Harish Damodaran

Shed the deficit obsession

HARISH DAMODARAN | Updated on March 09, 2018

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Fiscal consolidation will happen only when growth returns

Princeton professor Paul Krugman is known for ranting against ‘deficit hawks’ in his New York Times columns. These views may be of relevance to India now that there are growing voices pitching for fiscal consolidation.

Late last month, Columbia University’s Arvind Panagariya — tipped to head Prime Minister Narendra Modi’s economic advisory council — termed the previous government’s 4.1 per cent of GDP fiscal deficit target for 2014-15 as “unrealistic”.

Now, Panagariya is by no means a fiscal dove. Yet, he feels that in a situation of sub-five per cent growth for two consecutive years, the Centre needs to boost capital spending even at the risk of a higher fiscal deficit. A deficit of 4.5 per cent of GDP is “fine” in an economy “where you are trying to push up the growth rate”.

But if the views from those at the helm of affairs in North Block and Mint Street are any indication, even the slightest slippage — the 40 basis points increase suggested by Panagariya works out to just over ₹51,000 crore — is unacceptable.

In a Facebook post on June 1, Finance Minister Arun Jaitley underlined his government’s resolve to “move towards an era of fiscal discipline”. This expectation of “better fiscal consolidation” from the new government was also emphasised by the Reserve Bank Governor Raghuram Rajan in last week’s monetary policy review.

One reason for such hawkish obsession with deficits has got to with their being suggestive of fundamental moral deficiency. Just as families cannot indefinitely spend beyond what their incomes permit, good governments are defined by their unwavering commitment to keep budgets under control. Hence, the constant self-explanatory references to “fiscal responsibility”, “rectitude”, “running a tight ship”, and so on.

Moral arguments against deficits, however, tend to be weak more often than not.

The National Democratic Alliance regime under Atal Bihari Vajpayee was considered by many to be the epitome of moral virtue. Yet from 2000-01 to 2002-03, when it was in power, the Centre’s fiscal deficit — the difference between all revenue and non-debt capital receipts and total spending — averaged 5.7 per cent of GDP. The gap between revenues and current expenditures alone topped 4.1 per cent.

But things changed dramatically over the next five years. By 2007-08, the fiscal deficit had fallen to 2.5 per cent and the revenue deficit to below 1.1 per cent. Moreover, excluding interest payments from fiscal deficit calculations, the Centre actually ran a primary surplus of ₹44,100 crore amounting to 0.9 per cent of GDP. This was opposed to an average primary deficit of 1.1 per cent during the three years ended 2002-03.

No morality here

The turnaround clearly wasn’t brought about by any vast improvement in moral fibre; the United Progressive Alliance (UPA) that had taken over at the Centre didn’t earn a particularly formidable reputation on that score.

The deficit reductions, instead, happened purely due to economic factors — specifically, the revenue buoyancy that accompanied a doubling of GDP growth from under 4.5 per cent during 2000-03 to 9.5 per cent over the three years ended 2007-08. Just to illustrate, between 2002-03 and 2007-08, the Centre’s gross tax revenues rose from 8.5 per cent to 11.9 per cent of GDP.

The lowering of deficits, in other words, was simply a result of revenue buoyancy from growth, not rediscovery of the virtues of belt-tightening by a morally upright administration. And this wasn’t limited to the Centre; even states saw their combined fiscal deficit decline from 4.1 to 1.5 per cent of GDP between 2002-03 and 2007-08.

The short point is contrary to what the hawks want us to believe, low deficits are not a precondition for growth. It is the reverse: The Centre’s fiscal deficit consistently shrunk till 2007-08 when GDP growth was rising. The deficit went up in 2008-09 when growth slowed down following the global financial meltdown (see graph).

The good of bad

That raises the question of the desirability or harmfulness of deficits. The straight answer, leave aside the moral argument, is they are neither good nor bad in themselves.

Deficits are ‘good’ under two circumstances. The first is when they are incurred for productive capital expenditures. A basic error people make while applying the economics of households to the government is that the former live largely for themselves. To the extent families have to fend for themselves, they have to necessarily live within their means.

The government exists not for itself. Its raison d’être is to serve the needs of the general public. By spending on roads, irrigation, rural electrification, broadband, farm produce godowns and cold storages, health, education or mass rapid transit systems, it helps boost the productivity levels of citizens and thereby the wider economy.

Such public expenditure in physical and social infrastructure, moreover, aren’t inflationary even if financed through borrowings and running deficits. So long as productivity growth and social returns from these investments exceed the cost of capital, it makes for very sound economics.

The second circumstance under which deficits may be ‘good’ is when there is an investment slack in the economy, as is the case today in India.

I have recently argued (“Not by sentiment alone”, Business Line, May 19) that what we are witnessing is no ordinary slowdown.

Overcapacities across industries, along with the huge debt overhang of India Inc, rules out the possibility of an investment revival anytime soon.

Someone, therefore, has to take up the slack and that someone can only be the Government. If its investments help kick-start growth that will eventually translate into higher revenues, the deficits would take care of themselves — as they, indeed, did under UPA-1.

UPA lessons

We know that the UPA resorted to a fiscal stimulus after the global economic crisis when Pranab Mukherjee was finance minister. We also know this enabled GDP growth to rebound to 8.5-9 per cent in 2009-10 and 2010-11, having dropped to 6.7 per cent the year before.

In hindsight, the stimulus was flawed because the deficits mainly financed wasteful consumption and not investments for augmenting the economy’s productive capacity. The overall effect of increased government spending was, hence, inflationary even while giving a temporary boost to growth.

But Mukherjee’s successor P Chidambaram made things worse. Not only did he withdraw the stimulus but also slashed the Centre’s Plan expenditures by almost ₹2,10,000 crore over the Budget estimates for the last two years. Such austerity only deepened an already entrenched slowdown, even if it pleased the hawks and the rating agencies.

Jaitley should avoid the blunders of both Chidambaram and Mukherjee. For that, he must first ignore the hawks. The idea that government spending and deficits are bad in themselves has a basis not in economics but ideology or, worse, theology.

India today badly needs fiscal stimulus, but not of the consumption variety. Jaitley’s budget should aim at boosting spending on projects such as the dedicated freight corridor, the Delhi-Mumbai industrial corridor and building a new capital city for Seemandhra.

These will go a long way in reviving the economy’s stalled investment and growth engine. Once that happens, the deficit problem will automatically resolve itself.

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Published on June 08, 2014
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