Even as the pandemic continues to ravage India, there is renewed discussion in policy circles on kick-starting the economy, though there is a clear divide on when to unleash the second round of policy support. We don’t intend to get into a debate on its timing. Rather, we argue the importance of the year 1957 in India’s recovery and find that a coordinated inequilibrium strategy between the RBI and the government is the most effective policy response in the current pandemic. Most importantly, for such coordinated inequilibrium, a prerequisite, in the current circumstances, is effective communication from both RBI and government.
Coordination between monetary and fiscal authorities has been a thorny issue globally in recent years, particularly after the global financial crisis. India is no exception. Historically, if there is perfect coordination between the monetary and fiscal policy, then mathematically, there should be statistically significant negative correlation between the two. In the Indian context, for the 30-year period ended FY2020, plotting the scatter plot between the change in the consolidated fiscal deficit (as a crude indicator of the thrust of fiscal policy) on the horizontal axis and the change in the growth rate of broad money (as a crude indicator of monetary policy) on the vertical axis reveals no coordination, substantiating the dominance of fiscal over monetary policy. However, to be fair, the RBI did successfully stave off automatic monetisation and even the private placement of fresh issues with the FRBM Act in 2003. Non-coordination between the two in India is also constrained by several policy targets and fewer instruments.
Against this background, we show how policy coordination in India can result in a suitable, optimal combination of RBI/monetary and Ministry of Finance/fiscal strategy (based on “Issues in the Coordination of Monetary and Fiscal Policy” by Alan Blinder). Both the government and the RBI have two options between them — either a contraction or an expansion. Thus, we effectively have four policy options, and each of the options will have a particular benefit/payoff for the RBI and government. Our endeavour is to find out which policy option can result in a Nash Equilibrium. A Nash equilibrium occurs when neither the government nor the RBI can increase its payoff by unilaterally changing its action. There are four options — a fiscal policy expansion and a monetary policy contraction; a fiscal policy expansion and monetary policy expansion; a fiscal policy contraction and a monetary policy contraction; and a fiscal policy contraction and a monetary policy expansion.
The payoff scenarios are hypothesised as benefits accruing to the government and the RBI separately when they are deciding on either of the policy options: Contraction or expansion. Specifically, the government is assumed to favour an expansionary policy and gets maximum payoffs from a fiscal expansion, either with monetary expansion or contraction (the payoff is obviously maximum when the RBI also expands). Separately, the monetary authority ideally wants to contract the economy to fight inflation and gets maximum payoffs from a monetary contraction, either with a fiscal contraction or expansion (the payoff is obviously maximum when government also contracts).
In the current context, it is reasonable to assume that the government always prefers a tight fiscal policy for obvious reasons and expects the RBI to provide the necessary liquidity support through an expansionary monetary policy. This implies that the payoff matrix of fiscal contraction and monetary expansion would be the best optimal solution, at least from the government standpoint.
Is such a payoff matrix also a Nash Equilibrium for both the RBI and government? The answer is a clear no. This is because if the RBI opts for such a monetary expansion, the government also opts for an expansion as the payoff is higher. But this will compel the RBI to then opt for contraction, since that gives it a higher payoff. Knowing this, the government’s best strategy will be then an expansion — so the outcome will be always be a fiscal expansion with a simultaneous monetary contraction. This is the only Nash equilibrium for this game. It also seems to be the most plausible outcome of an uncoordinated but intelligent behaviour.
However, there is a twist in the tale. Interestingly, the choice of this fiscal expansion and monetary contraction outcome in the current pandemic (that defies all economic principles) must find a solution that is purely rational. We already know that the RBI is following an expansionary policy. The current pandemic, in fact, reminds us of the “Knightian Uncertainty”, based on economist Frank Knight in his 1921 book. “True uncertainty,” as Knight called it, cannot be measured. To extend this to the current context — who knew India’s economic outlook in a couple of months from March will involve so many unknown factors that it will become incalculable?
The only way we could then solve this problem is by invoking Herbert Simon’s explanation of “procedural rationality”. A brilliant exposition of such “procedural rationality” is given by Sudipta Sarangi and others (EPW, June 2020). The authors show how the current pandemic is resulting in behavioural changes of individuals in terms of risk-taking. In the Indian context too, there is a massive jump in health insurance in the current fiscal, indicating behavioural changes in terms of risk-taking. In FY20, the behavioural change was to build up retirement products as households deleveraged. People are now preferring small and medium size compact cars to avoid public transport.
Interestingly, many of the current companies were also born during the financial crisis, like Uber (2009), Microsoft (1975), Disney (1923), General Motors (1908) and General Electric (1890). Echoing such “procedural rationality” in the current unprecedented circumstances, we thus believe fiscal expansion and a monetary expansion is the desirable outcome. We call it a policy of “coordinated inequilibrium”.
What should we do to make such an unconventional policy successful? An essential prerequisite in the current circumstances is effective communication by both the RBI and the government, with both speaking in unison. The RBI has been largely successful in communicating to the market about its intentions and we now expect the government to manage expectations with coordinated communication and leave matters of financing the fiscal deficit, through measures like monetisation, to the RBI. To paraphrase from the recent Jackson Hole meeting “it is better to be constructively imprecise rather than being detailed”!
This article first appeared in the print edition on September 9, 2020 under the title ‘RBI-Government tango’. Ghosh is group chief economic advisor, State Bank of India and Chaudhuri is senior vice-president, Datamatics Global Services. Views are personal