Taming the cycle


Financial Express, 15 August 2006


The approach paper to the eleventh plan proposes an 8.5 percent target for GDP growth over the eleventh plan period 2007-08 to 2012-13. It, however, recognises that, " The experience of the past decade indicates that endogenous business cycles may have become an abiding feature of Indian macroeconomic behaviour. This can be addressed through appropriate fiscal and monetary measures provided that recognition is early enough."

It is significant that instead of assuming that India will go along a linear growth path, as was often believed before the libearlisation of the 1990s, there is now a recognition of the fact that now we have endogenous business cycles like modern industrial economies. However, counter-cyclical policy is not easy to implement by mere early recognition of cycles. As modern industrial economies have found, it requires a change in institutions.

Left to itself, fiscal policy is usually pro-cyclical. When the economy is doing well the government collects more taxes and thus spends more. This ends up in exacerbating the cycle.

Given the initiatives of the UPA under it Common Minimum Programme, it seems rather unlikely that a countercylical fiscal policy could be followed. For example, at present we are on the high of a business cycle. To be countercylical, fiscal policy should be contractionary, and government expenditure and deficits should be reduced. Instead, we have a spate of high expenditure welfare programmes and indications that fiscal deficits will be higher.

The fact the Congress itself and the UPA's Left allies do not see the need to reign in deficits, and even in this phase of the cycle recommend large government spending financed through borrowing are indicative of how difficult it will be for the government to implement countercyclical fiscal policy. Moreover, to change tax rates with the needs of countercyclical policy will be politically very difficult not just for the UPA but for any government in India for a very long time.

Thus, as in most countries, in India too, it will be difficult to make fiscal policy countercylical especially when it means cutting spending or raising taxes. It is rather easy to increase spending when the economy is in a recession as no one gets hurt, but to cut it is far more difficult, even in times of a boom.

Consequently, the burden of counter-cyclical policy falls on monetary policy. This task has been made easier by giving central banks just one responsibility i.e monetary policy.

In India, the RBI has multiple responsibilities. It is debt manager for the GOI, it is the banking regulator, it does exchange rate management and it does monetary policy.

World wide it has been observed that when a central bank is required to perform multiple tasks, its ability to do effective monetary policy gets limited.

For example, when the central bank is the public debt manager it has to worry about interest rates from the point of view of the borrower, i.e, the government. Contractionary monetary policy would involve raising rates, which would hurt the government, whose interest burden would increase.

If it is also responsible for banking regulation and the health of the banking sector, then higher interest rates would mean bond prices go down. This adversely impacts the balance sheets of banks. This concern would steer the central bank towards not raising rates.

If the booming economy encourages foreign capital to come into the country and this puts pressure on the currency to appreciate, a central bank that also does exchange rate management, will find it very difficult to raise rates if it wishes to prevent further appreciation. The net result of all this could be that the central bank does not wish to raise rates.

It has also been seen that the best countercyclical policies are obtained when the central bank targets inflation. The expectations this sets for the private sector are such that output volatility is reduced. But, most importantly, the impact of monetary policy depends on the expectations of private agents about what they think the central bank will do. Conflicting objectives create difficulties in giving a clear message to agents and dilutes the impact of monetary policy measures taken by the central bank.

India's situation is further complicated by the government ownership of banks. The latest episode about public sector banks being discouraged from raising interest rates even after RBI, in its monetary policy announcement, gave a clear signal for raising rates, is indicative of the problems that can arise in such a situation.


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