No magic cure for an ailing economy

The new government bears the burden of expectations. It has to fix an economy saddled by stagflation, policy paralysis and loss of investment appetite. What it should really come to grips with is certain issues of institutional reform, without which long-term growth will remain a mirage. What we will see instead is boom and bust cycles.

So, what is the mess that we find in front of us?

Decelerating output growth marked by volatile investments and stubbornly high inflation in consumer prices needs to be addressed..

Investment activity is under strain as forecasts of real returns to projects are not being realised due to generalised inflation. After a period of robust earnings growth in the 2000-07 period, real returns to investment projects are down because of inflation.

The recent industrial relations disputes in the manufacturing sector can also be understood in this broader context, as labour input costs are under strong upward pressure.

The gridlock in the policymaking environment had also contributed to dampening investment confidence. The regulatory obstacles have resulted in key projects not going onstream, thereby resulting in financial distress for borrowers. This has and further compromised asset quality in lending institutions such as banks. This gridlock is highlighted as the single biggest impediment to the revival of economic growth.

As a corollary, people assume that with a new, (decisive) government in place, high economic growth will automatically resume.

Such a simple solution does not seem to exist. After two decades into “reforms”, it can now be understood that the institutional foundation of economic policymaking in India is quite weak. This weak foundation would come back to haunt India’s medium-term economic prospects even if some or many of the “gridlocks” are opened in the next year or so.

At the global level, it does not seem like the world economy would turn around in a strikingly strong manner in 2014-15 to provide a noticeable lift to emerging economies. In this overall backdrop, there cannot be a stronger case for strengthening the foundation of economic policymaking in India so as to insulate the domestic economy from external developments.

Many fundamental questions have remained unanswered in the past two decades. The questions also relate to the institutional arrangements which should govern policy-making in the modern (global) economic environment.

Specifically, Indian economic policymakers still do not appreciate that monetary policy and fiscal policy are two distinct arms of economic policy. They should know that the monetary policy making arm should be independent of the fiscal arm and have the autonomy to work towards a clear economic objective.

Quite simply, the rule governing institutional arrangements at the higher echelons of economic policy making should be: the power to spend the money and the power to create money should be housed in statutorily separate, independent institutions.

The power to spend money rests with the Government and the party in power. The power to create money rests with the Central bank in a modern, fiat-money system based economy.

Where these two powers reside de jure in separate entities but are de facto exercised by a single entity (government), it is a recipe for macro-economic instability — of the kind India is experiencing now.

Unfortunately, though, Indian governments treat the central bank as just an appendage to finance the gaps in their spending budgets. They do not seem to recognise that monetary policy is a powerful macro-economic tool that, if employed with integrity to produce stable prices, can significantly advance the national priorities of stable long-run economic growth and increasing levels of employment.

At the institutional level, India can be ranked among countries with primitive economic systems marked by high budget spending, weak tax base/tax administration and the resultant temptation to use the central bank as a printing press to fill the budget gaps. Those are the hallmarks of an LDC — least developed country.

Is it not time India graduated out of the LDC category?

Therefore, some key questions that should find clearcut answers are:

How big should the Government’s spending commitments (subsidies, deficits) be? What should be the Government’s tax and revenue policy? Do we have a national policy on tariffs/user costs for key infrastructure such as power, roads, water, transport fuels, gas? How do we plug the overall spending gaps in the national budget? What is the role of the RBI in that process? Does the RBI have an objective with respect to the macro-economy?

If India does not answer these questions, we will have a repeat of what has happened in the past decade — booming activity both in real and financial sectors for some time (as was the case between 2001 and 2007 ) followed by a bust (between 2008 and now). That is, recurring boom and bust scenarios.

It may not be possible in today’s global economic environment for any country to completely eliminate domestic economic cycles. But, it is still possible for strong governmental leadership and disciplined economic policy to reduce the frequency and amplitude of economic cycles.

India seems to be on the cusp of such a combination of strong governmental leadership and disciplined economic policy.

The writer is a Chennai-based financial consultant