In a previous piece, I had argued that India’s current economic crisis, unlike in 1991, has been mainly brought about by the irrational exuberance and ‘animal spirits’ of private corporates over the last decade (India Inc’s austerity moment, Business Line, August 21, 2013).

It is the chickens of that excessive risk-taking and debt-financed investment binge which are now coming home to roost. The result is a process of private sector austerity or ‘deleveraging’, whose consequences are already showing up in terms of investments and jobs in the economy drying up.

A large part of this crisis has also been the outcome of an ideology that believes the private sector can do little wrong and only governments are prone to financial excesses. So deeply ingrained is this philosophy — promoted most assiduously by our own policymakers who created the ground for corporates to recklessly borrow in foreign currency and take up projects beyond their capacity — that it has been used to construct dubious theories defying ordinary economic wisdom.

This article will focus on two such erroneous concepts that have been elevated to gospel truth status by ideologues — sorry, policymakers — at North Block, Yojana Bhawan and Mint Street.

The first is ‘twin deficits’. The second is a related idea that investment and current account deficit (CAD) levels in an economy are determined by the extent of domestic, especially public, savings.

Myth No. 1

In the last few years, we have been repeatedly told that the root of all evil in the Indian economy is traceable to the so-called twin deficits, namely the gap between the government’s expenditures and revenues and the CAD.

The ‘theory’ here is that government overspending — whether measured by the fiscal or revenue deficit — spills over into generalised excess demand, leading to higher imports and a widening of the CAD.

If only that were true, the period from 2001-02 to 2003-04, which recorded current account surpluses on India’s external transactions, ought to have been years of admirable fiscal restraint. But as can be seen from Table 1, those were, indeed, times of high fiscal and revenue deficits. While these fell subsequently to reach all-time-lows in 2007-08, the CAD, nevertheless, registered a rising trend!

It is only from 2008-09 that one sees both government deficits and the CAD going up. Yet, rather than confirming the ‘twin deficit’ thesis, it only raises the question as to what really determines the CAD. That brings us to the second myth.

Identity versus Cause

The fact that investments (I) in an economy equal domestic savings (S) plus capital flows from outside to finance the excess of its imports over exports — in other words, the CAD — is something any elementary macroeconomics textbook would teach us.

But what the textbooks also point out is that I=S+CAD is just a macroeconomic identity. Table 2 shows that it applies to the Indian economy as well, with investment or gross domestic capital formation (column 4) roughly working out to the sum of gross domestic savings (column 3) and CAD (column 2).

The problem, however, comes when one starts ascribing causality to what is a mere identity. This is precisely what our ideologues masquerading as economists do by emphatically stating that high CADs are caused by falling savings. It’s something like saying that since a man is the sum total of his body parts, headaches are inevitably linked to knee problems.

CADs are essentially a function of global trade commodity price conditions. Any external ‘shock’ resulting in a collapse of export markets that take time to recover — as has been the case since 2008-09 — adversely impacts India. It does so even more given the limited possibilities for any corresponding reduction in the country’s imports, largely comprising commodities with inelastic demand such as oil, gold, fertilisers and vegetable fats.

During the early 2000s, the CADs were negative or low mainly because crude was selling under $30 a barrel. In contrast, crude prices have been consistently ruling above $100 in recent times. Combined with the sluggish demand environment for our exports and an overvalued rupee (until a few months ago), they have produced high CADs.

So where is the link with domestic savings, twin deficits, and all that? Well, you are right; there isn’t any. If only high CADs were due to generalised excess demand unleashed by government overspending, it shouldn’t plausibly have also brought down growth and investment so sharply. Try and tell any businessman today that the economy is now suffering from too much ‘excess demand’ and just check out his reaction!

If at all, the causality ought to work in the reverse : A widening CAD inducing large currency depreciation and, in turn, affecting economic activity, output, investment, jobs, incomes, government revenues and savings. It means high CADs causing fiscal deficits to rise and falling investments bringing down savings. That people save out of their incomes, which can come only from jobs, growth and investments, is a matter of common sense. The same logic applies to government revenues and deficits. The fiscal and revenue deficits fell between 2002-03 and 2007-08 not because P. Chidambaram was a better Finance Minister than Yashwant Sinha, but courtesy all-round growth and investment. As these have since slowed down, so have savings and tax collections, thereby pushing up deficits.

When ideology decides

Today, the real problem India is facing is not of deficits, but of no investments happening. Whether they lack the money or ‘animal spirits’, private corporates just don’t have the stomach to undertake new greenfield projects. And they are unlikely to, even if all the environmental and forest clearances come through.

Again, common sense would dictate that when nobody’s investing, the government ought to be taking up the slack. Fiscal stimulus may be a bad word, but I am not convinced why the government shouldn’t put money in highways if a GMR or GVK aren’t able to. The fiscal deficit will come down once growth returns, just as the CAD is going to take care of itself, now that the rupee is no longer overvalued and gold imports have practically stopped.

But knowing the deep commitment of our learned policymakers to ideology, they will chant the same slogans of twin deficits and fiscal consolidation, even as we watch factories closing and jobs disappearing.

It is nobody’s case that governments must spend recklessly — though that logic should have applied to corporate borrowings and investments as well — or deficits don’t matter. In an ideal world, we can possibly even do without governments.

However, in the real world and the situation we are caught in today, it would help if policymaking is reasonably divorced from ideology.

Also, spare a thought for the pristine discipline of economics, which, to paraphrase the incoming Reserve Bank Governor Raghuram Rajan in a different context, badly needs to be ‘saved’ from our economists. They are entitled to their conservative ideological views so long as they spare us — and economics.

Also read: > India Inc’s austerity moment

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