It takes two to tango

The car is the economy. Both the government and the central bank have one steering wheel and one set of brakes at their disposal

Cafe Economics | Niranjan Rajadhyaksha

Most of us have been through driving school — and seen the exasperated driving instructor take over the mechanical reins of the car at some point or the other. It is his deft combinations of the clutch and brake that sees the car up a hill or through a crowded street.

Something similar occasionally takes place in the world of economic policy. The two drivers trying to steer the car up a hill are the government and the Reserve Bank of India (RBI). And they cannot decide how to do it.

The current debate on how inflation should be brought under control reminds me of an analogy used by economist Alan Blinder many years ago. Blinder asked his readers to consider the problem of designing a car in which student drivers will be taught to drive. This car will need two steering wheels and two sets of brakes — one for the teacher and one for the student. Blinder used this example to illustrate an issue that has great contemporary relevance: What should be the respective roles of the government’s fiscal policy and the central bank’s monetary policy in steering the economy?

The car is the economy. Both the government and the central bank have one steering wheel and one set of brakes at their disposal. How should they coordinate between themselves to keep the car on an agreed course? Should one agency have the right to override the other in times of disagreements? Should one brake a little harder because the other is accelerating too much? These issues tell us a lot about the current fight against high inflation.

The two Indian drivers seem to be working at cross-purposes right now. It is fairly well known that RBI has been worried about the long-term damage the high inflation can do to the economy. It is only recently that the finance ministry has come around to this view. Since late 2004, the central bank has been nudging up interest rates and reducing the ability of banks to create credit in a bid to cool down the economy. Matters have become worse over the past few weeks, as inflation has jumped above the 7% level. RBI announced an out-of-turn increase in the cash reserve ratio (CRR) on 17 April. And it has followed this up with the Tuesday decision to push CRR up by another 25 basis points, to 8.25%.

And what about the government? It, too, has ostensibly been fighting the inflation battle with “fiscal measures”. These have largely consisted of dropping the import duties on some agricultural and industrial commodities. But a far more effective fiscal measure goes unmentioned — the politically tough decision to slash the fiscal deficit. A sharp drop in the fiscal deficit will do a lot to curb effective demand and inflation.

But that’s not the case. India’s total fiscal deficit — which should ideally include the deficits of the Union government, its various off-budget liabilities and the combined deficits of the various state governments — is rising at a worrisome pace. It could perhaps be close to 10% of the gross domestic product, which is not too far away from the level that led to the financial crisis of 1991.

In short, the government has been stimulating demand even as RBI has been trying to curb it. So, we have the strange decision to cut tax rates and push through a pay hike for civil servants even as inflation is rising. To revert to Blinder’s motoring analogy, the two drivers have not been working in coordination.

Some conflict between a central bank and a government is perhaps inevitable — and history is littered with examples of such conflicts. It’s because of the nature of the tasks. In a presentation made in February, Bank of Thailand’s deputy governor Atchana Waiquamdee gave a fine overview of the issue of how and why monetary and fiscal policies can be coordinated. A central bank tries to fine-tune short-term interest rates in order to influence long-term rates. It also tries to manage demand and inflation expectations through various tools at its disposal. The hope is that low inflation will keep down long-term interest rates and help investments.

Fiscal policy does have a role in stabilizing the economy. But it also has to deal with issues such as fairness in income distribution within and between generations. Tax and spending policies also affect the incentives to work, save and invest. These help sustain growth. It would thus be unrealistic to expect the government and the central bank to work in perfect coordination at every point of time. That’s why most countries have a system of discussion between the two economic authorities.

Both RBI and the government need to share the burden of keeping inflation under control. That’s not happening right now, with the government running a fiscal policy that is too loose.

It’s clear: A deep cut in the fiscal deficit will be of great help in the war against resurgent inflation. Till that is done, interest rates cannot decline.