Budget 2020 is going to be presented at a time when the Indian economy is experiencing a sudden and sharp slowdown. Across the board, economists have advised the government to take strong and significant steps to correct the situation. While some have suggested supply-side reforms in labour and land markets to be reattempted, most have argued that the government needs to revive demand growth immediately.
While there has been support for an expansionary budget, difference of opinion has been voiced on the most effective way to structure it. There are some who have supported the government’s initiative of decreasing corporate tax rates to incentivise business while others have suggested exemptions on the income tax putting more money in the hands of the middle class. Others, including Nobel laureate Abhijit Banerjee, have suggested that the budget should focus on programs that put more money in the hands of the poor for an immediate increase in demand growth in the economy. Arvind Subramanian, the previous chief economic advisor, has suggested a universal basic income as a strategy to increase consumption demand. The Finance Minister has also indicated that the government is considering more measures for demand creation. All of these indicate that an expansionary budget may be on the cards.
Almost without exception, these views assume that inflation will continue to be benign in the foreseeable future.
The Inflation Risks
This is largely based on the collapse in consumption demand, which has made it unlikely that demand-driven inflation would be an issue anytime soon. However, the same is not necessarily the case with supply-side issues. The most recent inflation data prints already show that at 7.35 percent, CPI inflation for December is the highest since July 2014. At 2.59 percent, WPI inflation for December is the highest in seven months. Weather-related shocks resulted in a 60 percent year-on-year rise in vegetable prices in December. Hopefully, this will abate once the full extent of imports and the domestic winter crop augment supply.
The Indian economy has always been vulnerable to food inflation, particularly due to unexpected rainfall shocks. Even if we are lucky with rainfall this year, there are two more sources of inflation that have a very real chance of bringing back high inflation.
- First, any further tensions in the faceoff between the United States and Iran would push up the price of petroleum products.
- The second is a possibility of an outflow of foreign capital from India due to investment sentiment turning on the prolonged weakness in the economy. This would result in a depreciating currency and more expensive imports.
Either of these, if not both, would also trigger inflationary expectations, leading to strong inflationary tendencies.
Knowing What Policies Won’t Work
The phenomenon of stagflation was first identified and characterised in the United States in the seventies, when, contrary to what Keynesian economics expected, inflation rose to very high levels despite slow economic growth and high unemployment. It gave rise to the revival of monetarism and the policy practice of attacking stagflationary situations with tight monetary policy. Later, supply-side economics also included policies like lower tax rates to encourage growth under stagflationary situations. Keynesians, on the other hand, feel that stagflations are caused by supply shocks and the best way to deal with this situation is to mitigate the shock. None of these approaches have proved to be costless as they have been either ineffective or strongly recessionary.
So what should the Indian government do if a stagflationary situation does indeed arise?
Since higher aggregate demand might make the inflationary situation worse, stabilisation policies during stagflation have to include tighter monetary policy with higher policy rates.
However, the monetary mechanism has recently been largely ineffective, and it’s not certain how much monetary policy will achieve. On the supply side, the two most frequently-debated policies—land and labour reforms—are both politically-contested and seem impossible in the current milieu where the government and the opposition are pitted in pitched political battles.
Politically Palatable Solutions
One supply-side initiative that is critical for our productivity but not politically divisive is skill enhancement. The NDA government has already prioritised skill enhancement through the Skill India campaign. It has also increased the budget for these programs from around Rs 1,000 crore in 2015-16 to around Rs 3,000 crore in 2019-20. The ministry has also been indicating some reforms in this area by moving from a subsidy-based system for training institutions to a voucher-based system for those seeking skills. Despite all these efforts however, the results in skilling have been quite limited.
In order to be more effective, the government can focus on subsidising in-house skill enhancement capabilities by private sector employers.
This model has similarities with the German system of apprenticeship and will probably be more effective than the current approach of subsidising training institutes or even the voucher-for-trainees method as these may not always understand and fulfill the skill requirements of industry.
Another supply-side initiative that would bring significant economic returns is governance and regulatory capacity creation. The Indian economy is becoming increasingly complex as it adopts some of the most-advanced institutional practices and technologies available. Examples of this are businesses increasingly shifting to web-based activities and payment systems becoming digital. Ease-of-doing-business in India would depend heavily on our bureaucratic and regulatory authorities developing capacities to handle such complexities. These would require both training and in-house research capabilities.
Traditional Policies, In A Few Areas
What else should the government do? One factor to keep in mind is that while aggregate demand expansion may be unwise in a stagflationary situation, there are opportunities to increase demand in particular sectors where there is significant excess capacity.
Thus, expenditure and tax policies that increase demand in, say, the automobile sector, should still be part of the budgetary framework.
Finally, it would also be prudent to attempt an arrest of any significant depreciation of the currency, should this happen as a result of financial outflows. As in the past, this approach could involve incentives to overseas Indians to increase their investment in India.
It is important to remember that Budget 2019 had to be changed significantly over the year as the economy did not perform according to expectations. This has an important lesson for the preparation of all future budgets. It clearly underscores the importance of keeping contingency plans for alternative economic scenarios so that the government is not taken by surprise when the economy takes a sudden turn. If the Indian economy turns stagflationary in 2020, we should be ready.
Sabyasachi Kar is a professor at the Institute of Economic Growth, University of Delhi.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.
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