friedman once said that inflation is anywhere and everywhere a monetary phenomenon (Fishers’s equation of exchange) and hence it is controllable by central bank . Pre 1970s was a period of fixed exchange rate and hence because of the principle of macroeconomic trilemma there were constraints on Central Bank in maintaining inflation . The early 1970s saw the breakdown of fixed exchange rate and a move towards managed exchange rates. Flexible exchange rates gave the monetary authorities the independence to using monetary tools for solving adverse economic shocks. In the mid 1970s many industrial countries resorted to money growth targets. Under this approach central banks sought to control inflation by aiming for intermediate target rates of monetary growth. However, this approach failed in achieving inflation targets as the relationship between M1 growth and inflation is not tight (mainly because of shifts in money demand).

It was realized that given inflation the prime target the policy should aim at targeting inflation, rather than money growth. Thus from 1990s there was a shift towards inflation targeting. Some economists believe that inflation targeting is an effective tool as it helped followers of inflation target to achieve low levels of inflation. But critics argue that low inflation was the result of global non-inflationary situation.

Benefits of inflation targeting for India

Prior to inflation targeting RBI used to target a host of indicators and this created uncertainty in markets. For example, in 2004 -07in order to prevent rupee from appreciation due to surge in foreign exchange inflow RBI lowered the interest rates . This led to credit boom and fuelled inflation as it was a pro cyclical measure.  Thus inflation targeting will act as a bulwark against discretionary monetary policy. The requirement of the monetary policy committee to publish reports after their meeting will further help in ironing out the wrinkles of uncertainities.

Challenges ahead

1)      Supply side inflation: The economic survey 2016-17 mentions that while headline inflation (as measured by CPI) has lowered but core inflation has increased. This reflects the persistence of supply side inflation in India. It is worth mentioning that inflation targeting can target demand side inflation and not supply side inflation. In view of this appropriate measures should be taken to solve supply side bottlenecks.

2)      Weak transmission mechanism: For inflation targeting to be successful the country needs to strengthen its transmission mechanism. For instance, lowering the interest rate at the time of low inflation may not have desired impact on the inflation in the event of existence of weak transmission mechanism .

3)      Paucity of data: India’s economy is mired in poor data.  For IT to be successful the quality of data needs to be improved. Also there should be willingness to revise the base year of CPI so as to ensure that it is a good representative of consumption expenditure.

Thus taking various aspects into consideration the recent announcement of RBI to move towards MCLR in a broader spectrum is a step in right direction because it will help in improving transmission mechanism. There is also wisdom in RBI’s mandate of targeting a band of inflation rather than a fixed rate as it will provide elbow room for reacting to short term economic problems without creating volatility in the market.

- Tanushree Dutta

Agricultural Distress

India is a country mired with agricultural distress. The government had promised to double farmer’s income by 2022  but the recent protests by farmers for loan waivers paint a different picture.

Indian agriculture is characterized by low scale and low productivity. About 85% of the operational landholdings in the country are below 5 acres and 67% farm households have holdings below 1 acre. The agriculture in India is exposed to vagaries of nature. Many households don’t have access to irrigation. The problem is exacerbated by market risks and institutional failures.

The latest National Sample Survey on Situation Assessment Survey of Agricultural Households (NSS-SAS) gives dismal figures. 13.9% farm households experienced negative returns from crop production during 2012-13. Non farm income comprised 40 % of the income of the households but the access is to non farm incomes is highly skewed.

The question now arises is that given this backdrop should government go for loan waivers to the farmers.

Firstly the waivers would mean waivers only for the loans that have been taken from banks. But mostly the poor farmers rely on non institutional sources for the loans which involve a higher rate of interest. This means that many of the potential beneficiaries would get excluded. The farmers borrowing from non institutional sources are equally vulnerable.

Secondly, the waivers might arise the classic case of moral hazard problem. It should be noted that farmers often take consumption loans and this pushes them towards a vicious cycle of debt. A loan waiver would encourage them in taking consumption loans. It severely erodes the credit culture, with dire consequences to the banking business. There is a strong need to change such kind of farmer’s mind set.

Thirdly, in many cases, one household has multiple loans either from different sources or in the name of different family members that entitles them to multiple loan waivers.

Loan waiver is not even a good short term palliative. The expenditure on loan waivers has serious drawback on developmental expenditure. For instance, loan waiver may cost UP government 36000 crore, which is 4.4 times the State’s capital expenditure in Agriculture including irrigation and flood management. The worst part is that due to inclusion and exclusion error such an enormous expenditure is likely to exclude most of the farm households in dire need of relief and include some who do not deserve such relief on economic backgrounds. The CAG findings in the Agricultural Debt Waiver and Debt Relief Scheme also highlighted this problem.

For providing immediate relief to the needy farmers, a more inclusive approach is to identify the vulnerable farmers’ based on certain criteria and give an equal amount as a financial relief to vulnerable and distressed families. The government can also utilize its machinery established for Direct Benefit Transfers for identification of vulnerable households.

The sustainable solution to indebtedness and agrarian distress lies in treating farmers as entrepreneurs. They must be incentivised to take calculated risks. This entails improving farmer’s knowledge about the market. The recent initiative of the government of e-NAM is a much-appreciated move.

As agriculture is a state subject so centre must promote states to engage in competitive federalism. A  state can reward its farmers for paying its loan on time , by increasing the development expenditure towards agriculture in the budget. This will not only improve the infrastructure in that state but will also create demonstration effect for the farmers in other states. Centre can come with policies such as giving more guarantees to loans to such states. This will provide an added impetus to the state government .

Agro processing industries and the non farm sector should be encouraged and farmers should be made aware of how non farm sectors help in diversifying the risks. The success of agro processing industries lies in consolidation of farms. This requires computerized land records. Economists have long argued for taxation of farmer’s income above a certain threshold as an effective measure to reduce inequality in rural areas and increased revenue for rural infrastructure. This solution albeit  a right one , often invites political complexities .The success of all these schemes requires awareness of the farmers mainly the middle and small scale farmers. Farmer’s Friends initiative in ATMA is a step in the right direction.

India’s geography has blessed her with vast and fertile Indo-Gangetic plains. Doubling farmer’s incomes is not a piped dream. We cannot alter the circumstances overnight. But to achieve great reforms, one must continue to move towards the goal with sincerity.  In order to translate “Jai Jawan , Jai Kisan” into reality there is a strong need to uplift farmers’ position atleast near to that of jawans.

(This article has borrowed some facts and ideas from "Think beyond loan waivers", which appeared in The Hindu dated 20 July 2017)