MMT at Work: The Case of India

In my mind, the best example of applying MMT, while juggling structural inflation and balance of payments constraints, is India since 1980. Before I delve into the main story, a 5-minute tour of modern Indian economic history.

Until 1980, India was stuck in what was pejoratively termed the "Hindu rate of growth" by economist Raj Krishna. It is now widely acknowledged that growth took off in 1980, although in popular commentaries 1991 is seen as the watershed year. The chart below and more sophisticated tests show that there was a trend break in growth around 1980.


 
However, there is considerable debate about the causes of the growth takeoff in the 1980s and whether it was sustainable. Many, perhaps most, economists believe that the 1980s growth was unsustainable, fueled by a rapid increase in government spending and deficits. The deficit-spending spree led to a steep rise in government debt, rising inflation, and a worsening current account deficit and foreign currency debt culminating in the 1991 BOP crisis. The major dissenters from this view are the current CEA, Arvind Subramanian, and his co-author Dani Rodrik, who argued that the 1980s growth was not driven so much by old-fashioned Keynesian stimulus but by a more business-friendly attitude of the Indira Gandhi government.

Post-Keynesians predictably have a different take on the entire growth take-off story. Kevin Nell has a few papers arguing: 1) India was demand constrained in the 1952-1979 period, and fiscal expansion took the economy closer to potential; 2) India faced a BOP constraint on growth that was significantly eased by the surge in exports post 1991; 3) the post 1991 export surge may have had a demand-side explanation. I largely agree with Nell's analysis, although I disagree with him (and others) about how much the 1991 BOP crisis was the result of "unsustainable" growth in demand.

I am going to look at the India experience from the MMT angle of government deficits and sector financial balances. Since 1980, India has in effect followed the prescriptions of functional finance--generally pursuing fiscal and monetary policies that support high growth but turning attention to inflation-fighting and BOP concerns when needed. This strategy has actually allowed India to address poverty alleviation while delivering solid returns on capital (India has been one of the best in delivering dollar-based returns over the past 25 years).

Evolution of Fiscal Deficits

One of the most striking things about India was that the gross public sector deficit (the public sector includes the central and state governments, departmental enterprises, and public sector corporations; deficits are gross investment less gross saving) scaled to GDP has been permanently higher since 1980 (chart below). Only in one year, 2007-2008, did it fall below the peak of the pre-1980 range; in every other year since 1980, it has been higher than the peak of the pre-1980 range. Yet, this period has also coincided with the takeoff in the India's GDP from the previous Hindu rate of growth. One cannot establish that the deficits caused the growth ( I am working on a paper that seeks to establish this more formally--anyone interested in collaborating please email me), but such a chart has to warm MMT cockles. 

At the same time, whenever faced with rising inflation, the government has throttled back. As the chart below shows, deficits have contracted whenever inflation has accelerated. This is straight out of the MMT playbook. The glaring error was in 2010, when deficits remained high despite surging inflation.

Meanwhile, government debt scaled to GDP has been relatively stable for nearly 30 years, except for the brief run-up in 2002-2003. Monetary policy may not have completely followed the prescriptions of functional finance, which is to conduct interest policy with a view to making debt sustainable, but it sure appears to have been doing something close.

One other point that supports the MMT view that government deficits are different from an expansion in money and credit brought about by private sector credit expansion. The Indian government nationalized 14 major banks in 1969 in order to make credit more widely accessible and to make "banks serve the needs of the nation." Nationalization appears to have been a factor in driving faster credit growth. M3 (which is a proxy for broad credit) scaled to GDP appears have had a trend break around 1969-1970, as the chart below shows. Yet, neither did GDP pick up nor did poverty decline in the 1970s.

The 1970s also illustrate the importance of supply side reforms to go along with demand push. In the 1970s, the government had terrible policies that hobbled the supply side: 1) harsh implementation of the monopolies and restrictive trade practices act that made plant sizes uneconomical and licenses hard to obtain, and 2) draconian controls that squelched imports of needed capital goods. Thus, inflation soared (of course, the oil shock of 1973 and poor monsoons aggravated matters). In the 1980s and much more so in the 1990s, the government eased supply-side constraints, allowing demand push to result in higher growth. Only demand push without supply side reforms would have been dissipated in higher inflation as in the 1970s.

Growth has been the Biggest Factor Driving Down Poverty

India has made remarkable progress in reducing the poverty rate over the past 35 years. The biggest factor driving the decline in poverty is economic growth, as the chart below shows. There was very little progress made in reducing poverty until 1980 despite the plethora of so-called poverty alleviation programs. 

Return on Capital has also been Solid

Since 1995, in dollar terms, Indian stock market returns have almost matched the S&P 500 and handily beaten the world and other emerging markets.

I have argued elsewhere that Indian equities have also outperformed gold since 1979. Lastly, India's public provident fund (PPF)--a tax-advantaged small savings vehicle fully guaranteed by the central government--has outpaced gold and provided modest positive, real returns.

In short, India has not treated capital too shabbily.

India has also adopted another MMT favorite--job guarantee--in a limited way in the form of MNREGA. The present government has tried to ensure that MNREGA employment goes toward building assets in the form of rural infrastructure. (I am personally ambivalent about job guarantee.) 

I am pretty sure that most Indian policymakers would be aghast to know that India has actually been following the prescriptions of MMT all along! 

Data Analysis Ahead of Theory

Almost everybody agrees that we need to rethink macro. Of course, there is very little agreement about what that rethinking will involve. Predictably, there is a strong desire on part of the "mainstream" to cordon off the debate, to assert that it is all in there in the mainstream papers, we just need to rediscover them. I propose a different approach. A moratorium on macro theory, at least for now.

A little over 30 years ago, Ed Prescott, proclaimed that business cycle theory was ahead of measurement. Although he said it because the data kept rejecting his pet theories, he was probably right about macro data, which was uninformative. Yet, today we have reams of micro and disaggregated data that are being used to inform the macro debate. Mian and Sufi of House of Debt fame are pioneers in this regard and many others have since followed suit. Not just micro data, researchers are able to use macro and macrofinancial data more effectively. It is theory that is still in the dark ages. So, let us focus on more data analysis and try to build a consensus on a new set of stylized facts. Then perhaps we can think of building theories.

In that spirit, I am going to compile a list of stylized facts based on empirical work of the past several years.

1. Demand has Persistent Effects

Since Samuelson's neoclassical synthesis, mainstream economics has generally operated on the principle that demand matters in the short-term but not in the long term. Theories have been updated to DSGE compliant NK models, but the principle of demand being a short-term phenomenon has remained constant. Post Keynesians have always disagreed with the MIT Keynesians in this respect. Yet recent empirical work almost unambiguously shows that recessions have persistent effects on unemployment and even on the long-term trajectory of output.

2. Fiscal Policy is Effective in Recessions

Until the Great Recession, the standard macropolicy consensus was that fiscal policy had no role in macro demand management, that monetary policy alone could steer the economy to nirvana. Most believed in what is called monetary policy dominance--that is monetary authorities would take into account fiscal actions and offset them. Outside of a few unreconstructed market monetarists, nobody now believes that because the data is simply overwhelming. Several studies show that a) fiscal policy is quite effective in recessions, and not just recessions at the zero bound, b) monetary policy does not come close to offsetting fiscal policy, c) fiscal consolidations have persistent negative effects on output whereas fiscal easing in recessions actually improves debt.

3. Private Debt Matters, Public Debt Not So Much

Private sector debt in mainstream theory was seen as an epiphenomenon. Macroeconomics has generally worked under the assumption that the financial dimension of the economy has no bearing on the working of the real economy. Balance sheets merely reflect the real economy. Buildup in private debt is of no consequence because defaults would just transfer wealth from creditors to debtors. Bernanke, Krugman, and others in their dismissal of Minsky's validity for understanding debt deflations have argued that private debt could not possibly matter on a scale large enough to cause depressions. On the other hand, fear of public debt as some sort of a burden was well-entrenched. Recent empirical work have turned both of these findings on their head.

Macrofinancial studies have consistently shown that a large buildup in household debt is often a precursor of financial crises and poor future economic performance. Meanwhile, Mian and Sufi have documented the channels through which debt and leverage work their way.

On the other hand, the dubious work of Rogoff and Reinhart combined with the fact that actual economic and financial markets outcomes have belied the public debt worry-worts has called into question the conventional wisdom about sovereign debt and default.

4. How Does Monetary Policy Work?

The general consensus seems to be that money is neutral in the long run and that monetary policy works by lowering the cost of capital (or expectations). The great inflation of the 1970s further reinforced the then emerging consensus that the job of the central bank is to deliver low and stable inflation and that everything else would take care of itself. Yet, the apparent failure of central banks worldwide to hit their inflation targets and the supposed failure of the Phillips Curve is causing some soul-searching. Meanwhile, empirical works suggest that inflation targeting does not work the way it is assumed to work, that the costs of inflation vastly exaggerated, and that the cost-of-capital channel of monetary policy may we weak.

There is increasing evidence that the expectations formation process is complex and informational rigidities abound. Not surprisingly, inflation targeting does not appear to anchor expectations in the ways widely assumed in New Keynesian models. Nakamura and Steinsson, in an excellent paper, find that the costs of inflation assumed by the standard policy models are elusive in practice. They also find evidence of non-neutrality in high-frequency data. Meanwhile, survey data suggest that business capital spending plans are not sensitive to the cost of capital—another presumed benefit of low and stable inflation. Moreover, a slew of papers finds that corporate capital spending does not respond to Q in ways predicted by conventional theory.

Concluding Thoughts

We may well be reemerging from the dark age of macroeconomics—a phrase memorably coined by Paul Krugman in 2009. The Peterson Institute for International Economics recently held a conference “Rethinking Macroeconomic Policy” that had an agenda questioning almost all aspects of the received wisdom of recent decades. The IMF too has been reexamining the consensus views and increasingly arguing for expanding the policy arsenal. Macroeconomists are discovering—rather rediscovering—that monetary policy alone cannot deliver stability and that fiscal policy and macroprudential policies have important roles to play. In treating finance as an epiphenomenon and money as a mere veil, Dark Age macro contributed to the Great Recession and its aftermath. Hopefully, we can now put that chapter behind us.

However, it is imperative that we keep the data horse in front of the theory cart. In this regard, I would like to point out the difference between ancient Greeks and ancient Indians in their approach to astronomy and astronomical measurements.

Needless to say, the Indians were far more accurate. In fact, their accuracy was not matched in the West until the 18th century.