This monsoon compensation model was never estimated but the conceptual structure does give an indication of the drivers of macroeconomic policy then. The challenge of short-term macro-economic management is now radically different and must take into account the following key difference between then and now:
In the mid-seventies agriculture constituted 38 per cent of our GDP. Now that proportion is down to around 17 per cent of GDP. Monsoon compensation or income shifts arising from changes in the agriculture-non-agriculture terms of trade are not as important a consideration for macroeconomic policy.
Exports and imports were 41 per cent of GDP in 2016-17 as against 12 per cent of GDP 40 years earlier. With a much larger part of the economy connected to the world economy and far fewer quantity controls on foreign trade, exchange rate management and fiscal and monetary policies that affect relative domestic costs become an important part of macro policy.
From the international side, another major change is importance of private international capital flows. In the national accounts the net inflow of capital from the rest of the world as a proportion of gross fixed investment averaged to 6.8 per cent during the first five years of this decade. The gyrations of the share market are heavily influenced by foreign portfolio flows. Hence, the impact of macroeconomic policies on foreign perceptions acquires additional salience.
In 1976-77 public sector investment was 9.8 per cent of GDP while private corporate investment was just 1.5 per cent of GDP. Managing investment 40 years ago was an internal public sector exercise. This direct ability to manage aggregate investment has been diluted by the shift in these proportions to 7.4 per cent of GDP for the public sector and 11 per cent for the private corporate sector.
Clearly, we need a different approach to macroeconomic stability in an economy that is more open, more private sector oriented and much less monsoon dependent. On the analogy of monsoon compensation we can conceptualise macroeconomic policy in an open economy as world economy compensation. This requires a clear understanding of the links between exchange rates, foreign capital flows and domestic aggregate demand supply balance.
A useful framework thinking about this is provided by a diagram first formulated by the Australian economist, Trevor Swan.
1963, in H Arndt and W Corden’s The Australian Economy.
This diagram (with the original terminology modified slightly) has relative domestic prices on the vertical axis and the fiscal deficit on the horizontal axis. If domestic costs are high relative to foreign costs, there will be a current account deficit and, to ensure that domestic demand equals full employment supply, the fiscal deficit would have to be higher. That is why the internal balance line slopes upwards. The requirement for external balance is the opposite — high relative domestic costs require a tight fiscal policy to contain demand so as to keep the current account deficit in check.
Above the internal balance line there is a deficiency of demand and below it, a threat of inflation. As for external balance, above the line relative costs and/or the fiscal deficit are at a level that would lead to a current account deficit, and vice-versa below the line. Swan’s diagram was developed for a small economy with free capital flows. Hence interest rates were assumed to be set exogenously by global conditions and the need to prevent reserve depletion.
There are some modifications one has to make to apply this framework in a global economy where private capital flows have increased manifold relative to those 40 years ago. Interest rates have become an important macroeconomic policy variable and one would want to add a third axis to the domestic interest rate. External balance would now be not just on current account but also on capital account with interest rates affecting not just domestic demand but also foreign capital flows. As for internal balance, the impact of interest rates would be not just on current demand but also on growth potential.
Applying it to Indian conditions today one could argue that we are in the top quadrant — demand deficiency and a current account deficit. Moving towards a balance requires an exchange rate policy that improves relative domestic cost advantage that boosts exports and, if that is not enough of a stimulus, then some more demand boosters would be needed from fiscal measures and an interest rate reduction (controlled enough to calm nervous foreign bankers).
The broader policy message is clear. The pursuit of macroeconomic stability cannot be based on simplistic fiscal deficit or inflation targets. Exchange rate management, the interest rate set by the central bank, the fiscal stance of the government must be set in the light of prevailing global and domestic conditions rather than be bound down by unconditional rules.
Trevor Swan and I overlapped for a year at Southampton University in 1968. He had one of the sharpest minds I have ever known. As a “remembrance of times past” I offer Swan’s Way of explicating internal and external balance as a useful tool for thinking about macroeconomic policy today.