Last year the Nobel Prize was given for behavioural economics. Behavioural constraints in policy making are under-explored, and can help to understand and perhaps mitigate the over-reaction we are seeing in many areas of policy.

Macroeconomic policy

After the global financial crisis (GFC) excess macroeconomic stimulus led to overheating of the economy. As a result, we bound ourselves tightly in monetary-fiscal rules. There was a welcome strengthening of institutions bringing in a long-run perspective. However, there was over-reaction in “too strict implementation” and neglect of demand.

The flexibilities and space available within the rules were not utilised. Since 2011, only structural reform took place, despite the necessity of increasing domestic demand to counter a collapse in export demand. The best became the enemy of the possible. The aim to resolve all structural issues before stimulating growth is quixotic, since new problems will arise. Under overall structural reforms, in a situation where industry is producing below capacity, all available space for stimulating demand should be used.

The experience of over-heating made policy-makers extra cautious. Macroeconomic stimulus got a bad name after too much of it. The post-GFC fiscal stimulus was very large. The deficit rose by 4 per cent of the GDP with the increase largely going to rural construction at a time when food inflation was high. That stimulated a rise in wages and led to further inflation. But government spending on social or physical infrastructure that reduces bottlenecks and costs in the economy would reduce inflation, not increase it.

The Pay Commission awards, increasing demand for consumer goods where industry had excess capacity, were not inflationary. This year’s 0.3 percentage point slippage was consistent with fiscal rules, since there were major tax reforms, but led to negative market commentary partly because of the over-emphasis on fiscal consolidation in policy communication.

Inflation targeting was applied without adequate adjustment to the Indian context — where fiscal supply-side policies affect inflation more and monetary policy has a larger and more immediate effect on output. In such a context, monetary policy should compensate for demand shocks, as long as adequate supply-side reforms restrain inflation.

The inflation targeting India adopted was flexible, but it was implemented too strictly. Rules perform a valuable function in constraining discretion, but some discretion is important — it allows transparent adaptation to the context.

Since foreign outflows can be a very public and concentrated event there is a fear of such outflows, and a bias towards conservative policies that satisfy foreign capital despite the high unemployment costs they may impose internally. There is excess weight on foreign reputation and external risks even though India’s less-than-complete capital account convertibility insulates it somewhat. Debt inflows have risen in absolute amounts but are still capped at 5 per cent of the domestic market. Even international investors say too high Indian interest rates in the post Euro debt crisis period gave excess returns to debt flows. In the longer-run even such investors value higher growth, which reduces country risk premium.

Stressed assets

Here again, in an over-reaction to the perceived ever-greening and credit boom, policy chose to apply the strictest possible criteria to both corporate borrowers and lending largely by public sector banks — never mind that, as a result, both credit and investment collapsed over 2011-2017.

Helping industrialists for a hidden payment was the earlier political mantra. There is a welcome shift to helping industry as a whole, through reducing business obstacles. There are signs that society is willing to shift away from a norm where corruption and gaming the system was acceptable. For the first time, serious action has been taken against industrialists accused of wrong-doing.

The earlier infrastructure cycle involved largely debt finance from public sector banks, with very little own equity. Thanks to delays in project implementation, a slow down and high interest rate regime, the loans of PSU banks became non-performing.

Taxpayer bailouts used to be the norm in the absence of a resolution regime, but now under the Bankruptcy Code (IBC) industrialists stand to lose their assets. This is inducing major changes in behaviour. Borrowers are becoming more serious about repaying loans since they stand to lose their assets; bankers are making faster decisions on haircuts required for resolution, because if the asset goes into liquidation they are not likely to get much.

But there were also external and systemic shocks responsible for the worsening asset quality. The climate of suspicion and allegations of corruption has been overdone. This started with the telecom scam of 2008 where the Minister was accused of selling bandwidth cheaply with kickbacks. But a special court acquitted all the accused in December 2017. Excessive witch-hunting can also become an obstacle to business.

Improvements in corporate governance and regulation are the way to progress. There are valuable systemic shifts towards a risk-based culture of lending. Forward-looking regulations improve incentives for compliance. Reviews must be timely. Reports today tend to cover a two-year earlier period. Digitalisation makes real-time evaluation possible.

But regulatory tightening must also be sensitive to the cycle. International research recommends easing in a downturn. But Indian over-reaction is doing the opposite. Suddenly closing all ongoing resolution schemes; refusing historical flexibilities in marking-to-market capital losses on bonds; insisting on early implementation of international accounting norms are all hitting already weak bank balance sheets.

Refusal to intervene in bond markets that then became thin and volatile raised the cost of government borrowing. The best response to excessive flexibility is not zero flexibility; to ever greening of loans is not turning off the credit tap; to misuse of credit instruments is not banning them.

Narrow vision or thinking in silos is another psychological problem afflicting financial regulation. This leads to a lack of coordination between macroeconomic and prudential policy. Regulators are missing the larger picture and getting bogged down by sectoral details. The Financial Stability and Development Council could perhaps take up this issue.

The writer is a part-time member of EAC-PM. The views are personal.