How to design a good policy mix in a crisis

There is no consensus about the design of a good public policy mix during a crisis. Prima facie , one would expect the fiscal policy to play a critical role if the origin of the crisis is the real sector. Per contra , if the crisis emerges from the financial sector, the central bank of the country should do the needful along with other financial sector regulators. Conventionally, demand management is vested with the central bank while supply management is done by the government. However, conventional wisdom does not work in the case of a crisis, as the policy mix is typically situation-specific. Moreover, a crisis tends to spread to all sectors, including cross-border spillovers, which warrant both demand and supply management. Hence, both monetary and fiscal policies need to be combined in a crisis and pursued in coordination.

Policy space

During the global financial crisis (GFC), fiscal policy space was not available in case of most of the advanced countries due to the high debt-GDP ratio. Hence, the burden of managing the GFC fell squarely on monetary authorities by default. Fortunately, monetary authorities had some space to aggressively cut policy rates and pursue quantitative easing as soon as their policy rates reached zero-lower bound.

The countries which combined quantitative easing with profligate fiscal policies ended up with either a sovereign debt crisis (Eurozone) or high inflation (India). The USA had a fiscal cliff before the GFC, that saved the country from a deadly combination of an ultra-accommodative fiscal policy and extra-loose monetary policy. This is probablywhy the US could recover early from the GFC compared to other advanced countries.

During the Covid-19 crisis, the situation appears to be broadly just the reverse. Currently, monetary policy space is not available as many central banks of the advanced countries have been operating with near-zero policy rates. Although the US Federal Reserve had some monetary policy space, it reached the zero-lower bound quickly. Currently, the Fed is somewhat reluctant to enter into the uncharted territory of negative policy rate like Japan or the European Central Bank.

To fight the Covid-19 crisis, advanced countries have been more aggressive in stimulating their economies through fiscal policies, with monetary policy taking a back seat, although it is accommodative. The same combination may not be appropriate for the emerging market economies like India.

The RBI had enough policy space before the outbreak of the Covid-19 crisis, while fiscal policy space was extremely limited. The natural outcome of the policy mix in the case of India has to be an ultra-accommodative monetary policy with a supportive fiscal policy to deal with the Covid-19 crisis. During 2008-09, the Central government committed the mistake of borrowing over 2.5x the usual borrowing to contain the spillover effect of the GFC, even though India was not directly affected. Committing the same mistake again will compromise the long-term interest of the country.

The Covid-19 pandemic caused both demand contraction and supply setback. While the demand management is being done by the RBI through ultra-accommodative monetary policy, the contraction of the GDP is being contained to the extent possible through the gradual lifting of lockdown restrictions together with the credit-led revival of economic activities, supported by credit guarantee and structural reforms. There is a need to understand as to why this combination is appropriate in the present situation compared to a combination of profligate fiscal policy and ultra-loose monetary policy.

Credit-led approach

In the short run, if the government borrows more from the market, the yield will go up. The government’s market borrowing has already been increased by ₹4 trillion in FY21 on top of about ₹8 trillion proposed in the Budget. State governments’ extra borrowings add another ₹4 trillion. These ₹8-trillion additional borrowings would certainly put pressure on the sovereign yield going forward. The government’s decision to limit its excessive fiscal stimulus through market borrowing makes sense, as this will come in conflict with easy monetary policy. Hence, the need of the hour is to stimulate the Indian economy through low-interest-rate policy, as the recession is likely to be deep.

If the government resorts to subsidised credit from the RBI through monetisation, it will take very little time for inflationary pressures to build up. In the aftermath of the GFC, India’s growth-inflation dynamics had proved that inflation could persist despite the existence of a negative output gap. Profligate fiscal policy through monetisation will anyway increase inflation, which will be reflected in the sovereign yield. A combination of ultra-accommodative monetary policy and profligate fiscal policy cannot be pursued without conflicting outcomes and a deleterious impact on the economy. Experts who advise private placement of sovereign papers with RBI at a subsidised rate seem to ignore the medium-term outcome.

The major conclusion that is emerging from the above analysis is that a suitable public policy mix depends on the policy space available during a crisis. Since February 2020, the RBI has announced several measures involving a more than ₹9.4-trillion liquidity injection to the market. Neither the RBI nor the market has unlimited capacity to absorb additional borrowings. The only option that remains is external borrowing/loans from multilateral institutions, which is yet to be explored by the government.

The author is a Visiting Fellow at IGIDR and former head of the RBI’s Monetary Policy Department. Views are personal

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