Economic Policy through the Modern Monetary Theory Lens

Crises drive change but often one crisis alone is not enough to cement a transformation. Over the course of past 12 years, the world has witnessed an era of radical changes in the way central banks manages the flow of money into the system. The 2008 Global Financial Crisis seemed like an inflexion point, but Covid-19 pandemic seemed to have cemented the transformation. The large stimulus packages announced by the Federal Reserve as well as other developed economies stand a testimony to this.

A strong Financial system has always been an edge for these developed countries. Despite such high stimulus, these countries are far from reaching their desired level of inflation, a fear Modern Monetary Economists have with the Central banks pumping so much money into the system. Japan, for instance has a debt to GDP ratio of around 200% but has not witnessed a debt crisis or a threating inflation number. History also validates the same fact- a bit over two centuries ago, the United Kingdom’s superior access to loans helped it defeat Napoleon. Clearly, the debt does not seem to be a problem for the advanced economies as feared since the debt is denominated in their own currency.

Though India is on its course to become a develop economy to have the financial autonomy enjoyed by the nations mentioned above but this is bound to take time. Unlike the US or Japan, there is a limit to the level of external debt which we as a nation can afford to take and with inflation numbers also going outside the range set by RBI, the policy makers have a tough task ahead.

The economic growth and the USD 5 Trillion target set by the Prime Minister has been seriously dented by the COVID-19, a health crisis which has brought serious spill overs on the economy and turned into an economic crisis. Unlike Fed or other developed countries, which have not experienced spike in inflation despite injecting so many dollars into the system, situation in India is different. The recent CPI inflation numbers of 6.7% are beyond the target range of 2%-6% set by RBI, thereby nudging the central bank to apply brakes on injecting further stimulus in the economy. This spike is on account of the supply side disruptions due to lockdown restrictions and as things would normalize, the food inflation is also expected to come down. The MPC has given unequivocal guidance that it sees the inflation surge as transitory and the growth risks as more durable. RBI projects CPI inflation to track 6.8% for Q2FY21 (July-September), but ease to 5.4–4.5% for H2FY21 and 4.3% for Q1FY22 (April-June), with risks broadly balanced. For FY22, RBI’s baseline projection has inflation tracking 4.1–4.4%.

Demand pull inflation occurs when business raise prices due to change in buying habits, when people spend faster than the economy can churn out goods and services, which is not the case here. But in the present scenario, the pricing power of firms remains weak in the face of subdued demand and robust summer crop sowing should improve the inflationary pressures. RBI’s survey shows that households expect inflation to soften over the next three months.

The Modern Monetary Theory (MMT) puts the fiscal policy at the driver seat of economic growth engine and in current scenario, prudent fiscal measures need to be implemented well to ensure we come out this shock soon. The economy is operating nowhere close to the full employment level and with the reverse migration to rural India, disguised unemployment is bound to rise. One of the ways in which the government can and is addressing the problem by providing guaranteed employment through MNREGA. Such schemes can play a big role to act like an automatic fiscal stabilizer. With such a job guarantee in place, millions of rural workers would find source of livelihood and their earnings would stir rural demand.

The market price of an unemployed worker is zero, that is, no one is willing to hire them but schemes like MNREGA create a market for these unemployed workers by setting a minimum wage to be paid. Once the economy revives, the workers would gradually migrate back to cities and the odds of earning more would increase. In crisis, such schemes would absorb the unemployed and provide them some source of livelihood while in times of boom, the number of people willing to enroll would be less. Thus, schemes like MNREGA act as an automatic stabilizer and keep the wheel of consumption moving, which is the primary contributor to our GDP. This might come at a cost in terms of increasing the fiscal deficit but at the same time it would reduce the infrastructure deficit which would create a multiplier effect going forward. Investing in Infrastructure would also augment the existing supply chains and ensure any such external shock does not lead to supply side disruptions and help in keeping the inflation in check.

The supply shocks would normalize with time, but adequate attention must be given to ensure the demand revives to pre-covid levels. Looking through the MMT Lens, the budget must be a means to achieve an end objective — economic stability. Though RBI has fired its guns over the past 6 months, yet the demand for credit remains tepid. If the monetary mechanism has to work effectively, with every rate cut, there should be a spike in loans and more and more people should purchase homes, automobiles while business should invest in capital assets. But remember, we are in a pandemic, and conventional monetary policy mechanism would not work.

Therefore, job guarantee schemes can be an effective tool to revive rural economy and build infrastructure which can spur economic activity once the world comes out of this pandemic. A labour intensive approach can be adopted to build rural and urban infrastructure as wage rates are low as the capacity of agriculture to absorb extra workers is questionable. We need to avoid the 2008 situation in India, when a global shock in the real economy went to Financial Sector while in the West, the crisis originated from the financial sector and spilled across the economy.

Views expressed are personal.

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