We are a fiscally constrained economy, the Prime Minister said recently. The context in which he said that suggests he sees those constraints as structural – which would not go away anytime soon. (The PM was speaking at an RBI function where he indicated that India may have to re-visit the limitations of monetary policy in a fiscally constrained economy. So fiscal constraints are a given; we have to see how best monetary policy can be conducted in that scenario.)

Indeed, India’s fiscal constraints have always been structural; with a gross tax take stubbornly not exceeding 8-9 per cent of GDP, but total government spending comfortably around 15-16 per cent of GDP, the budget gaps have been around for a long time.

And, they almost certainly seem like widening in the ensuing period — not only because of social welfare initiatives such as food security, but also more critically because of our burgeoning consumption of subsidised PoL products.

Even if you add a potential boost to the tax take with the proposed all-India GST, we are looking at continued gaps of around 7-8 per cent in the national budget.

How best can monetary policy be conducted in this scenario? This is probably the most important and difficult challenge confronting the new RBI Governor; more so as he has articulated that the RBI has to go back to the basics — its core job being to ensure that the rupee’s purchasing power is preserved internally.

That focus on a core “monetary stability and internal purchasing power preservation” objective is laudable, as monetary instability is arguably the root cause of so many other imbalances — for instance, in our external accounts and banking system. Budget deficits per se are not evil at all; more so in the developing and poor economies where governments have to take up large social commitments.

The question is limited to how monetary policy can be best conducted in a fiscally-challenged environment so as to serve the overall common good.

This is achieved when reasonable preservation of a local currency’s purchasing power enables all economic agents — producers, consumers, households — to make optimum decisions about consumption, savings and investments.

Such optimum decisions, in turn, preclude boom and bust scenarios of the type we are witnessing now in India and help preserve absolutely essential social sector expenditures in the national budget.

What limitations?

It is unfortunate that the Prime Minister stopped with pointing out that monetary policy faces severe limitations in a fiscally constrained environment -- and did not go on to either identify or explain how those limitations could be transcended.

Those limitations flow from the fact that there are basically only three ways in which stubborn, structural budget deficits (and the resultant public debt) can be dealt with:

a) pay it off with years of budget surpluses;

b) default on it outright;

c) lower the real value of deficits and debt by inflating them away.

Are options “a” and “b” at all possible in India or even in any other developing country?

Both politically and economically, they are non-starters or as they put it, “dead on arrival” if they are proposed in any legislature.

We are not the UK where a real-life experiment in cutting public deficits is underway — though, arguably the jury is out on whether it is a prudent move on the UK’s part at all. (But, with the Bank of England continuing its QE — for some time into the future — the UK’s deficits reduction may still go through without any major damage to the economy).

Can we envision that India’s oil companies will be completely freed from government control and will have full pricing power to protect their balance-sheets — any time in the foreseeable future?

DEBT DEFAULT?

Even if the oil companies get freedom, ultimately, the national budget will continue to be hobbled, as government cannot get away from subsidies. (As the Finance Minister said, end-consumers will be protected, come what may!!)

Defaulting outright on debt is also a complete non-starter. Almost all public debt is locally held and the main holders of debt are also majority-owned by government. Still, defaulting is like digging your own grave — it can potentially spark off a run on the banking system.

The third option is, therefore, forced on the policy-maker. And that is where the role of monetary policy comes in.

Faced with literally “no choice” options of “a” and “b”, governments — historically and across countries — have leant on national central banks to inflate away deficits and debt by directly financing them. Inflating deficits/debt away is akin to sugar-coated poison.

It is debt-default in a “sophisticated” manner. Not many notice it or understand it when that process is on. But, it hits hard at the health of the macro-economy in course of time, creating deep macro-economic imbalances and instabilities in the financial system.

Despite wide cross-country experience in this regard, India’s RBI too — and by extension the broader economy and the financial system — has gone through/is going through the same experience.

Untrammelled central bank financing of public deficits is one of the critical reasons behind India’s on-going travails (besides other factors such as supply-side constraints and governance issues).

Simple agenda

The agenda is brutally simple. We have to run public deficits. At the same time, we do not want central bank financing of those deficits, for that is a sure recipe for further messing up the economy.

If the RBI has to live up to its basic mandate, as articulated by its new Governor, it has to take a public pledge to not expand its balance-sheet from its current level of Rs 23 lakh crore. A

ny change, if at all, should be rigorously circumscribed and related to its core objective.

That seems the only way to overcome its limitations. Indeed, what we need is monetary contraction in the face of fiscal expansion, a la Paul Volcker’s counteraction of Ronald Reagan’s large deficits in the early 1980s.

Raghuram Rajan gets an early opportunity to announce such a pledge in his policy review on September 20.

One wishes he does that despite the inevitable turbulence which the US Fed’s QE tapering (likely to be announced this week) will cause.

(The author is a Chennai-based financial consultant.)

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