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.