The Criticality of a Coordinated Policy Approach in Covid Times

Livemint     6th October 2020     Save    

Context: India’s move to a rules-based macroeconomic framework was based on the global thinking that central bank cares more for price stability and the government for growth.

Policy Coordination in times of COVID:

  • Necessitated by supply constraints: The output shocks due to COVID have changed preferences of central bankers worldwide to give more weight to growth, leading to more coordination.
  • Changes in the preference of Monetary Authority(MA) and the Fiscal Authority (FA): As the MA also values growth more, enforce coordination. 

Issues with the Monetary Fiscal Policy Coordination:

  • Prisoner’s dilemma: While the monetary policy affects demand more, the fiscal policy affects supply-side costs and therefore, inflation.
      • Since each is more effective in achieving the other’s objective, total independence leads to a prisoners’ dilemma type of non-co-operative strategic interaction. 
      • As players follow their own interest, each is worse off in the outcome of higher inflation and lower growth. 
      • If the Centre cuts back on expenditure that could reduce inflation, monetary policies are forced to keep interest rates high.
  • Inflexible Rules: The Indian experience suggests a simple rule alone is not effective.
      • It could be either interpreted too strictly, as inflation targeting was in the initial years, or it could be avoided, as fiscal responsibility was after the global financial crisis (GFC). 
  • Impact of COVID: Loss of income, contagion and rising precautionary savings translates to depressed private investment and consumption. 
  • Inefficacy of fiscal stimulus: The lockdown created serious supply chain disruptions, which has made the fiscal demand stimulus less effective.
    • Gross domestic product estimates show that in April-June, supply-side contraction exceeded demand-side reduction. 

Way forward: 

  • Making the rules more flexible: The flexible rulemaking reduces pay-offs from non-cooperation, making coordination (and not a prisoners’ dilemma) the self-enforcing outcome. 
  • Since the Monetary Authority knows the Fiscal Authority will act on the supply side, it can lower interest rates. 
  • Government has space and can create more asset and expenditure restructuring:
      • The Fiscal Responsibility and Budget Management Act allows for monetary financing under a growth collapse. 
      • Medical aid, preventing hunger and protecting livelihoods are priorities. 
      • A moderate expansion in fiscal expenditure coinciding with the festival season and recovering supply chains could build private sector confidence and trigger spending. 
  • Inject Surplus Liquidity: 
    • Surplus liquidity aids government borrowing and also reduces financial sector tensions and future non-performing assets requiring more government support. 
    • Equity cushions are available for banks.
Conclusion: Monetary and fiscal authorities need to act in tandem to achieve better outcomes on driving growth and taming inflation