The Montek Monetization Moment?

Op-ed in the Business Standard, New Delhi

February 25, 2009

Some years ago, Montek Ahluwalia, early in his tenure as Deputy Chairman of the Planning Commission, argued for using India's foreign exchange reserves to finance a ramp-up in infrastructure. That proposal received a lukewarm response. One of the concerns was macroeconomic: The proposal really amounted to monetary financing of a larger, albeit public investment-driven, fiscal deficit. Many worried about this prospect of deficit-monetization, especially since inflation (based on wholesale prices) was then running at about 5-6 percent.

Might Montek's proposal have earned a new lease on life today? Might this be the moment for the Reserve Bank of India (RBI) to monetize the rising public deficit?

Every day, the economic news gets grimmer. The world economy is tanking more rapidly than many had forecast. The latest numbers show that India's exports (20 percent) and spending on consumer durables (12 percent) are declining rapidly. GDP growth forecasts of around 6 percent for 2009-10 are looking progressively unbelievable, 5 percent more plausible, and less than 5 percent no longer indefensible.

The fiscal deficit is rising in part for reasons unrelated to, and actions taken prior to, this crisis. There is little room for further discretionary stimulus because of the weakness of the public sector balance sheet.

Monetary policy will therefore have to bear the burden of helping to cushion the economy against the downturn. The case for monetary easing is undeniable now not just because growth is declining and inflation is decelerating towards temporary extinction but also because relative calm has been restored to currency markets. The fickle foreigners have fled but the loyal locals provide the comfort and cushion to embark upon more expansionary monetary policy.

But the really difficult and important monetary policy question for now is not whether to ease or how much to ease but whom to ease for: the private sector or the government?

A case for the latter, i.e., monetization of the deficit, can be mounted in the current circumstances. And it would run roughly as follows. Ideally, monetary easing should try to restore the flow of private credit with a view to reviving private sector investment and consumption more generally. But this desirable course may not be feasible or effective in the current circumstances for reasons related to the demand for and supply of credit.

First, we are in phase II of the crisis. In phase I, there was a sharp increase in the demand for credit as Indian firms scrambled to make up for the foreign liquidity that dried up with the deleveraging process induced by the crisis. Now, as activity declines, firms and households are likely to become more cautious in their spending plans. This would weaken the demand for credit. If so, interest rate cuts can only weakly stem this decline.

Second, there is some "dynamo trouble" in the monetary transmission mechanism. For a variety of reasons, declines in policy rates are not feeding through to lending rates. In part, there is a liquidity premium, inducing banks to keep deposits attractive (on their liability side), and hold government securities instead of making illiquid loans to the private sector (on the asset side). Whatever the reason for this impaired state of affairs, the effect will be to attenuate the reaction of the private sector to easier monetary policy. In sum, both the demand for credit from the private sector might be declining and the ability of policy to supply credit on cheaper terms to it is also proving difficult.

In these circumstances, directing credit to the public sector rather than the private sector could provide more bang for the monetary/financing buck. The public sector is at least capable of increasing demand-after all the overall deficit has increased by about 4.5 percentage points. The private sector might be less able to do so. Moreover, bond markets are becoming skittish, balking at the large increase in the government's funding requirements. For any given level of the deficit, increased monetary as opposed to debt financing of the deficit will have the virtue of keeping interest rates down on government securities, and hence arresting what might otherwise turn out to be a deteriorating borrowing environment for the private sector at just the wrong moment.

Of course, there is the technical matter of how the RBI can monetize the deficit given that it is prohibited from directly purchasing government securities. One possibility would be for the RBI to purchase them in the secondary market.

Even if technically feasible, central bank financing of fiscal deficits creates considerable risks. First, there is the precedent-setting nature of such a course of action, which might arguably be justified on the grounds that these are exceptional times. The second risk relates to inflation. Although deficit monetization might not entail inflationary risks in the short run, the considerable monetary overhang that will be created would have to be unwound at some future date to avoid an acceleration in inflation.

Perhaps the most serious risk relates to the relationship between the fiscal and monetary authorities. If the RBI finances the deficit today, might it encourage fiscal populism down the road? Could a new government in, say, July this year point to deteriorating economic conditions and present a more expansionary and consumption-loaded rather than investment-focused budget, banking on expectations that the RBI will come to the rescue once again? Also, what signals would such a course of action send in terms of the institutional independence of the RBI?

Thus, while there might be a case-admittedly exceptional-for the RBI monetizing the deficit and directing credit to the public rather than the private sector, the risks are considerable. The benefit-cost calculus of the RBI monetizing the fiscal deficit is now the important debate that India must have.

Montek Ahluwalia's original proposal amounted to inflationary financing for public investment and long-run growth reasons. Now, the question is whether inflationary financing to boost government consumption for cyclical reasons might be necessary.

Yesterday's doubtful proposal has become worthy of serious discussion today. Perhaps, there are no really good or bad economic ideas but only circumstances that make them so.