The amount India is putting into capital expenditure – mainly large-scale infrastructure – has been falling steadily, even as the government devotes more money to welfare projects.

While the welfare might be necessary, Sabyasachi Kar, who holds the RBI Chair Professorship at the National Institute of Public Finance and Policy, insists that India will have to find a way to spend on infrastructure again if it doesn’t want to be stuck in a low-growth trap. But with tax revenues falling and private investment declining, where will the money come from?

A recent blogpost by Kar envisions a new compact between the Reserve Bank of India and the Centre, in a way that keeps inflation in check while also providing more money for capital expenditure. His proposal, an “Augmented Flexible Inflation Targeting Framework” attempts to balance political and policy tensions while offering a blueprint to put India back on a high-growth path, albeit with a very unusual arrangement.

The post has prompted much discussion – see pieces by Andy Mukherjee and V Anantha Nageswaran – on how India should rethink its approach to inflation and growth, which we dig into below. spoke to Kar about the need for economists to consider political implications, why he believes it’s more important to think about “deals” than “rules” when looking at developing nation economies, and what he sees as the fundamental problems in the current government’s economic thinking.

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Could you tell me a little about your professional background and how you think about the Indian economy?
Well, professionally, I currently hold the RBI Chair Professorship at the National Institute of Public Finance and Policy. Previously, I was a Professor at the Institute of Economic Growth. For a very long period from around 2005 to 2015, I was working quite closely with the Planning Commission, providing them with macroeconomic inputs for the five-year plans, based on a macro model that I ran at the Institute for Economic Growth.

During this stint, I got very good exposure to how policymakers think of the problems that we academicians tend to think in a slightly different framework. And then, since 2013-14, I’ve been part of a large consortium based in Manchester University, which basically wanted to set up a framework where economic policies are rooted in the underlying political economy.

I joined NIPFP in July, 2020. This is only my second job. I’ve always worked in the Institute of Economic Growth before this. And one of the reasons I wanted to join NIPFP is because they do a lot more work which is closely related to policy. And this will probably help me understand the policymakers’ mind and their requirements a bit more. So, roughly you can say it’s been a journey for me from economic theory to policy.

I got a sense of your thinking from your book, The Political Economy of India’s Growth Episodes (co-written with Kunal Sen), but how would you describe how it differs from conventional wisdom about India’s economy?
About the economy, let’s think of it as a tree. We have roots which you don’t see and then you have a trunk and then you have branches. And conventional economics has basically been all about the branches. Only recently has economics started realising that it has to go deeper.

And so, there has been a move towards what is being called new institutional economics, where the institutional underpinnings of standard economic analysis are being researched, and the questions are now deeper. In economics, for example, you could ask questions like, why is trade not very high in a particular country or why is employment growth not up to the mark? And the answers that standard economics will give you are in terms of the incentive disincentive structures in these sectors.

But that only pushes the question back one level because then the question becomes why the incentive structures are the way they are. And then we start thinking about the institutions – in economics institutions do not mean organisations, but basically a set of rules that economic agents follow, so you could have the financial sector as an institution.

So, the institutions become more important and the more important questions have now percolated to the institution level. Now at the cutting edge of the subject is the understanding of what sets up these institutions.

And that’s where political economy comes in. And those are like the roots of the tree – where the institution is like the stem, the political economy is like the roots. That’s how I see the whole structure. So the political economy is at the base.

Do you think that not enough economists look at this structure as a whole?
Economics as a subject is, actually, still in its infancy. We have yet to work out a lot of questions, and we have yet to answer a lot of questions. The challenges as opposed to say physics, where the laws of physics do not change, over short periods of time in the economy, everything is changing. I would say that there is a sense in the subject, that we now need to go look at deeper questions.

The problem is economics as a subject has not yet been able to work out the framework in which some of these issues can be analysed. The basic framework that economics has developed over a century is based on incentive structures, and how individuals react to those incentive structures.

But in political economy, the most critical idea is the idea of a power relationship. Which basically means that individuals in many cases do not make their choices. Somebody who’s more powerful – political power or money power – makes choices on behalf of other people. And this is a framework that’s still not there in economics.

This is the future direction of research. But I don’t think we can, as policymakers or policy analysts, wait till the subject has properly theorised all of this. We have to bring in our ad hoc ideas and try to make sense of what’s happening using all of these ideas .

So how does your framework view the economy?
The most important idea that we have in our framework is that as opposed to what standard institutional economics describes as rules – legal rules or administrative rules or regulatory rules – what we try to highlight is that in developing countries, these rules are for the most part what we called de jure. They are there only in law and the de facto outcomes are determined by what are called deals.

Deals are a substitute for rules for economic agents. For any constructive economic activity to take place, you need some kind of property rights. Right now in a developed country and in the standard literature, this is ensured by the rule of law. But in developing countries, our legal institutions are weak. Our regulatory institutions are weak. Our state capacities are not very high.

So what happens is these are substituted by deals between powerful elites, like political elites or, say, in Italy, entities like the mafia. So whoever has sufficient power in a developing economy provides that guarantee to individual producers, farms, etc, that they can carry on their activities. And the quid pro quo could be in various forms.

We know, for example, of the close nexus between politicians and industrialists in some of these developing countries, what is called crony capitalism, right? The quid pro quo could be in many forms, but basically what happens is that the political elite provide these guarantees and, in exchange, they get something out of it. So that’s why it is called a deal.

Typically in a rule, you’re not supposed to make a payment against what you get. But a deal is a two way process. And also a deal is different from a rule in that everybody doesn’t get the same deal. So, there will be preferential deals for some people. Whereas in a rule-based world, everybody gets rights in the same way.

So this is the framework. We go on to show that, given this framework, there is a very high chance that developing countries will go through booms and busts of growth and development. So, some of these political elites provide a certain amount of guarantee to the business elite. Because there’s a quid pro quo those might be in sectors where they can make high profits, perhaps profits that are larger than should be happening in a healthy economy.

And what happens is that typically this kind of thing gives rise to certain booms in this country. But inherently there are inbuilt reasons why these booms cannot be sustainable long-term booms because they’re not healthy. So either because of economic reasons, because they run into certain bottlenecks, or because of political reasons because they run into scams or the kind of thing that happened in India between 2010 and 2014 which leads to some kind of political backlash, the boom fizzles out.

Our framework tries to highlight the fact that what is most important for long term development and long term growth for developing countries is to try and ensure that you use the deals to initiate your growth process, but you gradually have to start moving towards rules. That’s the only way in which you can avoid this boom and bust cycle that we see in so many countries in developing countries.

What has been the Indian experience?
I see the Indian experience in the last, let’s say the post-reform period, as exactly following such a boom bust cycle. What I argue in this book is that while the growth numbers shot up, the quality of the growth was questionable, and as a result, it led to a bust. And, as I see it, you know, we have never really got out of this bust.

The political backlash that followed the court cases and the so-called 2G scam and all those things that happened between 2010 and 2014, they not only put an end to some of those allegedly unscrupulous deals, but they put a question mark on deals themselves.

And I think what has happened is that we have not really been able to restart the growth process. In terms of macro variables, to my mind, the biggest one that is causing a problem is the fall in private investment. And I think a major reason behind this is because these institutional problems have not been resolved.

In fact, if anything, the way the GST has worked, or even the demonetisation episode, they have only helped in making the deals in India more shaky. Even the current government, despite having a majority, finds it very difficult to actually initiate those institutional processes which can restart investment and growth in this country.

Towards the end of the book, which came out in 2016, I got the sense that you were cautiously optimistic about the then-new government in India. But no longer?
The period that led to the bust is roughly around 2010 onwards. And that happened because of all these court cases, plus the media was very active in that period, plus we had the Anna Hazare movement, etc. But subsequently, our cautious optimism was because once there was a majority government, after 2014, and a prime minister with a lot of experience of running a state, we had a feeling that we got out of the policy paralysis and that the government was moving towards a more active policy role.

But the problem was that, I think, partly, the approach to economic policy in this government has been driven very largely by bureaucracy. And that has not been very pro-business. And, you know, by pro-business, I’m obviously not talking about a few top firms. You have to look at what the average businessmen is facing and even what the small and medium-sized industry is facing.

The bureaucratic approach to policymaking has not been very business-friendly, rather, it has focused too much on rules. So for example, one of the main programmes was trying to get better at the Ease of Doing Business ranking, and they did spectacularly well in that. But that means very little on the ground.

The other problem is I think that the basic economic philosophy of the government is they have a very strong belief in pure private sector-led growth. But what is very clear, and this is not only in India, but in many developing countries, is that the private sector needs very critical inputs from the government. And this is where my paper on monetary policy also comes.

I think the government has given the signal that it wants to allow the private sector a free hand to bring back growth in this economy. But that’s clearly not working.

That brings us nicely to your latest idea. You begin that blogpost, which has got a few people talking, with a “macro policy conundrum.” Could you explain what that is?
Let’s go back a little bit historically. For the longest period, before the reforms, it was felt that the government needs to be what Nehru called the commanding heights of the economy. Increasingly, what was happening is that the commanding heights basically started becoming the power-broker. And so we ran into a situation where the private sector was not being able to play the role that it should play in the economy.

We had the reforms in the backdrop of this situation and we got excellent results very fast. A generation grew up with their lives completely changed, and with a huge amount of trust in private sector dynamism. I told you I was working for a long time with the Planning Commission, and some of the discussions there would be, can we sustain this 8% growth path that we are on for 30 years?

The idea at that time was that we are already on a high growth path because of private sector led growth. And it’s not going to be very difficult to sustain. But that’s not the experience of most countries in this world. What happens in reality is that you get episodes of growth booms when certain constraints are lifted.

So in our case, the ’90s reform lifted a set of constraints and that gave rise to a certain growth impetus. But then we have reached a point where for sustainable and constructive and healthy growth, we do need other factors coming in. And that is where the role of the government is again becoming important.

Now coming to macro policy. The basic idea was if you have enough supply side reforms, then the growth will be driven by the private sector. And by its very nature, private sector growth is cyclical. And so the role of macro policy then, whether its monetary policy or fiscal policy, is basically to manage the cycles.

So what happened in India is, we moved from the idea that macro policies are basically developmental, which was there before the reforms, to macro policy being completely about demand management. But that is where I think we are now running into a bit of a problem because in a developing country, something as important as macro policy cannot only be about demand management, it has to think of developmental objectives as well.

But we have put in place certain frameworks – inflation targeting and the FRBM Act – which are actually detrimental to those objectives. We have tried to control the extent of the size of the government through FRBM. And we then try to incentivise growth in the monetary framework through interest rates, etc. Now, clearly, that’s not working. We have done all that. And yet we have run into relatively low growth episodes.

It is my understanding that in order to get out of this growth trap, we have to be more innovative and creative with our macro policy. So the conundrum is how we can think of our macro policies in a way that they continue to play their role in demand management but also not become completely useless as far as our developmental approaches are concerned.

Now, there is an additional problem which has made this problem critical. Which is that as the reforms have given rise to high growth rates, they have not in fact, given rise to similarly high employment growth . And inequality has gone up. So the political pressures on whoever is in government has been to increasingly compensate for this.

So, if you want the high growth rate not to be disturbed, then the distress has to be somehow managed. And what that has done is basically it has led to even more revenue expenditure and less capital expenditure. So, our macro framework, the FRBM framework, is already constraining the size of the government expenditure. And on top of that, even in the limited expenditure that the government undertakes, increasing parts of it are revenue expenditure because of the political economy of our growth. So, this is the conundrum.

A building being constructed in Mumbai. Danish Siddiqui/Reuters

You’ve proposed a solution to this, in which the RBI keeps a standing facility of funds available to the government for capital expenditure, but only on certain conditions. How would you explain your Augmented Flexible Inflation Targeted Framework?
Many studies have shown that building infrastructure is an absolute necessity for private sector growth to itself become sustainable. So even if we want the private sector to be the engine of growth of the Indian economy, we cannot do it unless a minimum amount of infrastructure is available.

Capital expenditure as a ratio to GDP has fallen to as low as you know, close to about 1.5% today. Even in the period before the global financial crisis it was about 3%. So, there has been a drastic fall in the capital expenditure ratio. If we want to boost private sector led growth, only part of the story has to be in terms of structural reforms that are still an unfinished agenda, but structural reforms by themselves will not give us our full potential.

We need this other input from the government, including infrastructure expenditure, etc, which has now started dwindling. With Covid, there is even more pressure to go in for more and more revenue expenditure. I’ve read that the government is considering an urban employment guarantee on the lines of NREGA.These are all perhaps required because of the distress. But we also need to be aware that what is happening is that we are basically focusing on the short term solutions only.

Unless we get growth back, even these revenue expenditures – what Rathin Roy has called the compensatory kind of expenditure – are not going to be sustainable. So, we have to get the balance back between the short term and the long term.

There are two tensions that I see. One between carrying out short-term welfare and the requirement of increasing long-term investment. The other tension is between foreign capital and domestic capitalists.. India has now reached a situation where we are part of international financial systems, we cannot make economic policies without considering the implications in terms of international financial flows.

And at the same time, we also have to keep in mind the requirement of domestic capital, the production base that we have, which wants this infrastructure. There’s a tension here as well. If you want to fulfil the wishes of domestic capital, you need to go in for more infrastructure creation, but more infrastructure creation means higher borrowing by the government – which foreign capital is very uncomfortable with. So, my approach has been to find out how to balance these different objectives.

What I have proposed in the Augmented framework is that the RBI keeps a standing fund which can be used specifically for creating infrastructure by the government. And there are a lot of conditionalities that have been put in. And these conditionalities have only one role – to ensure that foreign capital and rating agencies can see that this kind of monetisation is very different from the experience of monetisation that we had in the past, before reforms, or even afterwards.

It’s very important to, you know, make it very clear to the foreign rating agencies and funds etc, that this is a very different animal, it’s an animal that works within a certain framework.

So I have tried to balance in this framework each of these two tensions that I described. The rating agencies will have some comfort that this is not fiscal profligacy or going to lead to very strong inflationary tendencies. So, I have couched it within the inflation targeting framework.

In case there is any inflationary tendency this fund will immediately be stopped. And on the other hand, it also provides what domestic capital wants, which is expenditure on infrastructure. So, that’s a balance between domestic and foreign capital.

The other tension that I balance is between the government’s revenue requirement for reasons of the political economy, and its ability to undertake capital expenditure of its own choice. You will notice that what my framework does is that the RBI provides the funds, but the choice of infrastructure policy is still with the government because that’s what we have in a democracy. So whether it will be rural roads or big highways or whether it be ports, that’s up to the government and they are ultimately answerable.

But at least, you know, it allows the government to have a sustainable set of policies where they can continue with welfare measures in the short run without giving up on the longer run,

It’s easy to criticise this framework from both sides. But the main objective is to balance between the tensions. It will not be a perfect solution. But it will be able to give all sides something to work with.

This is an innovative, unconventional solution, which also means it will be difficult to convince the central bank and government and bring into being. How do you see things panning out if we don’t make changes like this?
There are two sets of forces that influence policymaking in India. One is in the realm of politics, and the other is in the realm of ideas. Now, as far as ideas are concerned, and as I have also clarified in the blog post, this is an unconventional idea. And so it is understandable that policymakers will be sceptical of anything that’s untried or different in the beginning.

But what I see is that this kind of approach is now sweeping the world. Increasingly, developed countries are finding out that the inflation targeting framework that they initiated is now not working so well for them. Increasingly I find that they are now coming around to the view that some kind of coordination between monetary policy and fiscal policy is going to be necessary moving forward

I think this new way of thinking is going to ultimately permeate down to developing countries as well. I see this as a process where the extreme rejection of ideas associated with direct monetisation that we had previously are going to be rethought. And we will realise that we can afford to frame policy in a way where we can avoid some of the problems of the past and still make use of some of these ideas, including some extent of monetisation.

I think even if it takes a little bit of time, we in India will also start rethinking our own approaches to this.

That is the realm of ideas, the other is the realm of politics. And that, I think, is also going to happen. If it is 1.5% capital expenditure as a percentage of GDP today, and if we’re going for more and more of these welfare programmes, you’re soon going to reach a point where the government will find it is unable to fund any capital expenditure.

It has worked around this in different ways. It tried these public-private partnerships and more private participation in infrastructure. And that has been disastrous. The biggest NPAs are in some of the infrastructure sectors.

In politics, you always take decisions that are very short term – till the next election – but sooner rather than later we’ll have to address this. So I think it’s a question of time before they open up to these possibilities.

Union Finance Minister Nirmala Sitharaman, flanked by her deputy Anurag Thakur and a team of officials, poses with the Union Budget documents at Parliament. Manvender Vashist/PTI

Considering the tumult that has overtaken government-RBI relations over the last few years, and the lack of trust in independent institutions, plus – as you said – a bureaucrat-led approach, do you think this is actually viable?
As a student of political economy, my theory always tries to take into account political implications. I think a theory which does not pass the test of political practicality is not a good theory.

As I said, I think politics itself will pressure the governments towards a solution to capital expenditure one way or the other. And it is my duty as an academic to throw up various ideas which they could think of. I do not think of this as a finished product that is, you know, absolutely ready to be implemented within a day,

The bureaucratic approach is mainly focused on the day-to-day running of government, but the big decisions are still political. And so, if the political imperative makes our political leaders and our government realise that they have to do something, then all that the bureaucratic framework can do is at most not implement it perfectly.

Now, here is my submission to all the people who have pointed out that this is not a perfect framework. I would argue that that’s not a bug but a feature of the framework. That’s exactly what it is supposed to be.

I’ve deliberately created a framework which is flexible. And, it is not perfect from any one particular point of view. But it keeps enough space for different objectives to be fulfilled.

In economics, we talk in terms of first-best and second-best solutions – this solution is not the first-best solution. In terms of conventional economics, the first-best solution would be that the government is able to carry out capital expenditure from its own budget. And to that extent, I’m not even claiming that this particular facility will substitute that capital expenditure for the government.

The government should, and I’m hoping it will, still carry out capital expenditure simply on the basis of its own budget. In fact, I have put in a suggestion about a clause that can be added, to you know, make this a matching expenditure to the government’s own capital expenditure in case the government thinks that since there is a readymade fund for capital expenditure, why budget separately for capital expenditure at all.

As for the bureaucratic approach, India’s state capacity is actually much better at the top. It gets worse as we go to the bottom. So programmes which are implemented at the bottom levels of the government do far more poorly. But most parts of this monetary policy framework deal with a high level bureaucrat. Decisions by the central bank on how much to give to the government and when to stop it are taken by top level central bank people or maybe a committee, where I don’t think capacity is really a problem.

And then it goes to the government. The only additional thing is that there needs to be some kind of monitoring to ensure that leakage into non-capital expenditure is minimum. That might need some capacity building.

The problem really lies with whether the government will like the RBI oversight in deciding how to use the fund. This question is at two levels, one is whether they will at all implement such a rule, and the second is even if they do implement it, will they follow it up properly.

If you compare this with the inflation targeting framework that we have now, that also had a similar history. We had a few episodes of extreme inflation following our approach to the global financial crisis. And the government was under pressure because of that inflation to adopt the current framework. So it was political pressure as well which led to this idea of inflation targeting.

By the way, I read recently that the Finance Commission is considering making the fiscal deficit target a range rather than a fixed amount. I really don’t see how that will help, because if there is pressure politically to carry out more and more revenue expenditure, then even if you have a range, basically the ceiling of the range will become the target. This will also not ensure that there is more capital expenditure, because this pressure for revenue expenditure will claim all the extra funds this range will allow .

So, we need to have a solution that ensures capital expenditure, and I have provided one. The Government can think of others as well, but I don’t see any sources of funding other than from monetary policy.

I think if the pressure is high, they will adopt it. And then we’ll have problems of implementation, the way we’re having problems of implementation with the current framework. My argument there would be that even if implementation is not perfect, I think we’ll still have substantial capital expenditure. I don’t see a situation where the government will take all the money and put it completely into revenue expenditure.

Basically, I’m trying to argue that in economics we do not always have first best solutions available, and we have to have solutions that are complex, and perhaps second best. And I think as long as it is fulfilling our main objective, which is to try and bring back infrastructure projects, and as a result, together with other reforms bring back private sector investment and growth, I think our objective is fulfilled.

I would be happy to dig in more, but we’re running out of time, so our standard final question: What other reading would you recommend someone who is interested in this subject?
Here are some recommendations:

  1. The Political Economy of India’s Growth Episodes, by Sabyasachi Kar and Kunal Sen, Palgrave Macmillan, 2016. (This book discusses the growth boom and bust in India. A shorter version is the article, “Boom and Bust? A Political Economy Reading of India’s Growth Experience, 1993-2013”, Economic and Political Weekly, Vol. XLIX, No.50, 2014)
  2. Dealing with the next downturn: From unconventional monetary policy to unprecedented policy coordination”, Bartsch, Elga, Jean Boivin, Stanley Fischer, and Philipp Hildebrand. Macro and Market Perspectives (2019). (This article by some of the most experienced central bankers and respected academics in the developed world discusses the need for a fiscal-monetary coordination and proposes a framework that have inspired my proposal)

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