The next government's biggest challenge

It now looks as if Narendra Modi will get a second term. What will his biggest economic problem be? No prizes for guessing: money.

As one looks at the fiscal performance of  governments all over world in the last 35 years, the question has refused to go away: Should they loot, tax or borrow – or indulge in all three to meet their expenditures? 

In the bad old days, they simply looted. All a chief needed was  gang of hooligans, grandly called an army.

Then came civilisation which meant a deal between the rulers and the ruled that the latter would part with some money voluntarily. This was called taxation. In return the ruler promised not to plunder and pillage. 

But globally expenditure always exceeds revenue. 

So the rulers started borrowing also. Increasing economic prosperity made this a mutually beneficially arrangement. 

Few people know it, but this is how central banking was born. In 1694, the money lenders of the City of London, in return for a loan of a million-odd pounds, wrested control of the currency from the sovereign. That became the thin end of the wedge and monetary policy came into being.

From the very start it monetary policy was the Yin to the fiscal policy’s Yang. They were opposed to each other and, simultaneously, complementary to each other. 

But the old problem remained: if you taxed too much the people threw you out. If you borrowed too much, they still threw you out because not only did you leave less for them to borrow, you also invited inflation.

Sometimes the process of throwing out a government was peaceful. But often it was violent. Whatever the process, everyone suffered.

India in the Modi era

India has now reached the stage wherein the government is taxing, borrowing and, via its ownership of banks, looting as well. The pips are beginning to squeak, and it is only a matter of time before something gives. 

A major financial crisis, involving severe deflation seems unavoidable. It will leave everyone worse off. Indeed, since demonetisation this has already been set in motion.

But as always it is hard to say when the big crisis will happen and what will trigger it. Suffice it to say that right now things are at the tipping point.

This happened once before, in 1989, when Rajiv Gandhi was prime minister. During his five years as in office, the budget deficit became four times as much as it was when he started out in 1985. 

It was financed by the printing of more and more notes, raiding the public sector banks and, of course, high taxation. Even so, Rajiv left behind a bankrupt government.

Then, in 1994, under severe IMF pressure, the government announced that it would stop financing its consumption needs by a subterfuge called ad hoc treasury bills, the euphemism for simply printing new notes. These had been around 1955 but under Rajiv, they took on gigantic proportions. 

The government said it would now have the equivalent of an overdraft; that this would not be a source of financing investment; and that it would not show up in the budget deficit. Only the IMF was happy.

A quarter of a century later it would seem that the wisdom of this decision has run its course. The government finds itself so helpless that it has gone back to the Rajiv formula: tax, borrow, loot.

Ad hocs redux

I think we need to reconsider the idea of printing notes to finance government expenditure by reintroducing some modified version of ad hoc treasury bills because the alternative is the diversion of savings from investment by the private sector to consumption by the government.

If Mr Modi asks me I will tell him to immediately set up a committee to devise a new version of the ad hocs. If something like this is not done, we will have governments going on the rampage, with increasing frequency.
The author is available on Twitter at @tca_tca