Prologue
This blog tried to unveil the mystery of central bank independence and need for fiscal-monetary cooperation in India. Most of the thoughts in this blog are based on Mr. Ben Bernanke’s speech in Tokyo in May 2003.
The latest GDP growth in India is 5.00%, way below the double-digit growth that is theoretically possible given very high disguised unemployment. The main culprit for the growth is tightening of actually implemented monetary policy in relation to actual inflation. In the month of January 2014, the average actual bank lending rate was 12.17%, while the CPI in India in that month was 8.60%, meaning the real rate of interest faced by an average Indian business was 3.57% in Jan 2014. However, in the month of July 2019, for which data is available, the average actual bank lending rate was 10.44%, while the actual CPI was 3.15%, meaning the real rate of Interest in India increased to 7.29%. This 204% increase in real rates over five and half years have hurt the economy and now defaults by various businesses is a daily news. The fiscal position and external position of the country has improved significantly, and currency has depreciated far lower than the inflation differentials in those 67 months. Why central bank is wanting such high real rates is a matter that they never explained in any policy documents recently.
Change in Direction Needed
Clearly, the situation is untenable, and, it is important to look at some of thoughts Mr. Bernanke laid out in that speech, as modified to suit current Indian situation.
- It is imperative to have highly coordinated monetary-fiscal policy
- This involves central bank demanding higher fiscal deficit and in return promising funding of the fiscal deficit by way of printing of money
- it would be helpful to break the link between expansionary fiscal actions today and increases in the taxes that people expect to pay tomorrow. This is achieved by inserting expansionary monetary policy to support fiscal needs.
- Monetary and fiscal policies together can increase the nominal wealth of the household sector, which will increase spending, as we have significant excess capacity due to high unemployment in India, it will not lead to inflation. The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern “broken” channels of monetary transmission.
- RBI purchases of government debt could also support spending programs, to facilitate industrial capacity building, for example. The RBIs purchases would mitigate the effect of the new spending on the burden of debt and future interest payments perceived by households, which should reduce the offset from decreased consumption. More generally, by replacing interest-bearing debt with money, RBI purchases of government debt lower current deficits and interest burdens and thus the public’s expectations of future tax obligations. (This assumes RBI returns without fuss interest received on GOI bond holdings as dividend.)
Concluding Remarks:
Last week ECB Chairman also called for coordination between fiscal and monetary policy, especially calling out the governments to spend more so that ECB can buy the extra bonds and monetize the deficit.
In India, Small Savings rate of 8 percent is a big hurdle to effective monetary transmission, and it is a political reality that it is difficult to move it lower immediately. Hence, it is essential to take unconventional approaches to ensure that transmission happens through other means as described by Bernanke in his May 2003 speech in Tokyo and as modified in this blog.