Planning a fiscal response around state spending: analysis
While we are still debating whether coronavirus disease (Covid-19) is a black swan or white swan event, there is little doubt that it has exposed how fragile the economic system is. The stress caused by the disruption of global supply lines and the blockade is expected to seriously affect GDP growth.
This could force the world into a prolonged recession. India may have escaped some of the ravages of the virus so far, thanks to the first steps taken by the government, including the national blockade. But it has had a huge cost to the economy.
Tens of millions have lost their jobs, production has stopped and aggregate demand has bottomed due to the sharp drop in exports, investment and consumer demand.
This requires an urgent and unprecedented response from the government. While the Reserve Bank of India (RBI) has taken some positive steps in this direction, it is doubtful whether the monetary response is effective in these circumstances. Monetary policy is of little use when interest rates are low and the economy operates below full capacity.
It also works indirectly through a network of commercial banks by providing interest rate incentives for people to readjust their portfolios. Today, due to the weakness of animal spirits and low demand, even the lower cost of capital will not induce companies to borrow or banks to lend. Banks will be unwilling to lend as they are already burdened with high non-performing assets and will be wary of further defaults due to this crisis. And the lower cost of capital or tax cuts by themselves do not stimulate economic activity if companies are not profitable due to weak demand.
Distributing a small amount of money to more people will also not stimulate the economy. What we need is a massive fiscal response based on direct state spending.
The implementation of a nationwide project to build new public health centers and hospitals will stimulate industrial production, put money in the hands of the people directly involved in the project, the newly appointed health workers and doctors, and generate consumption costs. .
Even from an equity perspective, since vulnerable sections are disproportionately affected, the government has merit to undertake fiscal expansion through activities that directly build social infrastructure.
Low inflation and low interest rates weaken the “displacement” argument. But where will the money come from? It cannot be increased by raising taxes, as companies are already badly affected by the disruption. Taxing the salaried class will further deplete the purchasing power of consumers.
This requires a large increase in government loans, including substantial RBI amounts at a below-market interest rate. But it appears the government is facing resistance from fiscal hawks who are still obsessed with the random 3% fiscal deficit target and are petrified by the downgrade by international credit rating agencies (CRAs).
The only thing consistent about these CRAs is their inability to accurately assess the financial situation of even individual companies, not to mention countries. They have been unable to predict breaches by large companies like DHFL, IL&FS and the Zee group. This irregular history is not only limited to India alone. In the United States, the Enron saga and subsequent hearings in Congress revealed that Standard & Poor’s (S&P) had reaffirmed the investment grade status for the company in October 2001, then downgraded it in November 2001 four days before file for bankruptcy.
Dubious ratings by credit rating agencies played a key role in incubating the 2008 financial crisis. Back then, questions were raised about the role of CRAs in delivering mortgage-backed securities packages, which had assets Underlying Toxic, AAA Ratings.
CRA methodology is opaque, questionable, and often lacks economic logic. Take China and India. In 2016, India’s S&P rating remained stagnant at BBB, despite improvement in growth and macroeconomic stability since 2014, while China’s rating remained unchanged at AAA despite historical credit expansion and a drop in GDP growth. Most CRA toolkits do not take uncertainty into account.
Since the 1970s, credit rating agencies have worked with the “issuer payment model,” where the issuer of any market instrument pays to obtain a rating that leads to an inherent conflict of interest. Competition between them and the customer’s desire for better ratings often lead to inflated ratings.
Furthermore, the de facto power of licensing implies that credit rating agencies obtain an income to allow borrowers to access the debt markets instead of granting certification after the due diligence on the quality of the borrower as provided in the regulation.
At this juncture, there can hardly be anything worse than making economic policy subordinate to international ACCs. Rather than trying to focus on speculative financial flows, the state must fulfill its obligation under its social contract.
If the state does not step forward during a pandemic, the battle against the virus cannot be won.
Abhinav Prakash Singh and Aasheerwad Dwivedi are assistant professors, SRCC
The opinions expressed are personal.