India’s fiscal mess

The Economic Times has a depressing story on the state of public finances in India:

…Expecting the fiscal deficit to come in at 4.1% of GDP for the whole of 2014-15 was widely predicted to be unrealistic, but the speed at which the gap between actual numbers and the projected figure has closed has exceeded earlier years. Last year, for instance, the fiscal deficit was around a third of the budgeted amount in the first two months of the year.

Essentially, what the government did was roll over, to the next year, payments which would have ideally come in towards the end of the previous financial year. The petroleum ministry, for instance, saw its expenditure for the first two months of this year coming in at 39% of its annual budget. In the same months of last year, the petroleum ministry had spent virtually nothing. Effectively what the government had done was delay payments of the fuel subsidy to oil companies till 2014-15. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. This way, it didn’t have to account for the expenditure in the previous year, resulting in a lower deficit. “The government left a number of expenditures uncovered,” points out Rajiv Kumar, senior fellow at the Centre for Policy Research.

Kumar points to the interesting fact that the fiscal deficit for the month of March last year was actually negative — in other words, the government received more funds into its coffers than was paid out of them for that month. “There was sharp fiscal compression in that month — more so than in earlier years,” he says, alluding to the fact that the government did not spend as much as it usually did.

March is an unusual month for government spending as the cement sector is well aware. Every March, cement consumption across the country spikes sharply. In recent years, that spike has been anywhere between 10% and 13%, but it’s followed in the subsequent month by a sharp fall. The spike is often because government departments would like to use up their budgets before the end of the financial year and binge on construction activity which was originally budgeted but failed to take off.

In contrast, in the early months of the new financial year, construction activity is slow as government budgets take time to be approved. Indeed government expenditure in March is regularly in excess of 15% of the budgeted amount for the year. In other months, the spending averages around 7-8%. In 2013 and 2014, though, the effect was more muted.

This, along with rolling over subsidy payments to the next year, helped the government push the fiscal deficit into negative territory. On the revenue side, dividend payments were sharply higher than originally budgeted for 2013-14 — by as much as 44%. “Notice also that the budgeted dividend payments by public sector undertakings [PSUs] for 2014-15 are much lower than earned in 2013-14,” says Sabnavis. Effectively the government asked PSUs to pay up higher amounts in dividends the previous financial year, with the sweetener that they wouldn’t be forced to do so again next year.

Then there is the tactic to give rosy estimates for the coming year, in order to give the markets and economists something to cheer about. Total subsidies for 2014-15 were pegged in the interim budget at just about 0.3% higher than the revised estimates for 2013-14. The government’s previous track record in managing subsidies gave little reason to believe this.

Last year, for instance, revised estimates were higher than their original budgeted amounts by 11%. Despite that experience, budget estimates were pegged at a lower level than a year before. At the same time, expectations of tax revenues are pegged at overly optimistic levels as well. All this means little fiscal room for Arun Jaitley when he presents his first budget next week.

India has enormous potential, but this story is yet another example of why India continues to fail to live up to her potential. I hope Premier Minister Narendra Modi’s new government will deliver on the promised reforms. Unfortunately given the historical experience it is hard to be optimistic.

Happy birthday Bob!

Today is the day. July 3 2014. Robert Hetzel is turning 70 today. Happy birthday Bob! I hope you will have a great day with your wife Mary and the rest of your family.

To quote myself:

Bob has been a great inspiration to me since the early 1990s and he is undoubtedly one of the economists who have had the greatest influence on my own thinking about monetary matters. Equally important today is that I am very happy to say that Bob is not only a professional inspiration. I am also proud to call Bob my friend.

And yes I write quite a bit about Bob’s contribution to monetary theory and the plan is certainly that I will continue to do that in the future. I will continue my series on Bob’s contributions in the coming weeks, but for now have a look at what I have already written about him over the last couple of years.

This is a list of Hetzel related blog posts:

The Fisher-Hetzel Standard: A much improved “gold standard”
Bob Hetzel’s great idea
Celebrating Robert Hetzel at 70
The ECB should give Bob Hetzel a call
Forget about Yellen or Summers – it should be Chuck Norris or Bob Hetzel
Bob Hetzel speaking at CEPOS
The Hetzel-Ireland Synthesis
The eagle has landed – Bob Hetzel visits Denmark
If you want to know about the Great Recession read Robert Hetzel
Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers
A few words that would help Kuroda hit his target
Imagine the FOMC had listened to Al Broaddus in 2003
Monetary disorder – not animal spirits – caused the Great Recession
The cheapest and most effective firewall in the world
Buy “The Great Recession: Market Failure or Policy Failure”
Guess what Greenspan said on November 17 1992

And here is a cartoon for you Bob. I am sure you will enjoy it.

Friedman

PS Doug Irwin was kind enough to send me the cartoon. It is from New York Times in 1970. I hope there is no copyright issue, but after all this is a kind of birthday present to Bob so I will have to risk it. After all Milton used to be Bob’s (favorite) teacher at the University of Chicago. 

PPS This is me in London yesterday being interviewed about the ECB. And yes it is very Hetzelian.

 

 

Riksbanken moves close to the ZLB – Now it is time to give Bennett McCallum a call

In a very surprising move the Swedish Riksbank this morning cut its key policy rate by 50bp to 0.25%. It was about time! The Riksbank has for a very long time undershot its 2% inflation target and inflation expectations have consistently been below 2% for a long time as well.

The interesting question now is what is next? The Riksbank is now very close to the Zero Lower Bound and with inflation still way below the inflation target one could argue that even more easing is needed.

I have earlier addressed how to conduct monetary policy at the ZLB for small-open economies like Sweden. Traditional quantitative easing obviously is an option, but it is also possible to get some inspiration from the works of such great economists as Lars E. O. Svensson or Bennett McCallum.

Already back in 2012 I wrote a post about what advice Bennett would give to the Riksbank in a situation like it now find itself in. This is from my blog post Sweden, Poland and Australia should have a look at McCallum’s MC rule

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? …

…What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target…

…The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

…So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank … should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

…Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank…can.. avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

That is it – now back to writing on the Polish central bank’s failure to do the right thing at it’s rate decision yesterday.

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See also A scary story: The Zero Lower Bound and exchange rate dynamics

Immigration is saving the US economy – some telling graphs

Apparently monetary theory is not sexy – or at least when I write about something else than monetary issues then I get more comments and activity on my blog than when I focus on what I really care about (monetary policy as you know…)

Recently I wrote a piece on why I think the best immigration policy is “Open Borders” and that got a bit of attention and interestingly enough some of my readers who normally tend to agree with me – disagreed with me.

I do not exactly seek controversy (some would say I do), but I simply have to write another post on immigration. Bloomberg chief economist Mike McDonough yesterday shared some very interesting graphs on Twitter on the demographic outlook for Japan, China and the US.

The graphs are extremely telling – while Japan and China are facing sharply declining work age populations in the coming decades the US is likely to more or less maintain its present demographic structure.

Demographics

Joe Weisenthal at the Businessinsider explains how this is possible:

The best looking, really, is the US, which has a nice evenly distributed population. The shape of the pyramid isn’t changing much, in part because our immigration policy keeps the population from getting too old.

Joe is of course right – the US is still attracting people from all around the world to come to the US to work and live and my bet (and hope) is that that will continue to be the case in the future. Immigration is part of the American success story and will continue to be so for decades to come.

PS I am in London today speaking at the CAMP Alphaville. I am on a panel on “Central banks and their jedi mind tricks”  (they stole that title from Matt O’Brien) with Lorcan Roche Kelly, Josh Ryan-Collins and Paul Woolley. The Session starts at 12.30pm London time (so I better get moving…)

HT Niels Westy

 

Sticking to its Knitting: Central bankers should forget about “financial stability”

These days central bankers seem more concerned about “financial stability” than ever before – and even more concerned about financial stability than nominal stability. These things go in cycles. After 1929 central bankers became terribly concerned about financial stability. Then again in the 1990s after the Mexican crisis in 1994 and the Asian crisis in 1997 and then after the bursting of the “IT bubble” in 2001.

But should central bankers really concern themselves with “financial stability” as a monetary policy goal? The great David Laidler gave the answer in a paper 10 years ago – This is from the abstract to “Sticking to its Knitting”:

It has become painfully evident that low inflation is not, in and of itself, sufficient to guarantee overall stability to the financial system. The bursting of the high-tech stock market bubble of the late 1990s in North America is sufficient evidence of this, but there were echoes here of the collapse of Japan’s bubble economy at the beginning of the decade, and even of the stock market crash of 1929 that marked the onset of the Great Depression of the 1930s. All of these episodes occurred at time when inflation was low and stable. At the same time, the Bank of Canada’s success in controlling inflation has been matched in many countries, to the point that monetary policy appears almost routine.

This combination of circumstances has led to a new interest in financial stability among central bankers, and a debate is beginning about what they might do to enhance it. No serious commentator is suggesting that inflation targeting should be abandoned for more ambitious goals, but there are those who suggest that existing regimes ought to be modified at least to the point of taking more notice of asset price behaviour, and others who argue that, sometimes it might be appropriate to trade off a little short term inflation stability in order to pre-empt financial market problems before they become acute.

This Commentary argues that monetary policy makers should think several times before becoming more ambitious in their goals. It notes that central banks already have all the powers they need to prevent financial market collapses getting out of hand in the wake of asset-price bubbles. In their role as lenders of last resort, they can and should be ready to provide ample liquidity to markets in such circumstances, measures which the Bank of Japan failed to take in the early 1990s. The Bank of Canada should stick to the single basic task of targeting inflation, while always holding lender-of-last-resort powers in reserve.

The Riksbank’s Stefan Ingves and the Bank of England’s Mark Carney should read David’s paper before talking more about macroprudential instruments and credit bubbles.

HT David Laidler

PS Tomorrow I will be speaking at the Financial Times’s CAMP Alphaville conference. See the programme here.

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