Rate cuts have not worked; it's time for fiscal policy to revive growth

Many of the things that Paul Samuelson, the doyen of economic-textbook writers, discussed in his 1948 textbook assume relevance in the situation that policy-makers in India are now. The predicament of the Reserve Bank of India (RBI) is akin to what he describes in his writings: “Even if the authorities should succeed in forcing down short-term interest rates, they may find it impossible to convince investors that long-term rates will stay low. If by super human efforts, they do get interest rates down on high-grade gilt-edged government and private securities, the interest rates charged on more risky new investments financed by mortgage or commercial loans or stock-market flotations may remain sticky. In other words, an expansionary monetary policy may not lower effective interest rates very much but may simply spend itself in making everybody more liquid”.

What this means, as economist Paul Krugman noted during the global financial crisis of 2008-09, is that “You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs. You can get some interest rates down, but not all to the same degree. You can tempt businessmen with cheap rates of borrowing, but you can’t make them borrow and spend on new investment goods”. This is exactly the problem that both the Finance Ministry and the RBI have to tackle now.

Holding the repo

The increasing loneliness of the RBI in fighting the mounting risk to the growth of the economy is out in the open now. This has finally forced the Monetary Policy Committee (MPC) to pause its easy money policy. The RBI’s move is in harmony with the thinking of most central bankers’ across the world, who are clamouring for more countercyclical policy measures from their governments to do the heavy lifting in reviving the economy. In a sense, this brings to the fore the limits of monetary policy in reviving growth, especially when the slowdown is triggered by a sustained demand slump.

Perhaps a realisation of this could have been the reason that persuaded the MPC to maintain status quo in policy rates for now.

Given the fact that it takes at least a quarter for the reduction in policy rates to get mirrored in the actual cost of funds for borrowers, it was only wise on the part of the MPC to halt the rate-cutting cycle till the full effect of its earlier rate cuts play out. Hence, the MPC is fully justified in its assessment of not proceeding with mechanical rate reductions unmindful of their outcomes.

Policy limits

The limits of monetary policy tools are evident from two recent empirical evidences. First, the RBI had to shrink its own GDP growth forecast for the full year. Second, banks have sanctioned loans of only about 40 per cent under the ₹3-lakh-crore Emergency Credit Line Guarantee Scheme (ECLGS) for the MSME sector, and the disbursements against this stood at 50 per cent of the sanctioned loans until recently.

The ECLGS is one of the biggest components of the so-called ₹20-lakh-crore Atmanirbhar Bharat Abhiyan package announced by the Finance Minister a few months ago. The contractionary growth path of the economy and the sluggish demand for credit give the message that the monetary policy cannot do much more, and the government should step outside the narrow central-banking remit and use the fiscal policy to arrest the present growth contraction.

In situations such as the current one, which are extremely uncommon, generally it is the fiscal policy that takes the lead and the monetary policy is at best expected to support the fiscal measures. Further, there is an expectation that the Finance Minister might announce countercyclical policies to address the economic growth concerns. Even at this point, the fiscal measures are too few, too late and perhaps have gone in the way of reducing the fiscal space of the government, putting the mantle of providing a big push to the economy on the RBI.

It is only logical that the RBI will now follow a wait-and-watch policy until it makes the next move. The RBI’s next big move hinges on many factors, including the Centre’s fiscal math and the deficit management plan. Further, the most recent measures of the RBI are a statement of its resolve to put more emphasis on preserving financial stability.

Need to shift focus

The recent economic contraction has made increasing demands on the monetary policy. The sedate fiscal reactions have resulted in the risk of an overburdened monetary policy with possibly incompatible objectives, which might result in its diminished credibility. Hence, setting realistic expectations of what the monetary policy can and cannot do is all the more important.

The problem that the RBI is facing now is that the monetary policy is approaching exhaustion. It is clear that interest rates cannot be depressed much further, as mechanical rate cuts have often proved to be the bridge to nowhere. This presents serious constraints on how much more the monetary policy can do. Other efforts are needed to complement the RBI’s moves. This fiscal-policy void has appeared even though the solution for the current growth crisis is relatively straightforward — fix the problem of deficient demand by boosting public spending.

The government needs to step up capital investments to fund projects which increase productivity, as currently such investments cost less, given the low interest rates. Productive public investment would also enhance the returns on private investment, encouraging firms to take up more projects. It is puzzling to see the outright refusal of policymakers to even contemplate such actions. But the message from the RBI is loud and clear: it is now over to you, Finance Minister.

The writer is Professor of economics at IIT Madras

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