Time to get rid of the FRBM Act

Ramgopal Agarwala | Updated on: Nov 02, 2020

Macro-economic management has to be integrated in its monetary, fiscal and prices and incomes policies and not work in silos | Photo Credit: suman bhaumik

The Act, enacted in 2004, is a new Avatar of the license-permit Raj based on faulty economics

We all know how the license-permit Raj was a hindrance to India’s development. Perhaps it is not fully recognised how it was a product of faulty economics based on Professor Lionel Robbins’ view that economics is about allocating the given productive resources.

What was forgotten is that level of productive resources depends on the incentive system and under a proper incentive system productive potential can increase allowing both private and public sector to achieve higher production. We are all grateful that license-permit Raj was abandoned and our economy grew at a faster clip.

Unfortunately, we have jumped to another form of license-permit Raj where there were limits imposed on public investment through the FRBM Act. The implicit assumption was that investible resources are given and if public sector invests more, private sector will have less to invest. The actual results have been creative accounting of the most deplorable kind by the public sector, little progress on price stabilisation and slowdown in growth momentum.

Forgotten lessons

In designing our FRBM, the lessons of Keynesian economics were forgotten. In an economy with underutilised resources, investment can create its own savings and both public and private investment can increase provided the financial sector is doing its duty of increasing finance for viable projects at reasonable real rate of interest and there is a surveillance mechanism to ensure that borrowers are utilising resources as proposed in their loan proposals.

Surveillance is needed at micro-level but macro-limits on expenditures are no guarantees of quality assurance. Taking a cue from countries such as China, agencies should be created for providing finance for viable projects in private and public sectors and up to a point, investment will create its own savings.

The Act was intended to affix responsibility to the Central Government to ensure inter-generational equity in fiscal management and long-term macro-economic stability. This was faulty economics. Fiscal deficits and domestic public debt management mean reallocation of resources within the generation and not between generations. And macro-economic stability depends on total effective demand (including both public and private sector) in relation to productive potential and not deficits of the government alone.

When private investment is buoyant, public investment may be modest to keep within the potential output and when private investment is muted, public investment may be buoyant. This requires a counter-cyclical fiscal strategy rather than a predetermined glide-path for fiscal deficits irrespective of the state of private investment which ended up with the target of fiscal deficit of 3 per cent of GDP for which no rationale was provided except copying the Maastricht guidelines which had a completely different background.

It is interesting to see that during 15 years after FRBM Act in 2004, the CPI inflation was 7.3 per cent per annum, only marginally lower than in the preceding 15-year period from 1990-2004 (7.7 per cent).

Terms of flexibility

The authors of the Act defined limits to fiscal deficits going up to March 31, 2021 which went well beyond their mandate as per the Constitution. They were aware of the need for some flexibility in the fiscal deficit targets but provided for a minuscule deviation of 0.5 per cent of GDP under very special circumstances such as “due to ground or grounds of national security, act of war, national calamity, collapse of agriculture severely affecting farm output and incomes, structural reforms in the economy with unanticipated fiscal implications, decline in real output growth of a quarter by at least three percentage points below its average of the previous four quarters.”

In the current situation, fiscal deficit needs to be increased to fill up the gap created by collapse of private sector demand. The fiscal deficit of the central government alone may have to be increased to at least 10 per cent of GDP during this fiscal year.

This cannot be done by providing a range for fiscal deficits while remaining in the fiscal silo as seems to be under consideration now. The fiscal policy, monetary policy and prices and income policy have to welded into an integrated whole by the Economic Committee of the Cabinet. Unless the FRBM Act is jettisoned, the Finance Ministry cannot do this under the laws of the land.

We need at least an 8 per cent annual growth during 2021-2035 to achieve our employment objectives and that will require some 40 per cent of GDP in investment with public investment rising substantially in the current period when the private investment is lacking in animal spirits. This will be impossible unless the FRBM Act is given a burial.

Also, as was done in China, macro-economic management has to be integrated in its monetary, fiscal and prices and incomes policies and not work in silos. The Cabinet Committee for Economic Affairs has to take over the task of macro-economic management with whatever advice needed from other agencies.

If the current government under strong leadership fails to take the necessary corrective legislative and executive action, we may well face a lost decade in terms of creation of decent jobs particularly for the educated youth.

Published on November 02, 2020
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