The Indian economy seems caught between tight fiscal targets prescribed under the FRBM (Fiscal Responsibility and Budget Management) review and a government which treats them as cast in stone, even at a time when the economy is reeling under the impact of the Covid crisis.
The best example of failure of the prescriptive approach is the Eurozone. The prolonged sluggishness of the Eurozone has been caused mostly by restrictive inflation targeting (influenced largely by Germany’s phobia for inflation given its post-World War-II memories), and tight fiscal deficit and debt/GDP targets. These were good for a select few countries, but out of context for the rest —those who were already better-off gained in relative terms but those who were not aligned with them have gone into prolonged sluggishness, and some even into economic coma. Overall, the Eurozone has has ended up being a major loser — it has become a sink-hole which the Chinese have expertly filled to their advantage.
Prescriptive and market-distorting interventions in agriculture products, along with minimum wages in labour markets, have been around in India for a long. But in recent years, such an approach has been extended to other areas of macro management. Prohibitive pricing under the Land Acquisition Act has virtually put it out of reach. Inflation management, which was largely situational or contextual, has become tightly prescriptive, where the midpoint 4 per cent has operated more like a hard-stop cap.
Faith in markets
The FRBM was loosely operated till 2016. With a rigid fiscal target (and glide-path) and debt-GDP ratio, it has started impacting other macro variables like output, employment and government investments, besides hindering response to six-sigma kind of events like Covid.
Such a prescriptive approach is born out of a lack of faith in market efficiency and its self-correcting nature. Fixing targets for macro-economic variables like inflation, interest rates and fiscal deficits is as detrimental to the efficiency of free markets and their equilibrium-seeking ways as fixing minimum or maximum prices in individual commodity markets or fixing quotas or tariffs, or licensing in micro markets.
A circuit breaker in stock markets at 10 per cent and 20 per cent might make sense, but at 3 per cent and 4 per cent it will affect free functioning of the markets — ie, adjustments to new information or assimilation of the effect of other economic factors. The trouble with tight targets is that they start affecting other factors and force them to operate at sub-optimal levels.
As an example, anyone seeking air tickets or hotel rooms on the Internet will know that the more conditions or filters one puts, the lesser number of options get thrown up. The recent prescriptions have operated like such ‘binding constraints’, reducing the value of the outcome rather than acting as circuit breakers.
Free of any prescriptions, major macro variables like inflation, investments, fiscal deficits, CAD, exchange rates, growth and output interact with and influence each other so that markets seek optimal or equilibrium ways. Such interplay also keeps the others in check so that they don’t escape their gravity.
The experience of Communist countries has proven that market-based equilibrium has been far more enduring and self-sustaining, with fewer glitches. Prescriptions should be like circuit breakers for extreme three-sigma events like the East Asian meltdown, the dotcom bubble and and Covid.
Are there risks in letting markets play? Will inflation, for example, run away to 20-30 per cent, or will interest rates go sky high and snuff out all investments? Will exchange rates break loose and settle at ₹120 to the dollar?. In an open economy, where most commodities as well as finances can be imported or exported, there is little risk in general inflation shooting through the roof — import parity prices will ensure domestic prices cool down. Sudden swift exchange rate variations are to release pent-up pressure. If the exchange rates fall far too steeply, higher exports and a greater incentive for overseas Indians to bring back money will soon cool it down. Any spikes in interest rates will increase the investment attractiveness and bring in money from savings here and overseas.
Unless the government resorts to absurd 30-70 per cent increases in MSPs (as it did in 2008 and 2010), extreme food inflation is unlikely. With our excess stocks and production of food grains, there is no need for food inflation fears; surely in contingencies we have enough forex reserves to import food and cool down prices — something markets will do anyway.
Safeguards, if any, should be limited to extreme events — specified or emerging — something that has a 1-2 per cent chance. For some essential items like food, safeguards may be necessary. But even in such areas it may be better to let the market find its level, while compensating the vulnerable through cash transfers.
During the 10 years before 2013, we have had some of the best growth years — the inflation range was 4-10 per cent and fiscal deficits were in the range of 6.4-3.3 per cent, with an average of around 4.7 per cent. Surely there was a causal connection between these various factors, when they were managed with caution than prescription. To aim 4 per cent and 3 per cent, respectively, is tantamount to ignoring these causalities and giving hygiene factors the status of main deity.
When the history of China’s stupendous rise from 1980 to 2020 is examined carefully, two things might become clear. Former US Fed chief Paul Volker’s constricting inflation control during the 1980s diluted the US’ investment spurs and helped China grow green shoots; the self-negating Eurozone policies of the last two decades helped consolidate it further. Europe, once the cauldron of new ideas in many facets of science and technology and corporate governance, is regrettably having to shield itself from Chinese investment invasion now.
Before we learn about Chinese manufacturing excellence, we might learn some lessons on how it has managed its economy. India seems fatally infatuated to Eurozone ways, and is replicating the resultant sluggishness.
The writer is author of ‘Making Growth Happen in India’