Is a new economic crisis coming? Is it just a playing out of the financial crisis of 2008? What should India?s policymakers do? These may seem like just a tough set of questions from a civil service exam. But they are real challenges that face India?s leaders. Unlike their counterparts in the US, Europe and China, India?s leaders actually have significant room to maneuver. What should they do, and why?
Let?s recap where things stand. Finance is at the heart of capitalism. When it works, it channels resources from savers to productive investors, leading to growth and real returns for both sides, as well as the financial intermediaries. The 2008 crisis originated with Wall Street and the US government. Between them, they allowed financial intermediation to become unhinged from productive investment?Wall Street through greed, dishonesty and incompetence, and the government through poorly chosen fiscal and monetary policies and poorly enforced regulation. Of course, there were many other villains, from Irish and Icelandic banks to the governments of countries like Greece. Bailing out financial institutions that made bad lending and investment decisions, plus pumping up government spending to prevent a complete economic collapse transferred some of the unsustainable private sector debt burdens to the already-stretched public sector.
So the latest crisis is partly fallout from 2008. Deteriorating public balance sheets are also hurting banks again. Assets that looked safe are again turning out to be risky?mortgage-backed securities and other financial derivatives then, government bonds now. Just as saving and lending was earlier channeled into unproductive investment (the housing bubble), now it is connected to unsustainable transfer payments by governments. There is no quick or easy fix, and the global economy will go through more pain. Given that certainty, what should India?s policymakers do?
In the short run, the increased uncertainty and dampened spirits surrounding the global economy suggest that the Reserve Bank of India should pause its tightening measures. Monetary policy works with a lag, and it makes sense to wait and see how the Indian economy and inflation are responding to the tightening already undertaken.
If China also slows down, as seems more and more likely, pressure on commodity prices may lessen, and ease India?s domestic inflation. Certainly, a slowing global economy is likely to put a lid on inflation expectations. Fiscal policy is already loose, so the prescription would be to stay the course there.
In the near-medium run, clearly the biggest positive policy step for India is implementing the goods and services tax (GST). A simple, well-functioning GST can solidify government revenues and streamline some aspects of doing business, while reducing the distortions that have plagued consumption taxes in India. Getting the GST in place soon is eminently feasible. More generally, the government could strengthen the economy by paying attention to the World Bank?s Ease of Doing Business Index, and making improvements in India?s ranking a policy priority. If animal spirits are dampened in the rest of the world, giving Indian entrepreneurs positive signals and encouragement can do much to compensate for a foreign slowdown. One of the US economy?s weak spots has been that small businesses are not creating jobs as they would in a normal recovery. Making business creation easier in India can boost employment and tax revenue, and start to ease supply constraints.
Small businesses in the US are also having trouble getting credit from banks that are repairing balance sheets and also meeting more stringent regulatory requirements. In India, the stock market and microfinance receive a great deal of attention, but finance for small and medium enterprises remains systemically weak. Fixing this may be a longer term project, since it will require legal reforms and improvements in managerial capacity and practices in the banking sector. In general, India has tremendous scope to expand its domestic finance sector in positive directions.
Parts of Europe and the US are also starting to reveal wider gaps between existing skill sets and what their economies need. India has faced this problem for a long time. If the 1950s and 60s saw a successful beginning in creating a modern education system in India, much of the recent past has been retrogression. Meanwhile, vocational training has never been on a firm footing in India. Expanding the education sector (and FDI here might be more valuable than in the retail sector) is the best bet for India?s long term future.
The second stage of the economic crisis of the US and Europe provides a clear set of lessons for India?s policymakers. They should prepare for a softening of global demand, and make sure that domestic investment has a favourable operating environment and that it goes to productive ends. India is well-placed to do these things, if its leaders adjust policy quickly for the short run, and keep their focus on the medium and longer run.
The author is professor of economics, University of California, Santa Cruz