New economic policy framework for the post-Pandemic economy

India’s second wave of the Kovid epidemic is moving at an alarming pace. In economic policy, the sharp contraction justified the Monetary Liability and Budget Management (FRBM) Act. As suggested by Arvind Subramanian and Josh Fellman, in the aftermath of the ongoing crisis, our dysfunctional FRBM framework needs to be completely overhauled (‘A Post-Kovid Fiscal Framework’, Indian Express, 7 April 2021). Their proposed framework, derived strictly from debt-stability conditions, is an important step in this direction. But some problems remain. The alternative approach suggested here is also taken from the debt stability requirements, is less discreet, simpler to implement and additionally builds on automatic stabilization.

The original FRBM Act set a target for a centralized annual deficit ratio (FD) of 3% of gross domestic product (GDP). States were persuaded to legislate their own FRBM laws, limiting a state’s FD to 3% of its own GDP. This translates to the 5.8% US FD target. The arbitrary arrangement of FD targets, which are unrelated to the real needs of fiscal stability and are independent of the current state of the economy, makes cyclical and cyclically destabilizing economic policy.

When GDP growth and revenue growth are high, the fixed FD target translates into higher cost growth, while pump-priming further growth. In contrast, when GDP and revenue growth are low, fixed FD expenditure slows growth, which further slows growth. Subsequent finance ministers have tried to overcome this problem by amending the FRBM Act or by pushing some borrowing budgets, a practice that has been fortunately discontinued by current Finance Minister Nirmala Sitharaman.

Subramaniam and Fellman proposed that the debt be stable if the financial balance of interest expense (PB) is greater than the net-interest rate-growth rate difference (RG). This situation was violated in India in 2020-21 because while PB was negative, RG turned positive, resulting in a sharp decline in growth. Therefore, the authors argue that PB should be increased. But instead of setting annual PB targets, they propose to increase PB gradually, allowing half of the average GDP per year, to accelerate or control economic integration when the economy is more or less flexible until PB becomes positive.

This proposal sounds logical, but it is very prudent to serve as a rule to guide the preparation of the annual budget. Determining whether or not to accelerate the PB target in a given year requires reliable application of debt dynamics mathematics prior to reliable rates of interest rates and growth. It is usually best to have a clearer, more indiscriminate rule for the budget team led by the general civil servant.

In the alternative framework, since the FRBM was first implemented in 2003, the law sets out guaranteed levels of fiscal deficit (WD) each year for five years. WD can be obtained from the nominal growth rate, which is calculated as the growth rate required for debt stability. This framework can also be extended to obtain the Warranted Primary Balance (WPB) path, i.e. the FD net of the past. Such a rule is built on automatic stabilization, because the fixed WD automatically raises FD (or PB) in a given year, when actual growth is less than guaranteed growth, and reduces FD (or PB) above the growth rate, thereby returning the actual growth to the desired growth path Leading. Note that WD is an absolute scale, while FD and PD are ratios of GDP.

How are growth rate and WD determined? In their recent paper ((‘Fiscal Policy and Growth in Post-Kovid-19 World’, Economic and Political Weekly, 27 February 2021), it also applies the PB> (rg) rule, with Chinai and Jain recognizing the 9% sword growth rate. Assuming a GDP-to-GDP ratio of 85% in 2021-22, it would allow the government to reduce the annual FDI in GDP by 0.5%, as recommended by the 15th Finance Commission. Over 9%, the GDP to debt ratio increases, and with growth above 9%, that ratio gradually decreases. So 9% nominal GDP growth rate. If the Reserve Bank can maintain an average inflation rate of 4% as specified in its monetary policy framework, the required real growth rate will be 5%, which is quite possible. The guaranteed growth rate also defines the nominal GDP path. Applying the consensus FD path — a 0.5% reduction in GDP per year — determines the guaranteed fiscal deficit level or WD each year for this guaranteed GDP path.

This 5 year series of WDs will serve as a reformed FRBM framework in line with the GDP ratio from steadily declining debt. It can be divided between the Center and the States as per the recommendation of the 15th Finance Commission and their respective FRBM Acts. This is a simple, indiscriminate deficit rule that is automatically stabilized. FRBM laws should also provide provisions to avoid severe shocks such as the current pandemic.

Sudipto Mundil is a Distinguished Fellow of the National Council of Applied Economic Research. These are the personal views of the author.

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