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C Rangarajan: The policy dilemma

In the US it is whether to continue with an expansionary fiscal policy for India it is working out a balance between growth and inflation

C Rangarajan 

Unlike the crisis of 2008, the current international crisis is not a financial crisis. This is a crisis of confidence. The rating downgrade is a reflection of the lack of credibility in the debt reduction programme approved by the and Senate in the More than the downgrading, what is relevant is the slow pace of economic recovery in the and Europe. It has put policy-makers, analysts and theorists in a dilemma. When the world was enveloped in the crisis of 2008, there was near unanimity on what the course of action should be. Almost everyone advocated expansionary monetary and fiscal policies. Three years down the line, the recovery is slow but the initial conditions have changed. The fiscal deficit in the has touched 10 per cent of GDP. Federal debt held by the public has risen from about 36 per cent of GDP in 2007 to 62 per cent of GDP in 2010. Expansionary fiscal policies played a critical role in averting a deeper recession. But the policy has also resulted in federal debt rising sharply.

Even with a sharp rise in debt GDP ratio, there is a school of thought in the that urges for a continued expansionary fiscal policy. This group includes two distinguished Noble Laureates. The argument put forward is that despite heavy borrowing, the interest rate remains low and that makes many projects worthwhile. It is also argued that public investment spending will increase GDP and tax revenues both in the short term and the long. Thus, in substance, these economists argue that increasing America’s indebtedness now and spending the money on high return investments will pave the way for reducing the long-term national debt. The opposite view is that with debt-GDP ratio soaring to a high level, it will be imprudent to continue with an expansionary fiscal policy. These analysts point to the serious problems faced by Greece and certain other European countries. The rating downgrade itself points to the need to bring down fiscal deficit and debt to GDP ratio to more reasonable levels.

Keynesian economics does not offer a direct solution to the current situation. Keynes himself was not very clear as to how the increase in government expenditure was to be financed. So long as the initial fiscal deficit and debt GDP ratio were low, the Keynesian prescription of expanding the government expenditure seemed appropriate and worked well.

Here is the dilemma. The American economy grew by 1.5 per cent in the first half of the current year. Unemployment remains high at nine per cent. There is a pressing need to find a solution to slow growth and high unemployment. The answer lies in increasing government expenditure but medium-term considerations require that the fiscal deficit is brought under control. In fact, some will argue that even short-term considerations require reduction in the fiscal deficit. The household sector saving in the is low. It is not adequate to absorb the debt floated by the Federal government. It has to depend on other countries to subscribe to the treasuries. It is true that borrows in its own currency. It so happens that the dollar continues to remain world’s reserve currency. At present, there is no other alternative currency to replace the dollar. Nevertheless, high current account and fiscal deficits and a depreciating dollar will cause concern from time to time in other countries. The dilemma can be resolved only if the government puts in place a credible medium-term debt reduction strategy, while pursuing with a moderately expansionary fiscal policy in the current period.

Transpose the problem to India. Do we face a conflict of the type that the and Europe face? Under the impact of the international financial crisis, India’s growth rate slowed to 6.7 per cent in 2008-09 after having grown at a rate exceeding nine per cent for three consecutive years. Since 2008-09, India’s growth rate has remained in the range of eight to 8.5 per cent. This growth rate, though lower than the earlier period must be considered high in the current world situation. The fiscal stimulus provided in 2008-09 and followed subsequently has had the effect of raising the fiscal deficit of the Centre. In 2008-09 as against the original budgeted deficit of 2.5 per cent, the actual fiscal deficit turned out at six per cent. In 2009-10, it went up to 6.7 per cent and it dropped to 4.7 per cent in 2010-11. In the current year, the fiscal deficit is budgeted at 4.6 per cent of GDP. It is going to be a difficult task to achieve this target. Following the recommendations of the 13th Finance Commission, the government has set out a path of fiscal correction. It is extremely important to follow this path. This is so for two reasons. First, fiscal prudence is extremely important for sustaining stability over a long period. Of course, the deficit target must be consistent with the obligations of the government and the level of savings of households, which is only the surplus sector in the economy. The target of six per cent of GDP for the Centre and the states taken together appears consistent with the level of household savings in financial assets. Second, as the current account deficit still remains in the range of 2.5 per cent of GDP, the financing requirements are large. So far, the capital flows have been adequate and we have had no problem in financing the current account deficit. We need overall capital inflows of the order of $70 billion every year. In this context, the perception of external investors is also important. Since investors, particularly in the context of the recent developments in the and Europe, attach a lot of importance to fiscal prudence, we need to ensure that the fiscal deficit does not exceed the target that we have set ourselves.

The policy dilemma in India now is different. It is a question of working out a balance between inflation and growth. We have had a high level of inflation for the last 18 months. Since January 2011, inflation as measured by the wholesale price index has remained above nine per cent. The policy priority should be to bring inflation down to a more acceptable level. Bringing inflation down, though seemingly at the cost of growth, may, in fact, be the appropriate policy for sustaining a high medium-term growth.

The author is Chairman, Prime Minister’s Economic Advisory Council

First Published: Mon, August 22 2011. 00:51 IST