India's Troubling Trilemma: The Reason Why Macro-Stability Is So Elusive for India

Op-ed in the Business Standard, New Delhi

December 13, 2013

Apparently, India is Baaack! The stock market is soaring, foreign money is pouring back in, and the current account deficit has declined, making the rupee crisis seem sooo yesterday. And Narendra "Mojo" Modi is poised to ride into town to boost the Hindu growth rate to, shall we say, the Hindutva growth rate.

But euphoria is overdone and highly premature. The most recent consumer price inflation number of over 11 percent is a pesky reminder that India's macroeconomic problems are far from over, in part because they have deeper structural origins.

India is on the trident of a trilemma (if that is the right metaphorical upgrade from being on the horns of a dilemma). The trilemma is that, as a competitive democracy with a weak state, India's embrace of financial globalization will make it difficult—not necessarily impossible—to maintain macroeconomic stability. Put differently, a country can retain two of these three features—competitive and imperfect democracy, global financial integration, and macroeconomic stability—but not all of them.

Why has the combination of a competitive democracy and an ineffective, corruptible state rendered difficult the attainment of macroeconomic, especially fiscal, stability?

On the one hand, the fact of poverty and inequality in a democracy will create pressures for spending and redistribution. Some of these pressures will be legitimate, because the typical voter in India is quite poor. But other pressures will be brazenly populist. To Montek Ahluwalia's dictum that in India there is a strong consensus for weak structural reforms, one might add that there is a stronger consensus for fiscal nonreforms: Fiscal populism commands multiparty popularity. Giveaways and subsidies are not just the preserve of the Congress. Bharatiya Janata Party and non-BJP governments in the states embrace them too. And even the new kid on the block, the sweep-away-the-old-order Aam Aadmi Party (with the broom as its election symbol), enthusiastically favors cheap and subsidized power for Delhi's residents.

On the other hand, the ability to finance this spending via taxation will be limited because of India's weak state. The powerful rich can bribe the state to minimize their tax burden. And the middle class can invoke a corrupt, inefficient, and redistributing state as reason or excuse to exit from the state and minimize its own tax contributions. If you don't provide us with essential services and public goods, or only do so wastefully and poorly, why should we finance redistribution, the middle class might implicitly ask.

It is noteworthy that fiscal prudence and overall macroeconomic stability prior to the mid-1980s owed in part to the noncompetitive nature of Indian democracy. Ironically, the Congress party's quasi-monopoly on power and the limited role of regional parties conferred on the political system a greater immunity to fiscal populism.

Difficult as this situation is, the problem gets compounded if the economy also embraces global, especially financial, integration. Financial integration, whatever its merits, exposes the economy to greater volatility. Cushioning against this requires social insurance mechanisms—often in the form of greater spending, especially during downturns. Dani Rodrik of Princeton has argued that open economies tend to have larger governments in order to provide such insurance. India's own experience provides corroboration. In 2008 and 2009, the Indian economy, buffeted by the vagaries of international markets—because of India's increasing integration with them—had to deploy countercyclical fiscal policies. One legacy is increased government spending and larger overall deficits.

The accompanying graphic illustrates the basic trilemma. Over the last decade, India has sacrificed macroeconomic stability in order to embrace financial integration (the left-hand side of the graphic). Before the 2000s, India struggled with macroeconomic stability but avoided extreme financial instability. Thus, India (on the right-hand side of the graphic) managed to escape the Asian financial crisis of the late 1990s and the fallout from it in part due to limited financial integration with the world.

Looking ahead, the case for caution, even pessimism, is the following. India is accelerating rather than slowing or reversing the pace of global financial integration. Its democracy shows little sign of overcoming the predilection for high spending and low taxes. Under these circumstances, macroeconomic stability could continue to prove elusive. It is somewhat of a mystery why India has been and become more vulnerable to this trilemma than countries in Latin America and sub-Saharan Africa that are no less integrated and have similarly weak states. And the irony is that many of these countries are latecomers to democracy compared with India.

So, is there a way out for India? Two possible avenues for escaping the trilemma offer themselves. The first is high growth. If India can return to something like 6 to 7 percent annual GDP growth, the fiscal deficit might correct itself because tax revenues will become buoyant. Indeed, this happened during the boom years between 2002 and 2007, when the overall fiscal deficit declined from nearly 10 percent of GDP to 4 percent.

The second and more sustainable escape route is for prudent macroeconomics to become good politics. Most post-mortems of the recent elections point to high inflation as one of the vote losers for the Congress. If the Opposition successfully mines mahengai and the Congress' dismal record on it in the general elections next May, that might possibly nudge India towards better macroeconomic policies in the future.

If the maturation of Indian democracy is necessary for escaping the trilemma and attaining macroeconomic stability, the pessimist might conclude that that might be a long wait. The alternative view is that an important step towards such maturation is perhaps just one election away, especially if that election sees the resounding rejection of the current purveyors of macroeconomic instability.