Government spending must increase for growth to revive, given demand is still quite weak
The European economies and the Indian economy do not look similar as the former is still in the stage of stagnation while ours is on the verge of recovery. But a common theme that has pervaded the policy options exercised across these two dissimilar geographies has been fiscal prudence. The euro region perforce has to control government spending and rein in the fiscal deficit as it was the cause of the Greek crisis to begin with.
This is also a condition put by the ECB when invoking its own version of QE. The Indian government has chosen to do its own tapering in the last three years after the pump-priming programme that was undertaken following the financial crisis to ensure that growth remained buoyant. The general tone at North Block on this issue appears to have changed, and rightly so.
Government expenditure is a very useful tool for reviving an economy especially when there is a demand-side problem. Today, there is absence of demand for goods and services in India as consumption is down because households are not spending; industry is not investing as capacities are still underutilised (71% as per the latest RBI data) and the government is loath to spend as the Fiscal Responsibility and Budget Management (FRBM) norms are held sacrosanct. Such spending was applauded after 2008 when the government ran a higher deficit; but once we slowed the flow from this tap, growth, too, slowed down. Critics blamed the government for spending too much by giving away money through social programmes (the MGNREGA spent only R30,000 crore, which is 0.3% of GDP) which caused high inflation (one minister even said that inflation was high because the poor were eating more).
The policy of following the FRBM norms has been pursued assiduously and has meant that the government had to cut back on expenditure to control the deficit when revenues did not increase—especially because revenue is dependent on the state of the economy and growth, over which the government has little control. In fact, John Maynard Keynes, the renowned economist, would have said that higher government spending would have created jobs and growth through the multiplier, and investment would have increased through the accelerator (the famous Harrod-Domar model). And this was notwithstanding the fact that the money was spent on frivolous activities like digging up holes to fill them up, which the MGNREGA is almost all about. In fact, the higher incomes of rural workers due to MGNREGA had actually made them spend more on manufactured products, which added to consumer demand in good times. Now, this has stopped as people spend more on food and have less to spend on manufactured goods which are indicated in the very low growth in production of consumer durable goods for the last 3 years with growth in FY15 being negative.
The government’s role is important here because we are all waiting for consumption or investment to increase, which is not happening. Incremental pick-up will take place but then we have to wait for the cycle to turn gradually and that can take 2-3 years, during which several things can change, viz., oil prices could move up, interest rates could increase, the exchange rate can come under pressure and so on. If a big push is required then it has to come from the government and this is why there is a call for such expenditure on infrastructure.
Curiously, the same voices which are asking for more privatisation (especially of the public sector banks) and the government moving away from economic activity as it is considered inefficient are now asking for more government activity in the productive sphere. There is an anomaly here which has come up more out of desperation. The Union ministry of finance, in the mid-term Economic Review, has indicated that there is a strong case for moving away from FRBM targets and being more accommodative of expenditure as it can trigger a virtuous cycle of growth and investment. The passage of the land laws through an ordinance could be a precursor for such a move which will be beneficial for the economy. The challenge really is to ensure that it goes in the required direction as all money is fungible and it is hard to finally say which part of the money goes for what purpose.
The way it works is simple. The government is a major consumer of cement, paper, steel, machinery and electrical goods. Any infra project will need more of all these products, and with the land laws being cleared, projects can take off in the PPP mode as well as through public sector initiatives. This will lead to higher employment and demand for these back-end products primarily produced by the private sector. Such demand will revive these companies and create more demand for labour as well as other inputs that go into the manufacture of, say, steel (iron, coal, power, etc).All this will add to the virtuous cycle.
Economists like Joseph Stiglitz and Paul Krugman have always argued that policies relating to fiscal stringency should be used in moderation and have to be geared as per the overall economic conditions. The euro crisis is mainly due to the governments cutting back on spending even while keeping interest rates low. This has not helped. Japan’s case, however, does provide a counter-view, that government spending too may not necessarily help.
For India, the government should start spending but to make sure that the environment is enabling, interest rates have to be lowered, or else the private sector may not be able to keep pace with the demand. As inflation has come down, and is likely to be around 5-6%, there may be a strong case for RBI to review the target of a 4%-rate (with a 2% margin), as the average CPI inflation rate has seldom gone below 6% on a sustained basis. Anyway, earmarking 0.5% of the FY16 GDP for project expenditure, which is spent immediately, can be a chance worth taking as it will definitely help create demand at a time when global economic conditions are also favourable. Hopefully, we will see such moves on February 28.
The author is chief economist, CARE Ratings. Views are personal