The expenditure specific multipliers that are being cited to proclaim this Budget as expansionary have no analytical foundation.
India’s government and central bank have, perhaps sensibly given their capability and competency limitations, stopped presenting a quantified medium-term macroeconomic policy framework. This has allowed a lot of spurious analytics to be touted by the policy ecosystem. When it fits their purpose, these are incorporated by the authorities, whose analytical cupboard is bare.
A prime example in the recent Budget was the touting of fiscal multipliers from public investment as expansionary fiscal policy. This is analytically wrong. A fiscal multiplier is simply the ratio of the change in national income to the change in total government expenditure, normalised as the share of gross domestic product (GDP). It is irrelevant whether the public spending increase or decrease is on consumption, investment or transfers —or on statues or healthcare for that matter. Thus, the multiplier measures the impact of an increase or decrease in the total expenditure/GDP ratio on future GDP. If the ratio is greater than one, then it is said to have a positive or negative multiplier effect. But in this year’s Budget, the expenditure GDP ratio has actually shrunk by 1.5% so it is just wrong to talk of positive fiscal multipliers.
The expenditure specific multipliers that are being cited to proclaim this Budget as expansionary have no analytical foundation. They simply correlate past changes in capital or revenue expenditure with changes in GDP growth. Because they have no analytical foundation, they cannot address the reverse question, whether reductions in public capital spending would cause reductions in GDP growth. Or, even more important in the pandemic context for policymaking, whether an observed decline in GDP and the consequent trend shock can be reversed by increased capital spending even when overall public expenditure/GDP ratios are declining.
Expenditure specific fiscal multipliers are purely after-the-fact empirical extrapolations. They are unstable and highly context specific. There is absolutely no basis to argue, from an analytical perspective, that an increase in public investment, at the expense of other spending, has a positive multiplier effect unless — as is inevitable in empirical excursions without an analytical framework — everything else is assumed to be the same as it was in the past. But today everything else is most certainly not the same. GDP has declined, there has been scarring due to the pandemic, inflation and unemployment are both rising, and there is a clear and present deficiency both in aggregate demand and in private consumption that was not the case before the pandemic. In economist language, there have been structural and parametric changes which do not validate the assumptions under which the sectoral multipliers were calculated.
The original proponent of these data mined fiscal multipliers, Mark Zandi found in the US context that the highest multiplier came from food stamps and lump sum tax rebates, not public investment (Zandi, Mark (2008) “A second quick boost from Government could Spark recovery” Edited Excerpts from Congressional testimony).
A 2013 study found that fiscal multipliers are lower in developing countries with high debt-to-GDP ratios and in less open economies, both arguably features of the Indian economy (Ilzetski, Mendoza and Vegh (2013) “How Big (Small)are Fiscal multipliers?” Journal of Monetary Economics 60:2).
The argument for public investment having a positive impact on GDP has nothing to do with sectoral multipliers. It rests on the premise that low-income countries have abundant labour and scarce physical and human capital.
Hence increased investment increases GDP. This would imply that an increase in total capital stock would always increase total output, ideally such that the incremental capital output ratio would be less than one. However, as Professor Rangarajan has previously argued, this has not been consistently so. In fact, India’s growth constraints have a lot to do with limited aggregate demand, sub-optimal output composition of demand, and other factors of importance especially following a period of sharp economic decline, than just supply-side bottlenecks. It is therefore wrong analytics, misplaced empirics, and incompetent policy craft, to celebrate a rise in public investment as a magic bullet, given falling private investment and shrinking overall public expenditure.
The lack of a coherent analytical framework for monetary policy formulation further cripples medium-term macro-policy formulation. Inflation is close to the top of the target band in a situation in which private consumption is muted. The RBI, in yesterday’s monetary policy statement, expects private consumption to pick up, as various indicators “augur well for aggregate demand”. In such a circumstance, in any analytical framework that I know of, inflation should rise, meriting an increase in the repo rate. But this has not happened because the RBI seems to view inflation as “transitory” without providing any logical or coherent explanation for this judgement. On the other hand, the RBI speaks approvingly of relaxed liquidity which, however, seems to find no takers, given the flatlining of private investment for some time now. The inescapable conclusion is that the RBI, to quote journalist Puja Mehra, today views not inflation targeting, but the targeting of the yield curve on central government debt, and dividend payouts to the Union government, as its principal responsibility. A single member of the monetary policy committee continues to refuse to acquiesce in this charade, but that is of little matter when the leadership of RBI is fully comfortable with its diminished, subordinate role.