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Moving with the cycle

Why the RBI must tighten monetary policy significantly.

High GDP growth in India has created expectations of sustained 9 per cent GDP growth. The government and various forecasters expect the Indian economy to keep growing steadily at 9 per cent year after year. Looking towards China and its multi-decade high GDP growth experience,it has been argued that India can,and should,aim for such growth. This argument translates into a policy stance which encourages expansionary fiscal and monetary policies when growth falls to 7-8 per cent. It is tolerant of higher inflation and it supports an expansion of demand even when inflation is already high.

But is a constant 9 per cent growth rate attainable,or even desirable,for the Indian economy? While high growth is good for personal incomes,and downturns in output and incomes can be painful,slower growth in some periods may sometimes be better suited to the economy. For example,in the current scenario where the economy is producing at nearly full capacity,where inflation is high,where the fiscal deficit is large and real interest rates are negative,a policy of tightening fiscal and monetary policy with a view to reducing aggregate demand will be appropriate. This would be inconsistent with the objective of 9 per cent growth,but would pave the way for long-run sustainable growth.

Macroeconomic policy can stabilise business cycles and reduce the volatility of output. Financial inclusion can reduce the volatility of consumption by giving consumers access to credit that allow them smooth consumption. Social welfare schemes can help people from falling into extreme poverty. But if downturns are altogether prevented by government spending more,or a high supply of credit,the resulting higher inflation can reduce the attractiveness of investment and hurt long-term growth. Similarly,if firms are prevented from closing down by bailing out those that fare badly,by giving them capital injections,cheap bank loans or any other means of public support,this can pave the way for zombie firms,as in Japan. A whole sector can be rendered uncompetitive by the presence of firms which can undercut healthy ones. In other cases,it can create excess capacity in some sectors,as in the case of China where the country’s production structure does not match its consumption needs,and consequently growth of output has exceeded growth of consumption leading to disruptive imbalances,both internal and external.

Ever since the mid-1990s when India started witnessing business cycles,as opposed to merely monsoon cycles that it witnessed in the pre-liberalisation decade,the economy has witnessed roughly an average of 7 per cent growth with cycles around the trend. Output has grown roughly within a band of 2 to 2.25 per cent around this trend line with visible periods of up-swings and down-swings.

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The presence of cycles around a trend line are consistent with what has been seen in other emerging economies and what economic theory would predict. Business cycles are an integral part of creative destruction. Recessions are the time when inefficient businesses,or those that are no longer in demand,lose their business,are unable to compete,and shut down. Both labour and capital get reallocated to uses that are more efficient,in demand and give consumers what they want. A dynamic and growing economy must see change. Producers making landline telephones when people want to buy cell phones must change their products or go out of business. Companies selling film when consumers are buying digital cameras must face difficulties.

Reallocation of labour and capital is not instantaneous. For labour,there are search costs and costs of learning. There will be periods when growth will not look as good. The question that policy-makers face is whether keeping consumption demand high,in an attempt to eliminate downturns,is a good idea. Long-term investment is necessary for growth and can be hurt by high investment. At the same time,long periods of unemployment and poverty can have huge costs by making large sections of the working force less productive. It is thus not possible to swing to one extreme or another. Macroeconomic policy,which includes both fiscal and monetary policy,has to fine-tune its stance all the time. It is to keep inflation low while not allowing growth to fall too low. The attempt has to be to keep the cycle in a narrow band around the trend line.

The framework of 9 per cent growth for long periods is inconsistent with this view of the Indian economy. In the long run,it is possible that the economy shifts to a higher growth path. The number of literate workers in India will double in 15 years if near-full school enrolment is to have an impact. Similarly,the number of college-educated youth available for employment will double. While the quality of education can be debated,these trends will improve labour productivity. The aim then would be to allow business cycles around a higher-trend growth path,but with low volatility. Neither completely preventing downturns nor allowing long and deep recessions is optimal.

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At the present juncture,it is important for policy-makers to move away from the 9 per cent growth target. It can prove to be disruptive because of its implications for inflation. The Union budget of 2011 gave an indication that it would like to move along a path of demand contraction. It,however,did not move away from the 9 per cent target. The 9 per cent target can raise expectations,making it more difficult to make higher interest rates more acceptable. Industry always wants low interest rates,high growth and low inflation. It is usually more vocal in its opposition to higher interest rates,seen as higher cost of capital than to higher inflation. Customers who suffer inflation rarely see the connection. The weak transmission of monetary policy doesn’t make it easier as rate hikes have to be large. The Reserve Bank,in its next credit policy,must both move towards a lower growth rate and tighten monetary policy significantly. This would be consistent with longer-term growth.

The writer is a professor at the National Institute of Public Finance and Policy,Delhi express@expressindia.com

First published on: 14-03-2011 at 11:39:18 pm
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