Dimensions of pro-cyclicality

The fiscal stance of sub-national governments

M. Govinda Rao taught me something very interesting yesterday:

• Suppose we had a country where there are strong fiscal rules which forbid deficits at the sub-national level. This is a nice thing to do from the viewpoint of debt stability - as anyone who has studied the fiscal excesses of Argentina's sub-national governments knows. But in this case, fiscal policy at the sub-national level is pro-cyclical. In a downturn, tax revenues are reduced (whether own revenues or transfers from above) and expenditures have to be crimped.
• In good countries, there is strong accountability at sub-national governments. The Mayor of New York is a person who runs for election on the strength of his achievements in delivering public goods. In Bombay, the Mayor is often someone you have never heard of, with little interest in delivering public goods; the typical reader of this blog doesn't bother to vote in these elections.

As a consequence, when (and only when) there is accountability at the sub-national government level, an effective strategy for a fiscal stimulus consists of delivering money to sub-national governments. This combats the procyclicality of their budgetary balances. If they embark on building roads or urban transport systems, there is a better chance that the money will not be wasted. But all this is conditional on having a proper mechanism of local government, where the Mayor of Bombay lives and dies by the delivery of public goods in Bombay.

We can describe these perverse problems with the fiscal balance of sub-national governments in India today, but there's precious little which we can do about it in the short run. Do read M. Govinda Rao and Ed Glaeser on these issues.

Some other examples of pro-cyclicality

On a similar note, see Surjit Bhalla's complaints about RBI violating the Taylor Principle. (You might find my comment here on estimating Taylor rules to be of interest). Badly structured monetary policy exacerbates the business cycle instead of stabilising it. And even if monetary policy sometimes does the right things, the malfunctioning Bond-Currency-Derivatives Nexus implies that there is a feeble monetary policy transmission; changes in the policy rate mean rather little for the economy. Long-standing policy mistakes have given us a crippled set of markets for government bonds, corporate bonds, currencies and derivatives thereof. A bad monetary policy framework gives poor choices on the policy rate; a bad financial policy framework gives a feeble monetary policy transmission.

For another example, witness companies using the 19th century mechanism of `company deposits'. This is the price that we pay today for ignoring bond market development for the last 25 years. When there are such deficiencies in financing firms, bad times become worse. Weak institutional capabilities in finance induce pro-cyclicality.

Or, of course, witness the inability of a government that's running a fiscal deficit of above 10% to meaningfully expand the fiscal deficit in a downturn. The good years should have been used to run up fiscal surpluses, which would have created space to enlarge the deficit in a downturn. That space is largely absent in India today. We are paying for our sins of not reforming the fiscal system in the great business cycle expansion of 2002-2007.

Stabilising the business cycle through sound institutional capabilities for fiscal, financial and monetary policy

More generally, look back at all the dimensions of pro-cyclicality of fiscal, financial and monetary policy which are hitting India in reverse now. When times were good, all these things are popular, because they convert good times into 10% GDP growth. Nobody minds pro-cyclicality when the going is good. It's only when the going gets hard that we realise how damaging these things are. John Kennedy said that the time to fix the roof is when the sun is shining. A storm has enveloped our house, and fixing the roof is hard.

Good countries avoid this boom and bust cycle through institution building on fiscal, financial and monetary economics. The best outcome that we can ask for, from the pain of 2009, is that the political and economic leadership brings better economic thinking into the institutional foundations of economic policy.

When India was a $250 billion agricultural country that was closed to the world, thoughts of fiscal, financial and monetary institution building were far away. We built and operated rickety structures such as the RBI Act. At that time, there was no `business cycle' in the modern sense of the term: there was just a sequence of monsoon lotteries. But now, things have changed. Operating the levers of a globalised $1 trillion economy with such institutional foundations is reckless. (You might like to read this paper).