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S. Venkitaramanan

Germany's fiscal deficit being close to the prescribed target of 3 per cent, the EU has issued the defaulting country an official warning, and a fine may be imposed on it. Thus, ironically, the straitjacket that Germany had itself devised is proving tight in the current global crisis. Germany's experience should make India consider carefully before it accepts too tight a straitjacket in an otherwise inflexible Fiscal Responsibility and Management Act, which should be refined to take into account the stage of the economic cycle.

AN INTENSE political drama has been going on at Brussels over Germany's fiscal performance. The situation is replete with irony. In the mid-1990s, it was Germany that had initiated the idea of a growth and stability pact to ensure good fiscal behaviour by all member-countries of the European Union.

Doubts were primarily about the laggards, Italy, Spain and Portugal. Ironically, this device has now proved to be a straitjacket for Germany itself.

Its then Finance Minister, Mr Theo Waigel, had unveiled the concept of a pact to ensure that those countries not observing fiscal deficit targets were to be disciplined first through warnings and, thereafter, through hefty penalties involving non-interest bearing deposits ranging up to 2 per cent of GDP with the European Union.

The present crisis in Brussels was triggered by the forecast that Germany is expected to reach a deficit of 2.7 per cent, which is too close for comfort to the prescribed target of 3 per cent.

As at the time of writing, the European Commissioner has officially sent a warning to Germany, to be confirmed at the ensuing meeting of the European Finance Ministers, to be held on February 11-12, 2002.

The present European Commissioner for economic and monetary affairs, Mr Pedro Solbes, formerly a Finance Minister of Spain, has been under considerable political pressure to modify his initially strong reaction. He himself is understood to be in sympathy with the predicament of Germany, suffering from the consequences of the global economic crisis, which has led to an industrial slowdown.

In spite of his sympathies, he is faced by a dilemma. Above all, he has to appear fair in his treatment of different countries.

Observers have been quick to point out that just a year back, the European Union had administered a stiff warning to Ireland for being slack in its budgetary policy.

In the interests of even-handedness, Brussels may have to take a tough stance with Germany's anticipated fiscal default. In its latest misfortune, Germany has an unaccustomed bedfellow in Portugal.

At the time the growth and stability pact was conceived of, Germany would never have thought that the first penalty from the Euro Commission would be visited on itself. Particularly galling is this when it is facing elections. Unemployment in Germany is at a record high. The Government's limited options are confounded by the unfolding drama in Brussels.

The events in Brussels lead one to realise that while downward adjustment of fiscal deficit is difficult at all times, it is particularly so in a decelerating economy.

Brussels' embarrassment at Germany's fiscal failure — albeit anticipated — only highlights the problems that the Finance Ministers of all countries face. Germany's political bosses feel naturally that the technicians in Brussels have not been fully sensitive to its practical problems.

Indeed, the next step is to impose a fine on the defaulting country. As a result of this penalty, a country already in trouble is forced to raise resources to deposit with the European Union. Shades of the Treaty of Versailles!

The fact is that the growth and stability pact, introduced with the best of intentions, may itself turn out to be too strong a medicine.

Indeed, strong voices have been raised in support of Germany. Mr Laurence Fabius, the Finance Minister of France, who recognises that Germany and France are not too distant in fiscal terms, is reluctant to support a formal warning, especially because the policies adopted by Germany have been considered even by the European Commission to be on the right lines.

The irony of it all is that the straitjacket that Germany had itself devised is proving too tight in the current global crisis.

This is the first time that an affluent country, which has preached the doctrine of fiscal responsibility, is itself facing the strains of a self-imposed discipline, which does not make adequate allowance for the changes in global economic fortunes. These developments hold important lessons for India. Maybe, the Finance Minister, Mr Yashwant Sinha, has already got measures up his sleeve to contain the fiscal deficit. While there is no growth and stability pact as such in India, Mr Sinha has devised his own straitjacket, as the Fiscal Responsibility and Management Act is to be implemented soon. Unfortunately for him, India is now going through a deceleration in economic growth. Government revenues have failed to reach the expected rates of growth.

On the other hand, expenditure has been on the rise. Mr Sinha will most probably not be able to meet the targets of fiscal deficit, except at the cost of severe — and unwelcome — contraction of essential expenditure. Imposition of higher taxation is also inadvisable at this stage as it will surely be counter-productive. Business sentiment is already at its lowest ebb.

While fiscal responsibility as a concept of financial management is all right, it should be flexibly interpreted, keeping in view the stage of the economic cycle. It should not be difficult to sensitise the targets to this concept.

Cyclically adjusted targets for fiscal deficit are increasingly felt to be the need of the hour.

The Procrustean bed of fiscal responsibility should not prevent the Budget from being used as a counter-cyclical tool for encouraging economic revival.

Germany's experience — including its dialogue with Brussels and elsewhere — has important lessons for us.

Particularly so in the current state of global economy, where inflationary threats have receded and fiscal compression will only accentuate deflation.

Strict unadjusted fiscal targets may lead to worsening deflationary trends. Germany's experience should make India consider the whole situation carefully before it accepts too tight a straitjacket in an otherwise inflexible Fiscal Responsibility and Management Act, which should be refined to take into account the stage of the economic cycle.

These comments are particularly germane in the light of the latest report of the RBI on Currency and Finance, which has pointed out that if policy leads to a 1 per cent decrease in inflation below the threshold level of 5 per cent, the economy could find itself faced by a loss of output of 2 per cent.

There has to be an integrated monetary and fiscal policy, which concerns itself not only with measures of fiscal deficit control, but with monetary measures designed to revive the growth impulse in the economy. These are not inconsistent objectives.

Unless the Government succeeds in reviving demand in the economy through adequate investments in infrastructure, there cannot be any revival in the economy.

And without such revival, any hope of checking fiscal deficit will be an unrealistic goal.

If a conflict is perceived, as is likely, between higher investments, on the one hand, and containment of fiscal deficit, on the other, the present situation demands Government's imperative and concrete action in favour of providing public investment.

This is not an impossible option, given the abundant liquidity in the banking system.

India's policy-makers and the innovative bankers can surely evolve suitable measures to marry this abundant liquidity with the growing need and opportunity for infrastructural investment, through flotation of bond issues by public-private partnerships in special purpose vehicles for investment in Railways, roads, irrigation and urban renewal.

Of course, all this should be subject to appropriate cost recovery measures being mandated.

The rumblings at Brussels should be a wake-up call for the Government not to stitch its straitjacket of fiscal responsibility too tight, banner that it can be kept flexible to handle a cyclical downturn.

Brussels reminds us that fiscal responsibility at all costs may turn out to be too costly an option.

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