Narendra Modi’s fiscal follies

Given the counterproductive behaviour suggested by Keynes, by both households and private firms, the correct policy response in a slump is to increase government spending. Unfortunately, Indian Prime Minister Narendra Modi’s government is doing the opposite during the current pandemic-induced downturn – with potentially disastrous consequences.

Modi’s fiscal rigidity is symptomatic of a broader long-term trend. In the mid-20th century, the Keynesian idea of boosting public spending to counteract a slump was mainstream and widely implemented. But, beginning in the 1980s, fiscal hawks started taking over both the economics discipline and most countries’ commanding heights of economic policymaking.

From that point on, “fiscal discipline” became the order of the day, and was enshrined in national laws and international treaties that sought to limit government deficits to some predefined proportion of national income, such as the European Union’s 3%-of-GDP ceiling. And the fashion in the developed world eventually became the norm for developing countries, too.

That was inevitable. The International Monetary Fund (IMF) and representatives of global finance were relentless in pushing their obsession with fiscal consolidation and then austerity (absolute reductions in government spending), to the point that it became dogma for developing-country governments. The new orthodoxy reached its apotheosis in the extraordinary concept of “expansionary austerity,” whereby large reductions in government spending came to be associated with faster economic growth, because of their supposed positive impact on investor confidence.

This notion was extensively refuted both theoretically and empirically for advanced economies. But it continued to dominate macroeconomic policy, until the economic disruption caused by Covid-19 led Organisation for Economic Co-operation and Development (OECD) governments to toss zombie orthodoxy to the wind and borrow heavily from central banks to arrest the decline.

Such a reaction is unsurprising: The sheer stupidity of pursuing fiscal austerity during a pandemic-induced recession should be obvious. But even today, it is not apparent to some governments, particularly in the developing world.

In some cases, a country’s knee-jerk austerity reflex stems from its external-debt burden and other pressures on public finances that limit spending. But fiscal restrictions are often self-imposed, reflecting policymakers’ fear of how financial markets and global investors will react to the larger deficits that are assumed to result from increased public spending.

This denial of the paradox of thrift betrays a basic lack of understanding of macroeconomic processes. And Modi’s government is exhibit A, providing an almost textbook example of how the paradox applies to public expenditure in a context of insufficient aggregate demand.

Even before the pandemic struck, the Indian economy had been slowing significantly for several years under Modi’s leadership. Falling employment and decelerating household consumption were clear evidence of weak aggregate demand.

This inevitably affected tax revenues in the fiscal year ending in March 2020. Indirect tax receipts were significantly below budget estimates, while a big corporate-tax cut midway through the year reduced revenue from direct taxes, even as private investment declined.

Sadly, and despite scoring this own goal, Modi’s government is now repeating its mistake amid the pandemic. It is stubbornly refusing to provide much-needed fiscal stimulus, relying instead on inflated claims that are unsupported by actual spending.