The CAD spin

Writings on economics and economies can confuse even the unconfused.

It took a century and a half after Adam Smith’s book Wealth of Nations to understand what precisely goes wrong in a capitalist economy. The world was in deep depression, there was mass unemployment and not the faintest sign of ‘green shoots’. Yet Governments, central banks and the economics establishment were in denial. It was left to Keynes to explain how unemployment is, in fact, the natural state of affairs when the private sector determines consumption, investment and saving. Can anything be more damning?

Yet a large and influential group of economists — followers of Milton Friedman — continues to peddle minimal government. Fortunately, the results of a three-year controlled experiment involving a ‘do nothing’ policy in the UK are in. They don’t make happy reading for the Friedmanites and echo John Kenneth Galbraith’s quip that the problem was that ‘Milton’s theories were tried’. The biggest shock for the ‘austerians’ was the UK’s ‘AAA’ rating being put on watch and increasing fiscal deficits, contrary to their predictions. The point of Keynes — this is counterintuitive —was that the rules of prudent household budget management don’t apply to governments, which must act ‘countervailingly’, when necessary, as in the present economic milieu.

How does all this add up for India? Fiscal discipline has become the mantra, but, given India, it’s a struggle. The easiest things to cut are capex and public asset maintenance at the cost of further deterioration in infrastructure and public services and we never had any qualms about the second.

It’s when the talk turns to the current account deficit that the spin starts. Don’t worry, the rising CAD is because our investment is more than saving, say Government spokesmen and editorial page articles. Put this way, the CAD is almost — why almost, it is — a virtue. So we can all go back to sleep.

There can be only two explanations or ignorance — both of which are inexcusable.

A little simple arithmetic clarifies.

GDP = c+g+i+(x-m), where c is consumption, g is government expenditure, i is investment (physical), x is exports and m is imports. For the present purpose, c+g can be lumped together as consumption, while i is capital formation in both private and public sectors.

There’s no question that in this identity the CAD is the difference between saving and investment.

But what’s saving? It’s what is left of GDP after consumption. So if we consume more, the CAD goes up, just as it would if investment went up. However, we know very well that capital formation is slowing, so the obvious reason for the rising CAD is consumption. And who’s responsible for the ‘excess’ consumption? None other than Government, as, again, it’s well known that the household sector is a (large) net saver.

The CAD is, therefore, directly connected to Government ‘dissaving’. In other words, the fiscal deficit. The goal must be to restrain, as much as possible, the fiscal deficit from spilling over into the BoP. And this, in turn, means differentiating a ‘good’ fiscal deficit from a ‘bad’ fiscal deficit, which only increases foreign debt.

Throw a fit the next time you read that the CAD is the result of investment exceeding savings.

Pure hogwash.

(The author is a Chennai-based financial consultant.)

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