The Indian economy is currently being hit by the mother of all external shocks. With the US and the rest of the developed world in its worst recession in 75 years, and the impact being felt on India's growth, employment, exports, asset prices, and rapidly falling inflation, this is not the average downturn in the business cycle.
It is nearly certain, as confirmed by the Government's Chief Statistician, that India will face a period of deflation in the middle of 2009. Most economists tend to think that it will only be a matter of a few months before prices start rising again. Under reasonable assumptions, however, wholesale prices may show year-on-year declines from April through end-2009.
The real danger to the economy is that due to the large negative demand shock, deflationary forces get entrenched, leading to a vicious cycle of falling output and declining prices. To counter this clear and present danger, policy, especially fiscal, will have to use all its firepower to forestall it.
So, is deflation in India really possible, and why should we worry about it?
Everywhere one looks, prices are falling. From airline tickets to cars, from household goods to clothes, and from property prices to stock prices, all are seeing declines. The whole sale price index is already showing the largest absolute declines ever since the series started in 1988, falling by 2.5 per cent month on month in October, 4.7 per cent in November, and 3.9 per cent in December.
Hence, by this measure, we are already facing deflation. Going forward, falling commodity prices, the bursting of the equity and property bubble, and ongoing demand destruction, can continue the downward movement in prices which have nothing to do with a high statistical base from 2008. But why should this be a cause for worry?
Deflation hurts the economy much more than inflation, as borne out by the US experience during the Great Depression from 1929-33 when output shrank 40 per cent and nominal prices by 24 per cent, and by Japan's 'Lost Decade' in the 1990s.
Consumers postpone expenditure, because they think prices will be cheaper going forward. This affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.
A temporary period of deflation can become sustained as asset prices fall, the credit channel stops working, and people start expecting falling prices. As property and equity prices fall, they reduce collateral which shrinks the balance sheet of firms and makes banks unwilling to lend, further hurting firms.
If consumer expectations of deflation become unhinged, which can happen very quickly, a temporary phenomenon becomes entrenched.
Although in India's case the supply constraints and traditionally high inflationary expectations militate against deflation, the size of the demand shock demand can outweigh them.
At any rate, policy needs to pre-empt even a small probability of such a grave threat to the India growth story. Policy has to re-inflate and re-ignite demand. It is better to err on the side of inflation rather than deflation.
Monetary policy, although it has been loosened considerably, still has considerable room left to ease. Short-term policy rates at 4-5.5 per cent are still too high, because with deflation on the horizon, real rates will be higher still.
With lending rates still in the 12-12.5 per cent range, real lending rates in India will be among the highest in the region. Given the long lags in transmitting policy rates to bank lending rates and then to overall activity, there is merit in getting policy rates down as quickly as possible.
Monetary policy alone, however, will not be enough. Its effectiveness is constrained due to rising credit risk, which is causing a divergence between policy and bank lending rates. Therefore, cutting policy rates is necessary but not sufficient to stimulate demand. An additional constraint is that at the extreme, nominal policy rates can't go below zero, so during a time of deflation, real rates can remain high.
The onus will then have to fall on fiscal policy. In particular, there needs to be additional stimulus in FY10, over and above the big stimuli provided in FY09. There is an argument that there is no more fiscal space for further counter-cyclical fiscal policy as it would lead to the crowding out of the private sector and could lead to our debt burden becoming unsustainable. Let us examine each in turn.
In the current abnormal environment, the private sector has been crowded out already as banks are not lending to them due to high credit risk. What is of concern is that corporate bond yields are very high relative to government bond yields rather than the level of government yields itself.
Indeed, if monetary policy is further loosened, in an environment of deflationary impulses, government yields can fall further. Additional fiscal stimulus is not part of the problem but part of the solution for corporates.
Although India's debt burden will rise, what matters more for the long-term sustainability of debt is the differential between GDP growth and interest rates. It would be much worse for our debt ratio if growth rates were to be significantly lowered due to the negative shock.
As long as the fiscal expansion is temporary and helps to boost growth, it will not endanger sustainability. India's favourable demographics will also help in bringing down the debt burden. However, the expansion should be carefully calibrated with a medium-term commitment to bring down the deficit when more benign conditions return.
So what form should a fiscal expansion take?
Increased spending by the government suffers from two problems - it takes time to filter through, and there are serious problems in implementation capacity. It is preferable to have a tax cut which is quick, equitable, and can unleash domestic demand from liquidity-constrained consumers. An income tax cut would fulfil all these requirements.
A good start would be to eliminate the education cess on income tax, and provide a one-year holiday on the corporate tax surcharge in the interim budget.
To get back to 8 per cent growth, the long-term policy response has to be more structural reform. But in the short term, where falling domestic demand can complicate the India growth story, the response has to be immediate counter-cyclical easing of both monetary and fiscal policy, while there is still time. There is no use saving ammunition if the battle is lost.
The author is Chief India Economist, Goldman Sachs. The views expressed here are personal