The Impasse over Economic Policy
NEWSPAPERS have been full of stories about differences between the Reserve Bank and the finance ministry over economic policy issues. The differences are so sharp that the government is apparently planning to amend the Reserve Bank of India Act to clip the wings of its governor. These differences however are symptomatic of a deeper malaise afflicting the Indian economy. The point in this case is not who is right or who is wrong; the point is that whichever policy is pursued, the economy is headed for acute difficulties.
If a crisis is defined as a situation in which any attempt to overcome its manifestation in one form only succeeds in effecting its manifestation in another form, then one can say not only that the Indian economy is in a crisis, but also that the current stand-off between the government and the RBI is about how it should be allowed to manifest itself. (This, needless to say, is not the way that the two protagonists see the matter).
The growth rate of the Indian economy is clearly falling. Of special significance here is the performance of India’s exports, which in dollar terms have declined by as much as 16.8 percent in the first quarter of the current financial year compared to the corresponding quarter of the previous one. (The decline in rupee terms is a little less, though still large at 11.6 percent, because the rupee has been depreciating vis-à-vis the dollar). This decline in exports pulls down the economy’s growth rate directly and indirectly (via its multiplier effect). It also puts a strain on the balance of payments. True, imports in dollar terms have also declined by 12.6 percent during the first quarter compared to a year ago (and by 7.2 percent in rupee terms), but this decline owes much to the fall in world oil prices. If we take non-oil imports, then, instead of a decline in dollar terms, there has been an increase by 2.6 percent in the first quarter of 2015-16 compared to that of the previous year. But even with the fall in oil prices, the trade deficit remains at $ 32.2 billion in the first quarter, which is roughly the same as last year ($33 b).
India’s foreign exchange reserves, as on July 10, were $334 billion, which at first sight appear adequate for financing the current account deficit that a trade deficit of this magnitude would generate. But these reserves are built largely out of financial inflows caused by Foreign Institutional Investors (FIIs); they can also take their funds out at the drop of a hat. To meet the balance of payments requirements, it is important therefore to prevent such taking out, and, indeed, to ensure that funds keep flowing in to an adequate extent.
One way of doing this is to keep the interest rate high. If the interest rate is brought down, and funds start moving out, then, even if this initial movement is no more than a trickle, the ensuing fall in the exchange rate, can turn this trickle into a torrent, by generating expectations of a further fall. And in such a case, even the reserves will disappear in no time, precipitating a financial crisis, and an acceleration of domestic inflation via the rise in import prices caused by the declining exchange rate.
It follows therefore that to avoid such a denouement the interest rate has to be kept up. On the other hand, for a revival of the economy’s growth rate, the appropriate policy is a decline in the interest rate. It is a separate issue whether such a decline in the interest rate will be actually effective in stimulating growth; but the direction of movement of the interest rate for this purpose must be downwards. We thus have a situation where the continuing crisis of the world economy (which is what is causing a fall in India’s exports), requires for balance of payments reasons (and for preventing an acceleration of inflation that balance of payments difficulties would cause via an exchange rate depreciation) a high interest rate, and for growth reasons a low interest rate. The same phenomenon has an impact on the economy in two different ways, one of which requires an increase in the interest rate, while the other requires a decrease in the interest rate. And while Finance Minister Arun Jaitley reportedly wants the latter, the governor of the RBI Raghuram Rajan reportedly wants the former.
Of course if, even while keeping the interest rate high, some other instrument could be used for stimulating the economy, then this conflict could disappear. But herein lies the rub: neo-liberalism systematically eliminates the use of the other, far more potent, instrument for stimulating the economy, viz. fiscal policy. Fiscal deficits are disliked by finance capital, which is why most countries pursuing neo-liberal policies enact “fiscal responsibility” legislation, limiting the magnitude of fiscal deficit relative to GDP (typically to 3 percent). At the same time, the possibility of providing a fiscal stimulus to the economy, even within the limits imposed by fiscal responsibility legislation, by enlarging both tax revenue and government expenditure, is also eschewed. Such enlargement of both can still provide a stimulus if the additional revenue comes at the expense of the rich; but taxing of the rich is opposed by finance capital.
As a result, the option of stimulating the economy through fiscal policy is ruled out under neo-liberalism. It is noteworthy for instance that the same Arun Jaitley who is at loggerheads with the RBI governor wanting the interest rate policy to be oriented towards expanding the economy, is busy curtailing the fiscal deficit, and even cutting back on programmes like the MGNREGS, which cannot but have a contractionary effect upon the economy.
The other possible policy instrument for stimulating the economy, namely exchange rate policy (which can raise the country’s net exports), is also ruled out for at least two obvious reasons. One is its inflationary impact, especially in an economy like India which is dependent upon oil imports: any increase in the rupee price of imported inputs owing to an exchange rate depreciation would get “passed on” in the form of higher final goods prices. The second reason is that any exchange rate depreciation is likely to produce expectations of a further exchange rate depreciation causing capital flight and hence an actual exchange rate depreciation that could even presage a collapse of the currency.
All this is in addition to the fact that an exchange rate depreciation can work towards stimulating the economy only if there is no retaliation by other countries (through similar depreciations), and if the country’s net exports are sufficiently responsive to such a depreciation. In the midst of a world capitalist crisis which is adversely affecting the exports of so many countries, to imagine that one particular country would be allowed to get away with exchange rate depreciation without inviting retaliation from others, is utterly unrealistic.
It follows therefore that the real basis of the conflict between the finance ministry and the Reserve Bank lies in the fact that in a neo-liberal economy, interest rate policy remains virtually the only instrument for achieving several different objectives at the same time, namely GDP growth, balance of payments management, and inflation control.
Now, achieving multiple objectives with a single instrument is a logical impossibility: the number of policy instruments must be at least equal to the number of objectives, if these objectives have to have any chance of being achieved. Putting it differently, “killing several birds with one stone” can only be a fluke; in general, one must have at least as many stones as there are birds, in order, even in principle, to be able to kill them all. Since neo-liberalism leaves a country with only one instrument for achieving a number of different ends, conflicts over how this instrument should be used are inevitable, with some wanting it to be used for achieving one particular end and others wanting it for another.
This is exactly what is happening in India. The finance minister of the NDA government, sticking even more rigidly to the neo-liberal diktat than has been the case till now, and hence meticulously avoiding the use of any instrument other than monetary policy, wants to use it to stimulate the economy. His government’s entire credibility after all rests upon such a stimulation, since it has been elected on the slogan of “growth” (which is supposed to bring in achche din). On the other hand, the RBI, as the body responsible for the management of foreign exchange and the control of inflation, remains firm in its view that a lowering of interest rate may well destabilise both the balance of payments and the level of prices.
The stand-off between the two is thus a reflection of the fact that the government, through its adherence to the diktat of neo-liberalism, has tied its own hands. It has left for itself only one instrument for achieving multiple ends. Even if this instrument was an effective one, which interest rate is not (at least for achieving growth), such a quest remains a logical impossibility.
This conflict, moreover, is going to worsen in the days to come. The economy’s growth rate is already slowing down. For instance, the growth of the general index of industrial production in the current financial year so far over the previous year’s corresponding period has been 3.0 percent compared to 4.7 percent in the previous year. With the Eurozone pursuing “austerity” with even greater vigour, and China experiencing a slow-down in growth rate, which its recent stock-market collapse will only aggravate, the world economy as a whole, and with it the Indian economy, is also set to experience slower growth. As the NDA government presides over this slowing down of the growth of the economy, and with it of the growth of employment, including among the urban youth many of whom had been its votaries, it would exert greater pressure for a lowering of the interest rate. But this very slowing down of the world economy, by reducing our exports further, would make the balance of payments even more dependent on continued financial inflows, for which the RBI would insist upon a high interest rate. The tussle between the two therefore would become even sharper.
But this tussle reflects a real-life contradiction, where, no matter what is done, whether the interest rate is kept high or is lowered, the economy will nonetheless experience a crisis.