Distribution: yearly

Context

Though there is coherence in India’s response to the Covid-19, still there is more that needs to be done.

Sense of coherence in India’s response

• Since last week, a sense of coherence is settling over India’s response to the COVID-19 outbreak.
• The national lockdown, the incomes and credit support, and the three-month debt moratorium announced by the government and the RBI are the needed first steps to contain the outbreak on the one hand and lessen the economic impact on the other hand.

Uncertainty in two important factors

• Several laundry lists of measures have already been proffered by many, however, these are not of much help.
• Uncertainty: Given the extreme uncertainty clouding how long and intensely social distancing policies will need to be pursued, the attendant economic impact and, crucially, how quickly and strongly the recovery can take place.
• 1. The answer to the first depends on how much the outbreak tests the capacity of the already-stretched public health system.
• Extending the social distancing policy: If the lockdown does not slow the spread of the virus to a rate that the healthcare system can handle, then the social distancing policies, in some form or another, will need to be extended.
• Destruction of demand: The longer such containment measures last, the larger will be the destruction to (of) demand and the bigger the collapse in output and incomes.
• 2. Then, there is the question about the pace and strength of the recovery.
• Much will depend on how much damage the eventual output loss inflicts on households’ and corporates’ balance sheets.
• Lower consumption: For example, even if a worker starts earning once the lockdown is lifted if one has incurred large debts in the interim, one’s consumption demand will naturally be much lower than before the crisis.
• The same holds for corporates, both big and small.
• No help from global demand: What makes the situation worse is that there is not likely to be much help coming from global demand.
• Growth estimates: It is now expected global growth would decline to 5 per cent (annualised) in 1H20 (first half 2020), considerably more than during the global financial crisis, and rebound only partially in 2H20, leaving global GDP 2.5 percentage points below its pre-crisis level at the end of this year.

How the uncertainty makes policy response calibration difficult?

• Difficulty in assessing economic damage: Given these extreme uncertainties, it is very hard to assess the economic damage with any degree of conviction.
• In fact, in last week’s policy review, the Monetary Policy Committee refrained from providing any projections for future growth and inflation, breaking from its normal practice.
• So, if the outlook is so uncertain, how does one calibrate the policy response?
• 1. Under-support the economy: One can easily under-support the economy, which could prolong the slowdown.
• 2. Or over-support the economy, which could end up stoking inflation (as it did in 2010-13 when the massive monetary and fiscal easing during the global financial crisis was not withdrawn quickly) or creating asset price bubbles.

What is the way out in such a situation?

• Don’t try to calibrate: The way out is not to even try calibrating policies under such extreme uncertainty but to let the size of the support be determined endogenously by the extent and nature of the economic damage.
• Falling back of first principles: This requires falling back on first principles. We know that the economic damage could be very large.
• Delay in recovery: We also know that if the damage to households’ and firms’ balance sheets is substantial, then the recovery could be delayed and weakened.
• Give extensive income support: This calls for extensive income support through existing government Jan Dhan and Mudra accounts to households and SMEs, and temporary tax cuts or deferments to the larger corporates.
• Tax cuts needed: It also needs substantial cuts in indirect taxes (GST) when social distancing is relaxed.

Problems with RBI measures

• RBI providing support: The RBI has begun to provide support via its liquidity facility (TLTRO) and regulatory forbearance that allows banks to offer a debt moratorium to their customers for the next three months.
• But both these measures work through banks.
• The problem of bank turning risk-averse: Given that banks have turned substantially risk-averse because of the restructuring and bad debt problems of the last few years, the RBI likely needs to start providing liquidity directly to corporates, as recently announced by the US Fed.
• At the same time, any debt moratorium will reduce profit and, in turn, capital, banks might be reluctant to extend it to all their customers.
• Accommodate capital shortfall in the bank: Consequently, the RBI also needs to change regulations to accommodate possible shortfalls in bank capital because of the debt moratorium.

What should be the scope and size of the policy support?

• Support should be based on the extent of the damage: The scope and size of such policy support need to be determined by the extent of the economic damage, and not by perceived limits about what India can afford or those imposed by existing institutional arrangements and practices.
• It is quite possible that the size of the economic damage ends up requiring support that widens the fiscal deficit substantially.
• India clearly does not have the fiscal space to provide any material economic support when measured against standard benchmarks of fiscal prudence.
• Directly funding the budget deficit: The market is on edge, and fears of eventual large government borrowing has spiked long-term interest rates despite large cuts in short-term rates by the RBI, which are likely to delay and weaken the recovery.
• Any large bond auction by the government, even if it is offset by the RBI through open market operations, is not likely to calm market nerves and bring down lending rates.
• The government should invoke “natural disaster” clause: What is needed is for the government to invoke the “escape” or the “natural disaster” clause in the fiscal responsibility act (FRBM) that allows the RBI to directly fund the budget deficit without having to go through market auctions.

Conclusion

Such a proposal is likely to raise the hackles of any fiscal conservative and there is the natural question about how rating agencies might react. As long as the government credibly commits to reversing the action as soon as the crisis is over, rating agencies and fiscal conservatives alike will likely treat this kindly, as it is a response to a crisis caused not by poor economic policies, but by an act of nature.

Context

We could take a leaf out of a booklet by Keynes in our effort to tackle some of the challenges posed by the covid-19 pandemic.

The Crisis-Keynesian Mode response mode to pandemic

• What is the war economy? One of the defining features of a war economy is that economic thinking is focused on quantities rather than prices.
• Much of the ongoing global response to the covid-19 pandemic is still in crisis-Keynesian mode.
• What is a crisis-Keynesian response: The nation-state has become the income supporter, financier and consumer of last resort.
• However, there are also clear signs of war economics as well.
• Signs of war economics: The decision by US President Donald Trump to use America’s Defense Production Act to force General Motors to make ventilators is one resonant example.
• Just consider some of the key questions that are being asked right now.
• How many ventilators are available? Are there ample food stocks? Can more hospital beds be made available? How many masks be produced in the next few weeks? Can the production of testing kits be ramped up? It’s all about quantities, quantities, quantities.

Historical background and impact of a shift in economic strategies

• Impact persists in subsequent decades: Such big shifts in economic strategies are usually not reversed overnight. Decisions taken in response to a particular emergency tend to remain with us in subsequent decades.
• World War II example: What happened in India during World War II is instructive. Many of the controls that were introduced during that global conflagration formed the basis of the later interventionist state that sought to control who produces how much. Here are a few examples.

1. Quantitative import controls

• One of the first moves by the colonial state was to impose quantitative import controls in May 1940.
• There were two reasons why this was done—to conserve foreign exchange as well as ensure that shipping capacity was used to bring in only what was essential to the war economy.

2. Food rationing

• Food rationing was also introduced during the war years.
• Over 700 towns were covered by some rationing scheme or the other by the end of the War.
• The government also brought in measures to buy surplus grain from farmers at administered prices.
• Various forms of rent control were also instituted. Most of these controls continued after India gained independence.

3. Balance of payment crisis in 1957

• India was hit by a balance of payments crisis in 1957.
• The massive investment thrust in the Second Five Year Plan had severely strained the country’s foreign exchange reserves.
• The Indian government, once again as a temporary measure, imposed stringent controls on imports.
• Many of these were quantitative in nature. They survived well into the 1980s.
• In fact, the entire trade policy approach since the 1957 crisis was to minimize imports in a bid to preserve foreign exchange.

Will the government opt for automatic monetisation of the deficit?

• Money creation by the RBI to fund deficit: There is now a growing consensus that the Indian government will have to fund part of its growing fiscal burden through money creation by the Reserve Bank of India.
• What about inflationary consequences? The inflationary consequences will be muted—for now—because the velocity of narrow money is most likely set to fall on account of weak demand conditions under a lockdown.
• Precedence: The automatic monetization of Indian government deficits was part of the policy playbook after the 1950s till it was thankfully discontinued in 1997.
• The main instrument for that was ad hoc treasury bills.
• These were introduced in 1954 as a temporary measure to replenish the cash balances the government maintains with the central bank.
• What was ad hoc treasury bills? Ad hoc treasury bills were not introduced through any formal law but as an arrangement between mid-level bureaucrats in New Delhi and Mumbai (i.e. RBI).
• What began as a temporary measure to smoothen government cash holdings had become a near-permanent feature of Indian macroeconomic policy by the 1970s.

The uncertain future

• Longer the war more profound will be the changes: The longer the global battle against the pandemic lasts, the more profound will be the changes across the economic landscape.
• In an insightful article in Bloomberg, Andy Mukherjee uses the lessons of history to look into the uncertain future.
• Among the possibilities he mentions are the contrasting ones of an economy run by robots and algorithms but with little labour, or an economy in which labour has clawed back the power it lost in the second age of globalization.

Managing the resources in the time of war

• Managing the resources: In 1940, John Maynard Keynes wrote a little booklet How To Pay For The War, Keynes essentially argued that the main challenge was not how to finance the war effort, but how to manage real resources to produce the arms that the UK needed to defend herself.
• Suppression of consumption: He then argued that war production would necessarily involve suppression of consumption, either through higher taxes or some scheme of deferment.

Conclusion

The war against the covid-19 pandemic is very different from the military war that Keynes was thinking about. Yet, his booklet offers useful lessons on how to think about some of our current challenges—and also about what we can expect once the situation returns to normal.