Limitations of Monetary Policy
Part I (Economic policy choices beyond immediate crisis - I) of this series highlighted the fact that the recent monetary policy measures are important and necessary to prevent the economy from slipping into deep recession (due to the external shock) with consequent damage not just to current activity but also the potential output capacity of the economy. However, these monetary measures have their limits. First, it is not feasible to print money in unlimited amounts as the reckoning will come via higher inflation and debasement of the currency, unless the productive capacity of the economy rises enough to generate GDP growth that can absorb the excess monetary stimulus.
Second, the efficacy of such expansionary monetary policy may itself be limited by leakages in the transmission mechanism, some of which Keynes himself identified. This means that the actual multiplier effect of monetary expansion is likely to be significantly lower than policymakers' expectations and so dilute the ultimate impact on employment and income generation. Third, for countries such as Pakistan with high debt-to-GDP ratio and low tax base, authorities need to keep an eye on the debt level and debt servicing requirements which will limit fiscal flexibility required to grow the productive capacity of the economy.
Leakages in the transmission mechanism reduce the efficacy of Monetary Policy
In terms of the bank lending channel, as noted in Part I of this article, the State Bank of Pakistan's actions of reducing certain reserve requirements have increased the potential loanable funds' size by banks to PkR860 billion. The question is, how much of this will actually be added to the money supply? Keynes thought that in times of uncertainty and weak business outlook, banks would be reluctant to create new loans to the full extent possible under reduced reserve requirements in fear of impairing their balance sheets. At the same time, borrowers would be reluctant to borrow as much, given the economic uncertainty they face and their fear of getting stuck with debt that needs to be serviced regardless of their own cash flow generation prospects. On the consumer side, uncertainty would cause reduction in the desire to spend with people preferring to hold on to their cash as much as possible.
As a result of this liquidity preference by economic agents, the velocity of money (V) in the Fisher equation MV = PT, will fall such that the full multiplier impact of the easier monetary policy will not materialise. In the aftermath of the 2007-8 financial crisis, the Bank of England discovered that bank lending increased far less than it had anticipated. In the case of Pakistan, there is another twist in the tale. As a recent report by the capable BR Research Team has pointed out, the ratio of currency in circulation to bank deposits has steadily risen over the last five years. This further weakens the transmission mechanism of monetary policy via the banking channel.
In the portfolio substitution channel, there are two possible venues for leakage. First, if the excess cash is used to purchase existing assets rather than invest in new plants and productive capacity, their prices will be bid up, such as existing real estate (land and buildings) and shares. This may not translate into new productive investment such as new businesses and factories that generate employment. Second, this channel also has distributional impact. Typically, asset holders are the richer constituents of society, so asset price increases typically lead to the rich become richer and wealth becoming more concentrated. This has been the evidence from the QE experiment in most countries.
The direct or 'helicopter money' channel, while most effective as the fastest emergency measure to support a degree of spending power in the economy, also has a leakage problem. If consumers' liquidity preference increases due to economic / income uncertainty, they are likely to save a portion of the 'helicopter money' rather than spend it all, thus reducing the multiplier effect on final GDP.
Furthermore, in Pakistan there is high dependence on imports not just for raw materials and intermediate goods but also a host of finished products (either due to lack of domestic industrial capacity or inability to compete with imports on the basis of price and/or quality).That is to say, the elasticity of demand for imported goods is low, so the leakage would be through the external trade account with consequent downward pressure on the exchange rate.
In economists' terminology, there is condition known as the Marshall-Lerner Condition. Basically, it states that if the sum of export and import demand elasticities is greater than one, then a fall in exchange rate will have a positive impact of the trade balance and increase output. If the combined elasticities are less than one, then the trade deficit will widen and output will fall. Trade data over last several years post-PKR devaluation indicate this inelasticity effect to be present.
Beyond the aspect of leakages that reduces the multiplier impact of the monetary injection on GDP, there is issue of sustainability. 'Helicopter Money' is unfortunately not sustainable for a country such as Pakistan with a weak tax base and high debt levels. Pakistan is not in a position to monetise public sector debt without serious inflationary and currency instability consequences.
In addition to the leakage problem, there is also the question of how far the central bank should go in its actions to support government policy before it begins to lose its 'relative' independent status and responsibility of keeping currency stable, inflation within a certain long-term range and financial sector risk curtailed.
Fiscal policy has a higher multiplier effect when there is large output gap
Given the above limitations of monetary policy, government policymakers need to focus on fiscal policy as the main policy tool to counter second round effects as well as put the economy back on to a sustainable growth path. But this is easier said than done. It is widely accepted that the fiscal multiplier is higher than monetary multiplier especially when there is a large output gap, i.e. the economy is operating below its potential capacity. At the same time, fiscal policy can have large income / wealth distribution effects, which makes it prone to political winds much more so than monetary policy. Fiscal policy operates via taxation changes and through government spending. While there is debate among economists which route has a higher multiplier effect, there is no doubt that in the presence of an output gap GDP growth can be accelerated via fiscal policy.
In the case of Pakistan, given the low tax base, high debt-to-GDP ratio, extraordinary expense burden of high defense expenditure due to hostile neighborhood and the need for large transfers to provinces under the 18th Amendment, the space for expansionary fiscal policy at the federal level is rather narrow. Furthermore, in the coming financial year (2020-21) there will be still be a need for emergency allocations in the face of Covid-19 crisis to protect the most vulnerable sections of society from its economic impact.
The government has already put in place a forum / think-tank of recognised luminaries to identify key areas to support the economy. This is a positive first step. At the same time, if a longer term sustainable growth is to be achieved (at least 6% real GDP growth per annum), the productivity part of the equation must be focused upon. Even before the Covid-19 crisis, although the government was near achieving primary surplus in its fiscal accounts, the foundational reforms to raise productivity were not in place.
Then there is the question of execution itself. Pakistan unfortunately fares rather badly on this crucial aspect. A case in point is rural development. A 2019 Asian Development Bank report on ADB supported projects for rural uplift notes that Pakistan had the largest number of less than successful (a polite way of saying 'failed') projects - seven out of twelve, in Asia. We will examine the causes of this as well suggestions for improving productivity in another article soon. For now, it suffices to say that given the fiscal space created in 2020-21 due to lower interest expense on debt servicing after reduction in interest rates, a relatively benign inflation outlook and support from multilateral and bilateral partners to provide relief on external repayments, the government should focus on allocating certain amount of resources on longer term growth inducing initiatives.