The Hindu Business Line : Using fiscal deficit to trigger investment

The Finance Minister, Mr. P Chidambaram, always stresses that fiscal deficit should be kept in control to attain high growth rates. Surely, low fiscal deficit is seen by investors as an indicator of good governance and can help attract large levels of private domestic and foreign investment. However, it also limits the government's capacity to make investments in infrastructure such as dams and roads, which, in turn, hurts private investment. Particularly, low fiscal deficit impairs the government's ability to create more employment in the economy.

In the 1950s and 1960s, the Philips curve showed up the inverse relationship between inflation and unemployment. More inflation meant less unemployment, and vice-versa. The underlying idea was that when the government prints notes to make dams and roads, it leads to two consequences simultaneously — the rate of inflation goes up and unemployment goes down. The current thinking is contrary to the teachings of the well-known economist John Maynard Keynes. The American economy was deep in Depression in the late 1930s. President Harry Truman was following the policy of balanced the budget or zero fiscal deficit. The slowdown in the economy was reducing the government's tax receipts and Truman was cutting government expenditure in the same proportion. The economy was sinking as a result.

Both private and government demand was falling and there was a steep rise in unemployment. In this grim situation, Keynes suggested that the American government print notes and increase demand in the economy, just as a dying person is put on the respirator. Truman accepted Keynes' advice and soon the American economy started looking up.

We have before us two opposite viewpoints on the efficacy of fiscal deficit. Modern economists consider it harmful while Keynes considered it to be a legitimate tool of economic management.

Professor Edmund Phelps of Columbia University suggested that Keynes' strategy can possibly be useful in the short run but not in the long term. The beneficial impact of an increase in government expenditure occurs only if the prices do not increase in tandem with an increase in fiscal deficit.

Say, the total government expenditure is Rs 5000 crore and the daily wage of the worker is Rs 100. The government decides to print notes worth Rs 500 crore and the total expenditure increases by 10 per cent to Rs 5500 crore.

Now, the total employment will go up if the wages remain at the previous level of Rs 100; but not if the workers start expecting an increase in prices of food, clothing and housing and start demanding a wage of Rs 110 per day. The number of jobs would remain unchanged then.

The same 500 million man-days of employment will be created by a government expenditure of Rs 5000 crore at a wage of Rs 100 before fiscal deficit was incurred; and by government expenditure of Rs 5500 crore at a wage of Rs 110 after fiscal deficit was incurred. Thus, Phelps said that expectation of the people regarding inflation can undo the beneficial effects of fiscal deficit. Since, in the long run people are sure to anticipate an increase in price, the strategy of liberal fiscal policy will be ineffective in the long term. Phelps was awarded the Nobel Prize for this insight.

Impact on currency

Yet another factor against a liberal fiscal policy is its impact on the domestic currency. High fiscal deficit will lead to an increase in domestic prices and, correspondingly, the value of the deficit-ridden currency will decline vis-à-vis others.

The decline in the value of domestic currency leads to high cost of imports and, at least partially, undoes the benefit of increased government expenditure. Of course, the high fiscal deficit will take some time to translate into a decline in the value of domestic currency.

It is clear that fiscal deficit-led growth strategy, as advocated by Keynes, is beneficial only in the short run. What, then, of the American experience of the 1930s? Actually, the Depression was broken by the start of the Second World War and the generation of demand for armaments and other supplies from Europe.

The mantra of fiscal deficit suggested by Keynes only triggered this change of gear. It provided a short-run trigger to unleash long-term growth that was propelled, in the main, by the Second World War. The revival of the economy in the long run was wrongly ascribed to Keynes' formula.

Yet another factor is the quality of government expenditure. Say, it takes six months for the impact of fiscal deficit to translate into rising expectations and declining value of the currency.

Now, if the government makes investments that lead to increased production in, say, three months, then the fiscal deficit will not lead to an increase in prices. If the government provides assistance, for example, to rickshaw pullers to buy auto-rickshaws, the benefits to the economy will accrue almost instantly and such expenditure may not lead to an increase in prices. The production will increase by the time the impact of fiscal deficit is felt in the economy.

It thus appears legitimate to use fiscal deficit as a tool to jump-start investment as it happened in the late 1930s in the US. The Finance Minister can incur fiscal deficit only for expenditure that quickly push up production. Printing of notes to finance such expenditures appears to be a legitimate option for the government.

(The author, a freelance writer, can be reached at bharatj@sancharnet.in)