Fiscal Policy dilemma – [Part-I]

Covid-19 pandemic had brought unprecedented crisis. The World Bank in its Global Economic Prospects (June 2020) says -

“… the COVID-19 global recession will be the deepest since the end of World War II, with the largest fraction of economies experiencing declines in per capita output since 1870. Output of emerging market and developing economies (EMDEs) is expected to contract in 2020 for the first time in at least 60 years... Since 1870, the global economy has experienced 14 global recessions. Current projections imply that the COVID-19 global recession will be the fourth deepest in this period and the most severe since the end of World War II...”

Lives are lost. Economies are in doldrums, unemployment rate is high, educational calendar is disrupted, young people are waiting in anticipation to join their new jobs, many even do not have a job offer.

Expectations from govt. has increased. Govt. is also on a spending spree especially on people who are at the bottom of the pyramid. This is pan global phenomena. Solutions are also more or less converging. Aspen Institute in June 2020 put out a road map to come out of this crisis in the context of US. When you look at the solution, you will see – more or less these are what countries are already doing – supporting the poor, supporting the MSMEs, supporting local and state governments, various incentives for workers. Only degrees vary.

The sovereign supreme is in a dilemma. It is facing two issues – rising ask for additional support with a shrinking treasury chest.

People in trouble are expecting more from the government. At the same time, govt. has nearly hit a fiscal dead end. It is across continents and countries. Monetary expansion and liquidity measures have its own limitations. That deserves another post. Nevertheless, the best place to start is to read Milton Friedman’s presidential address in 1967 AEA meeting – The Role of Monetary Policy. Fisc would remain supreme in all times to come. After all they represent the sovereign will of the people.

Coming back on Fiscal policy, Govt. has exceeded the fiscal deficit target or debt to GDP target considerably. GDP would contract, Tax collections are going to be low, Asset monetization (divestment) is not an overnight job, increasing direct tax is not an option, wealth tax would further depress sentiment, infinite increase in indirect tax will only make things worse in multiple ways. Psychology matters and Keynes General Theory has made it abundantly clear even before the behavioral economics movement.

In nutshell, whatever sources need to be tapped are already tapped (getting tapped) in the short run and in the long run, we are all dead – typical Keynesian jibe.

So, what should govt. do in the short run?

From here the real battle begins. A battle where govt. does not appear as the main character while being influenced heavily by this ideology.

After all, in Keynes word – “…Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back”.

Imagine from our childhood we were told that – debt is bad, live within your means. Therefore, we have a budget constraint. We were advised to live within that budget constraint. [Scenario-1]

Contrast this with a situation where you have unlimited access to currency but to get those currencies you must do hard work; availability of productive work is not a challenge. So now the constraint took a different form – it is not the shortage of currencies, it is your willingness to put up those hard work. [Scenario-2]

You replace yourself with the government. Therefore, govt. is either having a constraint (Scenario-1) hence should live within its means or govt. does not face a hard budget constraint if it can find idle resources that it could use. [Scenario-2].

This became an ideological battle ground in economics – those who believe govt.’s budget constraint is like a household/firm and hence the requirement for rule based fiscal policy pegging the target to certain deficit and debt ratios via-a-vis an alternate scenario where the proponents say – a sovereign currency issuing govt. does not face such hard constraint as long as there are idle resources (typical scenario in emerging market economies) which it can put in work. So, there is no ‘nominal’ constraint in terms of ‘money’ but the ‘real’ constraint in terms of its ability to put in use those idle resources.

Imagine you are the govt. and you are told repeatedly over generations that you have no constraint if you have physical resources/human resources which could put to optimal use. You will behave very differently than if you are advised again and again that – live within your means and that ‘means’ is the nominal ‘money’ – largely tax revenues.

The Neo-classical and their successors in various forms have made these fiscal constraints a rule-based policy while the Modern Monetary Theorist (MMT) says – these are artificial constraints.

Most of us are taught in the neo-classical tradition with a little exposure to Austrian or MMT or to any other non-orthodox schools.

It is not important to arrive at who is correct or who knows the truth. Economy and society are too complex to have a simple narrative. It is always important to understand different perspectives and widen the horizon of thinking. Rule comes to make lives simpler and predictable. At the same time, rule also binds our hands in extraordinary times. It is important to understand – how did that rule came in the first place and whether it has any scientific basis. What seems so simple is not that simple. Look at this piece and numerous other criticisms on hard rules. However, what these authors could not offer is – where from here?

The other reason why the rule comes into play is lack of faith on the behavior of economic agents by their principals. The branch of economics which deals with these aspects is known as ‘public choice theory’ highlighting multiple reasons of govt. failure.

If we believe that govt. could be reckless and spend without purpose, a rule brings credibility. But it raises another question – If the govt. is the pilot in the plane and we believe it to land us safely and leave almost everything in its hand, why then so much concern on its spending power and decisions. Well, history will tell you that – there are many hard landings and that made the case for rule based fiscal policy quite appealing.

Now question arises – what should anchor that rule?

More on next post.