Fiscal policy should return to fundamentals

Source: The post is based on an article “Fiscal policy should return to fundamentals” published in the Business Standard on 5^th August 2022.

Syllabus: GS 3 Issues and Challenges Pertaining to the Indian Economy

Relevance: Macroeconomic Conditions; High Inflation

News: Recently, the US Federal Reserve and the European Central Bank have hiked large interest rates to forcefully bring down inflation.

Some experts are of the opinion that deficit spending needs to play a much more active role in managing business cycles.

Evolution in the use of fiscal and monetary policy in the business cycles?

(1) Before the 2008 global financial crisis, Monetary Policy was the main device to address ordinary business cycles. On the contrary, it was suggested that fiscal policy should play a supporting role, except in the event of wars and natural catastrophes such as pandemics.

(2) Post-financial crisis 2008: Over the past decade, it has been firmly established that even in normal times, the fiscal policy should also play a more dominant macroeconomic stabilization. Monetary policy could respond immediately, but it was suggested that fiscal policy through taxation and government expenditure should quickly follow and take the lead over time.

It is true that “helicopter money” and other transfer programs proved extremely effective during the initial stages of the Covid-19 pandemic. These programs helped to cushion individuals while reducing long-term economic scarring.

However, both monetary and fiscal policy are vital to handle a routine downturn in the economy.

What are the challenges in the conduct of fiscal policy?

The large and politically divided countries, such as the United States or the United Kingdom, have not figured out how to conduct technocratic fiscal policy on a consistent basis. Because politics is hardwired into fiscal policy.

There are horse-trading and issues in the implementation of the fiscal measures or transfer programs. The implementation remains inefficient, and these tend to be bigger as the spending bill increases.

The fiscal measures resulted in increased inflationary pressures and reduced capacity to respond to the supply shocks triggered by the war.

What should be done now with high inflation and slowing growth?

(1) Interest rates need to be raised, but not at the pace at which it is happening. This entails a risk of yet another deep recession at the end of 2023

(2) Some mainstream economists believe that public debt could be much bigger without any negative consequences.

What should be done?

The governments should redistribute income on a sustainable basis. It should raise taxes on higher-income individuals and increase transfers to lower-income, especially very low-income, segments of the population. Higher taxes on high-income and upper-middle-income individuals will also lead to the achievement of social cohesion.

Fiscal policy needs to go back to fundamentals and be recalibrated. There is a need for the readjustment of macroeconomic policy gradually, as it is important to avoid a deep recession.