Should states borrow from the RBI?

The proposals put forward to the states by the Finance Minister on August 27, 2020 to which states have seven days to respond are clear indication that the center wants to protect its fiscal space and tilt the balance of power in its favor. It also violates the terms of agreement on initial phases of GST implementation where states are owed compensation for loss of dues. Such turnaround does not bode well for centre state relations in India.

Asking the states to borrow money from the RBI for the compensation that is due to them is essentially saying the following: “I owe you a compensation but I am not going to borrow from RBI to pay it, I will ask you to borrow and repay it back.” This is problematic on several counts. If a private party did that to a lender it would be clear grounds for breach of contract and therefore for a court case! Maintaining the sanctity of a contract by the State is of utmost importance for keeping sanctity of law. Secondly, if states agree to this, the borrowings become the borrowing state’s liability. Given that states have limited capability to raise finances, it means that the borrowing state will have to ask for help from centre if it cannot repay. This puts the borrowing state in a weaker bargaining position and the center can use its superior position to further its agenda.

Additionally, if the states’ borrow from the RBI, the central bank will have to do so by buying the borrowing state’s bonds. The RBI will receive the interest payments on these bonds which will show up as profits on its balance sheet. The centre then can have the central bank to transfer the profits back to it. This way, the centre not only saves on paying the GST compensation, but my making states borrow from RBI, also gets additional funds from them in future. This arguably is worst bargain for states and serious breach of trust on the part of the center.

States should consider this double whammy of loosing bargaining power as well as interest money as they consider the centre’s proposals. Doing so would be in their best interests.

PS: This post has benefitted from a lively discussion on twitter with @Sabya_K, @dugalira, @qfint, and @akshayalladi. All errors are mine.

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Policy in the era of a pandemic

The COVID Pandemic has stretched all the economies around the world to their limits including India. Add to that the fact that the Indian economy was already experiencing a recession kickstarted by demonetization, worsened by GST, and now most likely prolonged by COVID 19. While there is no doubt that increased government spending or fiscal stimulus is the need of the hour, financing it amidst the dismal economic conditions is going to be difficult. At this point there does not seem to be any viable alternative to monetizing the resulting deficit by the RBI and most likely government will take that route.

However, there is no reason for suspension of the Monetary Policy Committee as has been suggested by some. The monetary policy independence and credibility through the establishment and functioning of the MPC over the past couple of years is certainly hard earned. The current crisis should not be used to sacrifice this important institutional innovation despite the disagreement one may have over its narrow mandate of inflation targeting. It will need to decide on policy rates from time to time as the inflationary effects of increased government spending unfold over next few quarters taking into consideration the economic conditions then.

If the RBI monetizes the deficit, it means that it will print money to purchase government debt. This is one of the ways of financing government spending, the other being tax on labor income among others. The benefit of raising revenues by printing money- seignorage- it can be accessed relatively quickly than a labor tax. However, it has the disadvantage of being inflationary if it has kow output elasticity. Besides, the debt subscribed by the RBI to finance the spending has to be serviced and retired later. This can be done by again printing money or raising labor taxes in future. If government keeps on rolling over the debt by printing money, eventually there is the risk of hyper inflation. Therefore, to honor its inter-temporal budget constraint , the only sustainable way for the government to accommodate deficit monetization today, will be to raise labor income taxes in future to pay for the spending today.

The crisis precipitated by COVID 19, however, is a special case. It is essentially a supply shock, where the productive capacities of the economy have been temporarily suspended. Many of such firms will resume business as the lockdown is lifted across India gradually. However, given the nature of production relationships some of these businesses might just close shop as a result of destruction of relationship capital. Moreover, investment spending which already had started falling may not recover so soon because of significant future uncertainty. Therefore, the replacement of destroyed capital and productive relationships by new ones may not happen if left entirely to the private sector. Government spending can certainly help some of these businesses survive or revive as the case might be.

As with any macroeconomic shock, its initial nature does not remain permanent. A supply shock eventually could become a demand shock and vice versa. The current crisis is no exception. With hordes of informal and some formal workers loosing jobs, the COVID crisis is now also a demand one. Informal sector workers as well as firms are cash strapped and direct infusion of liquidity could be the only way to help for now. Such fiscal stimulus could help in a big way alleviating starvation and joblessness. Also, given that many of these workers are also migrant workers, a substantial burden of expenditure will be on the host states which the center needs to finance.

Unfortunately, center state relations have already been stressed because of shortfall in the GST revenues. There are important political economy considerations which are in play. Helping out a state with a non-BJP government may bolster the support for the non-BJP party in that state, while not doing so hampers any chances BJP might have to form state government in future. How and when the central government resolves this tradeoff will depend on how it perceives the probability of it being reelected in the next elections.

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COVID-19 Impact: Some Contrarian Views

Two important questions: How deadly is the virus and what should be the policy response. Two articles that make convincing arguments about deadliness of the virus being overestimated are as follows:

  1. Covid-19 total lockdown: An economic and humanitarian disaster by Rupa Subramanya on
  2. Is the Coronavirus as Deadly as They Say? by By Eran Bendavid and Jay Bhattacharya in the Wall Street Journal.

Both the above articles argue that the actual fatality rate of COVID-19 should be much lower than what is being reported if calculated correctly. The second article is behind a pay wall unfortunately but the crux of the argument is based on the wrong way of fatality rate calculation- should be calculated as percentage of infected population and not as of confirmed cases done by several epidemiological modelers. Here is what they say:

How can we reconcile these estimates with the epidemiological models? First, the test used to identify cases doesn’t catch people who were infected and recovered. Second, testing rates were woefully low for a long time and typically reserved for the severely ill. Together, these facts imply that the confirmed cases are likely orders of magnitude less than the true number of infections. Epidemiological modelers haven’t adequately adapted their estimates to account for these factors.

Given this background, an article by two renowned development economists, Debraj Ray and S Subramnain becomes especially pertinent.

In India’s battle against Covid-19, we are inevitably confronted by the choice between social distancing on the one hand, and denying people their livelihood on the other. Recognising the unsustainability of a general, mandatory lockdown, Ray and Subramanian put forth a proposal whereby the young are legally permitted to work and the locus of measures to avoid intergenerational transmission is shifted to the household.

I am glad that at least the Delhi and Kerala governments are resorting to humanitarian policies like opening food shelters to care for the plight of migrant workers, however, it might be worth deliberating on the policy proposals by Ray and Subramanian above.

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How has currency in circulation behaved in India?

The following graph represents the behavior of currency in circulation in India over the past two years following the demonetization announcement on November 8, 2016. The giant dip you notice is immediately following the announcement that rendered Rs. 500 and Rs. 1000 currency notes illegal. They contributed 86% of currency in circulation at the time. It took about two years for the currency in circulation to be back at the pre- demonetization level.

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Dynamic macro perspectives on India’s Monetary Policy

I reviewed the book Monetary Policy in India: A Modern Macroeconomic Perspective edited by Chetan Ghate and Kenneth M Kletzer, Springer, 2016 for EPW recently.

Overall, the articles in the book represent a significant and substantial contribution to the literature on monetary policy of India- definitely from the point of view of application of dynamic macroeconomic models to the policy environment of a typical developing economy.


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NPR’s Podcast on Demonetization

NPR’s Planet Money did a two part podcast on Anil Bokil and his organization Arthakranti who convinced Prime Minister of India Mr. Narendra Modi about demonetization as a solution to India’s poverty, corruption, and black money related problems. This was back in 2013 when Mr. Modi was Chief Minister of Gujrat.

Arthkranti is a plan conceived by some accountants and engineers to curb corruption and improving tax compliance in India. According to them, limiting the use of cash is one of the solutions. I have already talked about what is wrong with this solution here, here, and here. I also wrote a critique of Arthakranti proposals few years ago while I was grad student and did not think that anyone would take these proposals seriously!

Nonetheless, it is interesting to hear what Mr. Bokil has to say. NPR guys did a good job here.

I thank J P Konning for making me aware of this podcast through one of his tweets.

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Demonetisation and the recent GDP growth estimate

My paper on Demonetisation is now published at the Economic & Political Weekly as Demonetisation through Segmented Markets: Some Theoretical Perspectives.

The analysis therein concluded that there would be a decrease in real GDP over the next few quarters as all the adjustments forced by the demonetisation pan out. The extremely slow remonetisation of the economy on account of shortage of new cash and poor logistics only seemed to be reinforcing this conclusion. Therefore, the recently released GDP growth estimate of  7.1%  does not make sense. It has surprised economists and political commentators alike. For example,  Ajit Ranade expresses his surprise in the following tweet:


Expressing doubt about the estimates, Mihir Sharma at Bloomberg asks if the Indian data is going the Chinese way.  So how do we explain this estimate when economists as well as the IMF predicted the growth to be down to 6%? The analysis put together by The Wire based on interviews of some economists suggests the following possible reasons:

  1. The downward revision of Q3 F16 growth is pushing up the growth estimate for the current quarter. This downward revision could be because of poor agricultural growth in 2015-16.
  2. Pile up of inventories in the distribution channels could have been recorded as increased consumption expenditure. This is the channel stuffing phenomenon where the wholesalers pushed goods down the distribution channel still probably expecting the sales to revive after remonetisation.
  3. The rich may have spent on big ticket commodities like cars. For e.g. Maruti Suzuki recorded some increase in revenue pushing durable consumption expenditure up.
  4. The official GDP estimates don’t really measure informal sector activity with accuracy and it is the informal sector (unconnected households and firms) that has been hit very hard by demonetisation.

If the above reasons are true, then the growth estimate would most likely be revised downward later as data catches up with the decline in economic activity. However, for now the BJP government  and Prime Minister Modi could take all the credit for the improved growth and boost their political capital when it matters given the UP elections.


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How India can reduce the size of its black economy

Here is the link to my article, “How India can reduce the size of its black economy” in

It is partially based on an earlier blogpost on the same topic.

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Demonetisation: Some Theoretical Perspectives.

Read my latest paper on the Great Indian Demonetisation Experiment here.

The analysis is based on a simple textbook version of a segmented markets model (Williamson 2011). I prepared this is as a teaching note and therefore is fairly non-technical. The reference to an older edition of Williamson’s brilliant text is because the segmented markets model has been dropped from its subsequent editions to accommodate latest macroeconomic developments in the developed world.

Williamson S (2011), Macroeconomics, Pearson. 


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How to keep the American Dream intact?

The Equality of Opportunity Project is an impressive research venture using big data to explore new pathways to upward mobility in the American society. One of the pictures that came out of this project and that has made quite a few rounds of tweets is the following one: project_abs_lato

It shows the percentage of children earning more than parents over the years according to when a child was born. So if you were born in 1940 there was higher likelihood for you to earn more than your parents than if you are child born in 80’s. It is a very interesting data in itself and the paper itself makes an interesting read. (alternative link here)

I think this measure of the fading American dream provides an incomplete narrative of what might be happening in the US today. Given, that per capita incomes were much lower in 1940s compared to today and that economic growth rate measured by growth in per capita real GDP has stayed constant over this period at 2 percent per year (see graph below), it seems obvious that children born later would face a lower probability of doing better than their parents than children who were born in earlier decades.


I think the story of decline in absolute mobility is invariably linked with the nature of growth process in the US. Today there is an unprecedented increase in the skill requirement on an average to produce 1 unit of real GDP than in 1940s. Also, aging population means that there are less people who can acquire those skills. If this is coupled with a simultaneous rise in required time for skill accumulation, then at any given point in time we might see an increase in the proportion of people working part time reducing the probability of earning more than your parents. See Acemoglu and Autor’s Handbook chapter for skill biased technological change and its impact on the US labor market.

When looked at in conjunction with these changes in the American economy, we get some interesting policy implications.

  1. One, there should be more spending on education- given the importance of ideas for economic growth in future, the case for education having diminishing returns is already weak.
  2. Second, have more skilled people come in through immigration-directly as workers or indirectly as students- which can help increase the size of economic pie while people born in the US get the required time and money for education.
  3. Third, there should be a change in the way we approach education in order to foster life long learning capabilities in those being educated.
  4. Fourth,  Redistribution-More public spending on education also means more redistribution, something that the paper finds reverses the decline in probability of earning more that your parents.

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