TCA Srinivasa Raghavan

The standard is so poor

| Updated on: Aug 07, 2011
image caption

S&P has, in effect, told lenders, ‘lend to America if you must but it is your funeral'. A funnier joke one has yet to hear. If you won't lend to America whom will you lend to? North Korea?

Last Friday, S&P downgraded US government debt from AAA+ to AA+. This reminds one of the boy who cried “The Emperor has no clothes.”

But there is a difference this time. This boy has cataract.

Where sovereign debt is concerned, credit rating agencies have a long history of getting it wrong. That's mostly because the little boys who do the sums have no sense of history, politics or even culture.

So they apply the logic of rating private sector firms to rating sovereign countries. And they get it wrong.

Just as well, then, that everyone would have had the weekend to regain their senses.

Western fetish

That said, it is interesting to trace the history of this particular Western obsession with budget and fiscal deficits. It has almost become a fetish and has the usual four elements to it — political, historical, cultural and economic.

The political element arises from the inability of the sovereign to tax the people to its heart's content, not because it did not have the power, but because there was often nothing left to tax.

The historical element arises from the need that this unleashed on Kings and Queens — to bring under your territory more peoples who could be taxed, either because they were being taxed less than your own or because you wanted them to subsidise your people.

The cultural element arises from the injunction on Christians to ‘neither a lender not a borrower be'. This led Christian kings in Europe to borrow from the Jews because when the time came to repay, they could always be persecuted as ‘Christ killers'. You might, if you like, say that debt waiver was built into the contract.

But until the mid-1970s, no one really worried about government deficits, at least not as much as they do now.

The economic element of this fetish is thus very new and gained ascendency only in the last quarter of the 20th century.

It is part of what came to be known as the Washington Consensus. The private sector could over-borrow but not governments.

From Gramm-Rudman…

As mentioned above, by the third quarter of the 20th century, thanks to the threat from Communism and hence the need for Western governments to spend more on social welfare, the first three elements had almost died out.

But, then, populism took over and there was a reaction from the rich that governments should spend less, especially on the poor — and, more especially, if it meant taxing them, the rich, even more.

The idea gained ground because of growing income inequalities and, thus, was borne the Gramm-Rudman-Hollings Act of 1985 in the US. Basically, it mandated automatic spending cuts on the US Government if its budget deficit exceeded some fixed number worked out mechanically by a formula.

Upon this, someone went to court and in 1986 the US Supreme Court said the law was unconstitutional. Not to be deterred, the legislature passed an amended law in 1987 to undo the effect of the judgment. But the US Government proved equal to the task.

In 1990, it enacted a law that mimics our own system of supplementary grants.

And this law, somewhat ironically, is called the Budget Enforcement Act!


By this time, India too was moving in this direction. The first letter from the RBI Governor to the government about the need to do something about the practice of monetising the deficit automatically was written in mid-1988. This meant the RBI would not automatically print notes to finance the budget deficit. Following IST, this was eventually done in 1998.

Then, in 2003, came the Fiscal Responsibility and Budget Management (FRBM) Act to impose limits on the fiscal and revenue deficits. The revenue deficit had to be reduced to zero by 2009 and the fiscal deficit to 3 per cent of the GDP by 2008-09.

Everyone clapped. They thought India's conversion to the new orthodoxy was complete. Then, for the next four years, Mr P. Chidambaram tried hard to stick to the law. But even he, despite his clairvoyance, was unable to foresee the crisis of 2008. By end-2009, even the RBI was pleading for more government spending! The wheel had come full circle.

Square One

So all restraints on Government spending have now been removed because of demands made by the very rich people who were earlier demanding such restraints.

If the government doesn't spend, they say, demand will go down; if demand goes down, growth will go down; if growth comes down, our profits will come down; if profits come down, your taxes and our dividends will come down. Since this is a fate worse than death, better spend more.

But there is a problem, as the Americans have discovered: Deficits can only be reduced by spending less or taxing more.

If neither is possible, you have to borrow more. That's fine if someone will lend you the money. Till last week, there were. Then enter S&P which has, in effect, told lenders, ‘lend to America if you must but it is your funeral'.

A funnier joke one has yet to hear. If you won't lend to America whom will you lend to? North Korea?

Published on August 13, 2011

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