ExplainSpeaking: Fisc in times of monetary tightening

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Dear readers,

Which is worse: high inflation or high unemployment? Not only is this one of the most intriguing questions in economics, it is also a key concern of policymakers, let alone people.

At least in the short term, there is a trade-off between inflation and unemployment. When an economy goes through a period of high inflation, there is a good chance that the unemployment rate will fall. That’s because firms, lured by higher prices, try to boost production by hiring more people.

Curiously, while high inflation robs people of their purchasing power, it often gets the unemployed into jobs!

The opposite is often the case in economic phases – low inflation but high unemployment.

So what’s worse?

A study entitled “The Happiness Conflict Between Unemployment and Inflation” by David G. Blanchflower et al. (2014) examined data from Europe between 1975 and 2013 and found that both higher unemployment and higher inflation reduce well-being, but unemployment depresses well-being more than inflation. In fact, they found that unemployment was a significantly greater hit to well-being than inflation.

“Our estimates, using European data, imply that a one percentage point increase in the unemployment rate reduces well-being by more than five times that of a one percentage point increase in the inflation rate,” the study says.

On one level, that sounds plausible too. Whilst inflation is eroding our purchasing power – Rs 100 this year is not buying the same goods it bought last year – it does have its benefits such as rising sharply etc. What is the positive side of high unemployment?

A worker wheat at an APMC in Jetalpur on the outskirts of Ahmedabad. (Express photo by Nirmal Harindran)

And yet, when it comes to the political cost, and especially in India, the choice is not so easy. In India there have always been many people who have been unemployed, underemployed or involved in undercover employment.

Take the last few years. Regardless of which data you look at, India has faced relatively high unemployment since 2016. Yet the ruling party continues to enjoy considerable popular support.

Contrast this with the fate of governments that have allowed inflation to remain high.

The UPA-II immediately comes to mind. If you look at retail inflation numbers, UPA-II allowed inflation to fluctuate around 9% to 10% over the last four years of its five-year term. Of course, that wasn’t the only reason, but persistently high inflation played a big part in the UPA’s spectacular defeat in 2014.

In 1998, the ruling BJP government in Delhi (state) suffered a similarly impressive loss when a surge in onion prices brought a wide-ranging mandate to Congresswoman Sheila Dixit, who won two more consecutive terms as chief minister.

It can be argued that political sensitivity to high unemployment and high inflation varies from country to country and may be strongly influenced by a country’s past.

In the US, for example, where the mass unemployment of the Great Depression of the 1930s was a particularly painful experience, even the central bank’s mandate gives equal weight to achieving “maximum employment” and containing inflation.

A worker arranges “Khus” – the grass cooling pad for air coolers in Ahmedabad. (Express photo by Nirmal Harindran)

In India, governments seem to fear high inflation more than high unemployment. At least the current government seems to think so.

Once it became clear that high inflation cannot be wished away, and is likely to get worse if immediate action is not taken, all policymakers acted – unlike the government, which denies any unemployment stress.

While the RBI already hiked interest rates in early May and is expected to hike further in the coming meetings, the government played its part last week, deciding to reduce taxes levied on fuel as well as tariffs on several companies’ imports of raw material.

Was that the right decision?

More broadly, what should the government do in terms of fiscal policy – ie its spending and taxation – when the RBI is about to tighten monetary conditions in the economy?

Again, this is one of the more contentious issues in economics, and the recipe changes depending on ideology and understanding of what causes inflation.

The first thing to understand is that a significant part of the current surge in inflation is due to the high cost of fuel (most of which India imports) as well as other imported commodities. The high costs are due both to higher prices of these products themselves – for example more expensive crude oil – and to high taxation.

It is also important to understand that monetary policy has no direct solution to controlling such “cost-push” inflation. It cannot lower fuel prices by raising interest rates. All it can do is control demand in the economy. By slowing aggregate demand – and hence the overall GDP growth rate – tighter monetary policy is expected to give more time for ‘supply’ to align more time with ‘demand’. For this reason, tighter monetary policy tends to dampen economic growth.

Given that India already lacks robust demand, tighter monetary policy may trigger a scenario in which India’s overall growth momentum is hampered. As the chief economist at the leading international bank, who asked not to be named, said: “If you consider the so-called Hindu growth rate of 4% GDP growth to be insufficient for India, then, yes, we could look at stagflation.” Typically required Stagflation A contraction or stagnation in GDP growth.

A good way to counter such “push-up” inflation and reduce the likelihood of stagflation is to tighten tax policies and lower taxes on fuel and other imported commodities. It is noteworthy that when a government imposes (or increases) tariffs, it is essentially taxing its own people by making imports more expensive.

Cutting taxes on fuel and imported commodities will not only dampen inflation but also increase aggregate demand – something RBI’s monetary policy cannot achieve.

“Reducing such fuel taxes will serve the economy on both counts,” Pronab Sen, India’s former chief statistician, said while speaking to this reporter last week, just hours before the government announced its decision.

What about government spending? Should that be increased or decreased? Should the government prioritize spending to provide income support to the poor, who are hardest hit by inflation, or should it instead prioritize spending on building infrastructure?

The starting point is again the finding that the tighter monetary policy of the RBI will give the economy a contractionary impulse.

As? explained Sen.

“Tighter monetary policy will reduce demand driven by borrowed money,” he said. “Therefore, as interest rates rise, you will see private sector companies cutting back on new investment. Similarly, you’ll see a fall in consumption driven by borrowing — housing demand, for example, is likely to take a hit,” he said.

The question is: if these major drivers of demand falter, should the state intervene or not?

Sen believes the government should intervene. “The government should increase public investment to offset the (probable) fall in private investment,” said Sen.

In other words, while government revenues may fall, it should not allow capital spending – that is, the expenditure that goes into the production of productive goods such as roads, bridges, schools, etc. – to stall.

Sen was also clear that the government should spend on small projects like highways and affordable housing rather than big projects, even in urban areas. Because millions of micro, small and medium-sized enterprises (MSMEs) can participate in such projects.

“MSMEs are the lower arm of the K-shaped recovery. Public investment in such projects will provide ways for MSMEs to get back in the game.

NR Bhanumurthy, Vice Chancellor of the Dr. BR Ambedkar School of Economics, Bangalore, also stresses the need for the government to “contain capital spending”.

“It’s important to remember what the government spends its money on,” Bhanumurthy said. If the government borrows money to spend on everyday necessities, it will only make inflation worse. On the other hand, if the government borrows money to spend on building assets that will allow the economy to be more productive in the future, then the government is justified.

What do you think the government should do? And what is the bigger problem for India: high unemployment or high inflation? Share your views and questions at udit.misra@expressindia.com

Stay safe.

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