Why a Fiscal Stimulus Will Not Work in the Indian Context
The dust has finally settled after the announcement of the latest Union budget by finance minister Arun Jaitley and there are now signs that the Indian economy is finally gaining some momentum. GDP has been rising for three consecutive quarters now after a prolonged slowdown that saw economic growth come down over six consecutive quarters, as observed in 2016-2017. GDP growth rate declined from 9.2% in the quarter ending March 2016 to 5.7% in the quarter ending June 2017.
There was intense debate during this extended period of slowdown on whether fiscal policy should be used more aggressively to combat the economic slowdown. Students of economics are taught in introductory macroeconomics about the standard Keynesian solution to this problem. John Maynard Keynes prescribed a fiscal stimulus package along with a combination of higher government spending and lower taxes when an economy is facing a recession-like situation. In theory, such a stimulus will boost aggregate demand, which in turn will increase spending by a multiple of the stimulus. It will push up the price level, put spare capacity to work, reduce involuntary unemployment, restore confidence, and perhaps increase stock market and private investment.
The case for a fiscal stimulus is particularly strong when an economic slowdown is driven by a weakness in aggregate demand. But was the recently observed slowdown in India due to weakness in aggregate demand? One way of understanding this issue is by looking at the price behaviour with respect to output.
If indeed the demand side is responsible for the slowdown, prices and output would move together. An increase in demand would push up prices and output would increase. Hence, prices would be positively correlated with output, i.e., prices would be procyclical with respect to output. In this case, we would say that the demand shocks are more prominent in the economy and are a dominant source of business cycle fluctuations. Demand shocks include a sudden increase in government spending, a decrease in taxes, autonomous tightening of monetary policy, a tech bubble burst, a terrorist attack.
On the other side, if supply shocks are more prominent in the economy, then prices and output would move in the opposite direction. An increase in supply would push prices down. Therefore, prices would be negatively correlated with output, i.e., prices would be counter-cyclical with respect to output. Supply shocks could be in the form of a series of crop failures, a sudden increase in oil prices due to war, earthquakes or some other natural calamities, computer and internet revolution in the 1990s.
We try to determine whether the slowdown observed recently in the Indian economy is due to a shortage of aggregate demand or are supply side issues responsible for it? If indeed aggregate demand is the driving force in the Indian economy, then prices should be procyclical. So, we ask the question: Are prices really procyclical in India?
The rising prices of Indian goods would make it more uncompetitive, making imports more attractive. This may result in widening of trade deficit. Credit: textilelearner.blogspot.in
To answer this, we take the monthly series of the index of industrial production (IIP) as a proxy for output (for India, we often take IIP as an indicator for output rather than GDP since the agricultural sector depends upon monsoon performance which makes GDP highly volatile). For a measure of prices, we take the monthly wholesale price index, excluding food, fuel and power as they are the most volatile components of the wholesale price index. The data used for the analysis is from April 2005 to October 2016, a month before demonetisation.
Using econometric techniques, we extract the cyclical component from both the price and output series. A time series can be decomposed into a trend (long-run), cycles (short-run) & noise (irregular component). For this analysis, we were interested in the extraction of cyclical component of both the price and the output series while ignoring the trend and the noise component.
We observed that the cyclical component of prices and output is negatively correlated. Thus, prices and output are moving in the opposite direction indicating that supply shocks are more dominant in the economy then demand shocks. We conclude that prices are behaving in a counter-cyclical manner with respect to output.
Earlier studies have also presented evidence of the counter-cyclical behaviour of prices with output for the sample period — between 1975 to 1995 — using other measures of prices such as the consumer price index. Thus, the counter-cyclical behaviour of prices seems to be one of the stylised facts of the Indian economy post-1975 and continues to remain so. The important lesson for policymakers from the counter-cyclical behaviour of prices is that supply shocks seem to be a more dominant force in India as compared to demand shocks. Thus, the recent slowdown in output growth observed has not been due to lack of aggregate demand, rather due to the pre-dominance of supply side issue.
Another question which emerges is, do developing countries like India experience the same type of supply shocks as advanced economies? New studies suggest the term ‘supply shocks’ could have a different connotation for middle-income countries like India as compared to other advanced economies. Developing countries like India would be subjected to large terms of trade shocks. Terms of trade is the ratio of export prices to import prices. Thus, developments such as swings in oil prices, food prices which affect the prices of imports and exports lead to terms of trade shocks. These terms of trade shock may have both supply and demand side effects, with substantially larger supply side effects in the context of India.
Thus, due to the dominance of supply shocks over demand shocks in the Indian economy, the Keynesian prescription for a fiscal stimulus package, as described in economics textbooks, will not bring the desired effect for a country like India. On the contrary, it would have a severe impact on government’s commitment towards its fiscal consolidation path (i.e., in reducing deficit & debts).
Such a fiscal stimulus would result in a higher fiscal deficit. The additional demand created through the fiscal stimulus would see a surge in inflation (It’s like too many people chasing too few goods). The rising prices of Indian goods would make them uncompetitive globally, making imports more attractive. This would result in widening of the trade deficit. All these factors may contribute to worsening of the rupee. Historically as well, the benefits from fiscal stimulus in the case of India have been unclear.
Instead of going for big bang reforms, such as demonetisation or GST, the government should focus on addressing structural issues. Credit: Reuters Files
Instead of going for one big bang form — such as a fiscal stimulus package, demonetisation, one shot implementation of GST (which should have been implemented in a phased manner) — the government should focus more on making several small tweaks in the economy. These big bang reforms should not be seen as a silver bullet to the structural problems faced by the Indian economy today. The government should avoid having a ‘one size fits all’ approach.
The government should pay particular attention to specific sectors and sub-sectors to sort out structural issues. Addressing problems such as supply chain bottlenecks in agriculture, inefficiencies in production, lack of property rights and labour reforms, improving the regulatory business environment and access to credit for informal small and medium-scale enterprises, large non-performing assets with public sector banks should be given a higher priority. The case for using the fiscal stimulus as part of the fiscal toolbox in the case of India would be a more of a quick-fix solution and is likely to result in a waste of money unless it confronts structural issues.
Mayank Gupta is a Research Scholar working in the area of Econometrics and Business Cycles at Mumbai School of Economics And Public Policy (Autonomous), University of Mumbai.
This article went live on April eleventh, two thousand eighteen, at forty minutes past eight in the morning.The Wire is now on WhatsApp. Follow our channel for sharp analysis and opinions on the latest developments.
