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Fix fiscal account to tame inflation
GLOBAL inflation has remained stubborn, despite unprecedented action by central banks, leading to a debate on the underlying causes of inflation and the effectiveness of conventional tools to tackle it.
Contrary to the belief that inflationary pressures can be addressed through monetary policy alone, the role of fiscal policy in managing inflation is being increasingly discussed.
I believe fiscal policy is the main driver of inflation in Pakistan. Addressing the structural deficits in fiscal policy is critical for inflation to come down.
In his work The Fiscal Theory of Price Level, John Cochrane argues that “the prevailing inflation spurt seems clearly related to the massive fiscal expansion of the Covid-19 recession. In the shadow of large debt and deficits, taming inflation will require stronger fiscal-monetary coordination. So fiscal policy correction is important to remedy inflation”.
He says that it is becoming “increasingly obvious that current theory on inflation targeting doesn’t hold together logically, or provide much guidance for how central banks should behave if inflation or deflation do break out. Central bankers rely on late 1970s IS-LM [investment saving-and liquidity preference-money supply’] intuition, expanded with some talk about expectations as an independent force. They ignore the actual operation of the new Keynesian models that have ruled the academic roost for 30 years. They tell stories of great power and minute technocratic control that are far ahead of economists’ models or solid empirical understanding”.
Monetary policies set up at the global level over the last few decades require a weighting of the counterbalance between monetary and fiscal policies, and a deeper analysis of comparative, established and international and regional perspectives.
The dilemma is that our public debt is rising and so is private wealth, which is concentrated in a few hands.
Pakistan needs recalibration perhaps more than others as it confronts regional conflicts both communal and transnational, along with complex forms of conventional and unconventional inflations — ‘debt-flation’, ‘shrink-flation’, ‘greed-flation’ — which are manifestations of both structural deficits and post-Covid pro-cyclical policies.
The structural deficit is where the level of government spending exceeds that of taxes collected. The primary balance of government spending — where we’re struggling with the IMF target of 0.4 per cent of GDP — is related to the structural deficit.
However, on top of the primary balance are the skyrocketing costs of servicing debt. In FY2023, debt-servicing costs increased to 74pc of FBR tax revenues; in FY2024 they are likely to rise closer to 90pc. In this situation, the use of monetary policy as the sole instrument to tame inflation has not worked and has actually proved counterproductive, given the inelastic demand of debt by the sovereign to fund its deficits. The government remains agnostic to interest rates to fund its deficits, considering limited financing options, while funding needs are inevitable.
Effectively, monetary tightening has been diluted by the large fiscal deficits. Hence, inflation is being fuelled by ‘debt-flation’, with the government’s deficit financing needs driving growth in money supply. External sources of funding have dried up due to global liquidity conditions and credit-rating downgrades by international agencies. This means that nearly 95pc of the fiscal deficit is being financed by the domestic banking sector.
Currently, the ratio of public domestic debt to bank deposits is over 85pc with almost a quarter coming from funding provided by the central bank through liquidity injections. Inflation has remained high at around 30pc in 2023, with average inflation almost 4.5 times higher than the regional average.
Reduction in local currency debt can’t be achieved through restructuring, as I have argued previously. Any attempt to restructure debt without overhauling the fiscal account will be short-lived and have grave consequences on the overall economy. We can’t get carried away with temporary patchwork, like local currency debt restructuring; now is the time to take bull by the horns, ie, fiscal account restructuring.
The dilemma is that our public debt is rising and so is private wealth, which is concentrated in a few hands. The massive imbalance in our subsidy structure promotes rent-seeking by powerful lobbies. Therefore, de-leveraging is only possible through mending the fiscal account but, as experts say, de-leveraging episodes are painful, lasting six to seven years.
Typically, GDP contracts during the first several years and then recovers, but the objective should be a clear focus on long-term stability and growth; achieving responsiveness of the monetary policy to check inflation. Meanwhile, an obsession with monetary policy — and finding in it the solution to all our ills — is nothing short of disaster.
The reforms needed to overhaul our fiscal imbalances will cause much pain. But it is not a question of pain or no pain, it is about when and how we decide (or are forced to). Delay will only increase the size of adjustment needed. There are no easy paths, but some choices may be better. Each country or society faces its own moment of necessity. An immediate ‘charter of society’ on fundamental economic reforms is needed. We are standing at that juncture where rectifying our fiscal account is the only way to address our inflationary pressures.
There should be a ‘progressive social agenda of inclusivity and tolerance’ based on the redistribution of wealth. The starting point should be taxing the super-rich and untaxed sectors — real estate, retail and agriculture. This crisis might be our best opportunity to tackle these deficiencies. We must knock down the convenient myth of ‘trickle-down’ policies. Tax cuts for the richest and the latter’s capture of untargeted subsidies will only accentuate the imbalances.
Tax collection is a challenging task. But the recent collection drive — including the crackdown on smugglers and hoarders and the move to cut utilities if taxes are not paid or one is not a registered taxpayer despite the manifestation of taxable income — seems to be bearing fruit.
On the expenditure side, the time has come for fostering private-public-partnerships for the government’s own developmental projects, pension management and privatisation.
The writer is a development and social-impact focused banker and a public-sector specialist.
Published in Dawn, February 10th, 2024
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