Instead of engineering a growth acceleration to go with a demographic dividend, policymakers have allowed growth to slow

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Published: October 11, 2019 1:11:34 AM

The government has a perennial problem of failure to raise adequate tax revenues. Periodically, it resorts to “tax terrorism,” which only creates more uncertainty and damages growth.

The biggest priority is a clean up of the financial sector. An overhang of bad debt can kill growth for many years.The biggest priority is a clean up of the financial sector. An overhang of bad debt can kill growth for many years.

The Indian economy is in a very difficult position. Instead of engineering a growth acceleration to go with a demographic dividend, policymakers have allowed growth to slow dangerously, with underlying causes that can lead to long-term harm. The most severe problem lies in the financial sector. Financial intermediation is meant to channel funds from savers to investors. The investors are supposed to put the money to productive use. This generates returns for investors and savers, and overall economic growth.

When the global economy was booming, India also grew rapidly, and saving and investment rates went up, supporting that growth. When the financial crisis hit, like most countries (developed or developing), India injected fiscal and monetary stimulus to ward off a depression. But, this allowed a situation where a lack of structural reforms meant that savings were going more and more to speculative or unproductive investments (or simply being effectively stolen).

What we are seeing now is a wave after wave of problems associated with a speculative boom gone awry. First, it showed up in the banking sector, then in non-bank financial companies, and most lately in cooperative banks. There is plenty of blame to go around for this situation: politicians who are corrupt and lack knowledge, or are focused on their own power; bureaucrats share the same traits; regulators are out of their depth in a complex modern economy; and economists know less than they admit.

But rather than spending time at pointing fingers, we should focus on remedies. The situation is dire enough that this should be thought of as a rescue operation. The broad contours are easy enough to lay out, but turning those into detailed, coherent, well-implemented policies will be a challenge, as it always has been in India. The biggest priority is a clean up of the financial sector. An overhang of bad debt can kill growth for many years. Just look at Japan. More focus, attention, expertise and resources need to be devoted to this ongoing task.

Second, clean up needs to be accompanied by structural reforms. Too many financial institutions in India are poorly structured, poorly managed, poorly regulated. Fixing this will be a Herculean task. Structural reforms create losers and they resist those changes, but the danger of extreme outcomes can help to concentrate everyone on minimising the pain. Of course, sometimes an outsider has to make the tough decisions. The additional cost of bringing in expertise is trivial compared to the potential economic damage of a financial standstill. The regulators really need to step up here, since the problems have arisen because of their failures as well.

With respect to demand and growth, consumption and investment are the major components of demand. There is a chicken and egg problem here. If households are not spending, then firms have no incentive to invest, especially if they already have too much capacity. The government has given tax breaks to households and firms, but directly putting money into consumer pockets is needed. Rural work programmes are a relatively inefficient way to do this, but putting money into all the new rural bank accounts that have been created might help.

What happens to inflation and the fiscal deficit? In retrospect, the inflation hawks seem to have missed the signs of a downturn. Monetary policy stayed tight long enough to crush high inflation expectations, but too long, given all else that was going on. Aggressive monetary easing, as is going on, will help, but it has its own problems, since it hurts savers, and doesn’t necessarily increase borrowing and investment when balance sheets are bad and uncertainty is high.

The biggest mistake has been a fiscal responsibility framework that neglects the business cycle and the possibility of severe downturns. The government should be less focused on fiscal deficit targets in the short run, and should not try to pretend they are being met by creating over optimistic projections. In all of this, the failure of economists to provide robust and reliable models of the behaviour of India’s macroeconomy is striking.

The government has a perennial problem of failure to raise adequate tax revenues. Periodically, it resorts to “tax terrorism,” which only creates more uncertainty and damages growth. A programme of improving the tax structure and administration from centre down to states, cities and villages needs to be implemented to address this problem. Meanwhile serious privatisation is an obvious and necessary step to reduce one aspect of the government’s own wastefulness.

In 1991, India faced a severe crisis that triggered major reforms. Those reforms would have been politically difficult otherwise, but were easy to conceptualise and implement, since they involved removing controls that were strangling economic growth. The problem had been brewing since the late 1980s, and smaller efforts at reform had been made. Now the government has to conceive, prioritise and implement more complex reforms, which involve improving the quality of many public institutions. Its recently won robust parliamentary majority give it political room to do so. It will be interesting to see if it can, and will assemble the varied expertise and knowledge needed to rescue India’s economy before things get even worse.

(The author is Professor of Economics, UC, Santa Cruz. Views are personal)

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