Government must spend better to address slowdown

At 5%, the rate of GDP growth in the first quarter of 2019 is the lowest in six years. It is also likely that even this may be an overestimate. Given that the impact of demonetisation fell largely on the informal economy and official statistics do not adequately measure its output, the actual output and demand in the economy are probably lower than officially captured.

For the common person, the weakening of the economy is evident in two ways. Unemployment is at a historic high and is rising. And adjusted for inflation, wages in rural as well as urban areas, and in casual as well as regular wage work have either stagnated or declined.

The response to the rapid rise in prices in 2013 took the form of inflation targeting by the RBI. This may have erred too far in the other direction resulting in very low inflation, depressed earnings (particularly in the rural areas), and hence weak consumer demand.

It has been pointed out that the RBI’s inflation target of 4% is too low for a developing economy. Added to that, private investment has suffered due to the build-up of bad loans in banks and non-banking financial corporations, a legacy of the rapid growth years. On top of these two factors, demonetisation and GST compliance have also hit output and earnings, particularly in the MSME sector.

In addition to these problems building up over the past few years, a longer-term increase in economic inequality resulting from higher-income growth at the top of the distribution (the top 20%), is also a factor. Growth has failed to create an adequate number of well-paying jobs.

Some economists have suggested that India’s growth model, based on top-end consumption, has run into its limit and without a more broad-based demand structure, the days of 8%-plus growth may be over.

Finally, to domestic woes has been added a global element, with the world economy entering a downturn. Thus, there are a variety of factors, cyclical and structural, domestic and global, at work, together contributing to the slowdown.

The responses thus far have included a reduction in interest rates by the RBI, cut in GST rates, and a reduction in the corporate tax rate. These are mostly what economists call ‘supply-side’ measures to boost private investment. But they are unlikely to work.

Even if the RBI target rates were to translate into lower costs of borrowing for the economy in general, higher borrowing (and hence investment) would not follow because, in the absence of consumer demand, businesses would not want to borrow, no matter how cheap the credit. For the same reason, corporate tax cuts are also unlikely to work.

The logic of the cuts is that more money with corporations will induce them to invest more. But again, with demand being weak, it is likely that they will simply sit on the extra cash, waiting for demand to pick up.

So, what can be done? Clearly, with consumer and investment demand weak, and global demand also slowing down, there remains only government expenditure. That is, the government must spend in order to create demand and kickstart spending in the other sectors.

Two questions arise - does the government have money to spend? And if so, what should it spend on? Regarding the first question, it has been widely suggested that there is no room to expand government spending because the consolidated fiscal deficit (central + state + PSU borrowings) is nearly 10% of GDP, which is almost large enough to mop up all available household savings.

But this is not the right way to think about government spending. In fact, government spending is not constrained by the supply of funds, it is rather constrained by physical resources. As long as actual resources such as labour and production capacity lie underutilised (which is clearly the case now), government spending can enable these resources to be used and such spending will not be inflationary.

Where does the money come from? The RBI simply creates it. This is sometimes called ‘monetising the deficit,’ and is considered a slippery slope to fiscal profligacy (irresponsible spending) and high inflation.

But with low inflation, high unemployment, a large number of women as well as some men out of the labour force, and low capacity utilisation, we are very far from any such scenario. An unlikely prospect of high inflation should not be used to perpetuate the harsh effects of the current slowdown.

As long as the government spends in a way that puts money where it is most effective, it will work. The increase in the fiscal deficit will be controlled when the economy rebounds, raising growth and tax revenue.

What form should the spending take? Two considerations are important. Spending should directly target the bottom 80% of the economy, where demand needs to be boosted and it should, in some measure, improve productivity to alleviate supply constraints (that will cause inflation if unaddressed).

Rural job scheme

The MGNREGA budget should be increased at least by 50% in real terms. An urban employment programme similar to MGNREGA, already in operation in states like Kerala and Madhya Pradesh, should be expanded nationwide. Wages of anganwadi and ASHA workers and other similar lower-rung government workers should be increased.

Public investment in local infrastructure (as opposed to large infra like highways and airports) should be increased. This includes not only local roads, but also storage facilities, irrigation canals, extension services, and other farm support.

Wage subsidies to the private sector, again tried in a few states, can also be considered. Vacancies in government services like education and health should be filled. All these interventions will boost demand and create productive physical and human capital. Corporate investment and growth revival will follow.

Between recapitalisation of banks, corporate tax write-offs and other stimulus measures, the government has already spent several lakh crores on measures that are unlikely to work. But it not too late to start spending better.

(The writer teaches Economics at Azim Premji University, Bengaluru)