The Hindu Business Line : Little incentive to reduce fiscal deficit

Developing economies sometimes effectively engage in fiscal deficits to increase the economic growth rate. But though India has long been reconciled to high fiscal deficits, the economy is in a slowdown. It has, however, been spared some of the negatives, such as higher rates of inflation and interest, and increasing current account deficit. Thus, the Finance Minister has little incentive to reduce the fiscal deficit, argues Dhanmanjiri Sathe.

ECONOMIC policies all over the world are formulated under various kinds of pressure. More specifically, when finance ministers make Budgets, they are constrained by diverse pulls and pushes, which could be political and /or economic.

In a way, they balance each other and stop the minister from taking extreme positions. This is good at times, as Russia's experience has shown. The failure of the `shock therapy' has illustrated the pitfalls of going in for abrupt, major changes in a very short period of time.

On the other hand, very slow policy changes may not bring about any ground-level alterations in a horizon of meaningful time-period. In India, what we are seeing is that, except in a situation of crisis, very few policy changes are pushed through. However, in a situation of crisis, bold steps have been taken — as were taken in India in 1991.

Currently, the Indian economy is giving out many conflicting signs. A simple look at the economy shows that there are many strengths showing up. The economy seems to be, slowly but steadily, coming out of the recession.

The manufacturing and services are both showing robust rates of growth, though the agricultural sector has contracted by 3.1 per cent.

At 6.7 per cent growth, the non-agricultural sector has shown a rate of growth, which is highest in last five years. Exports have grown at a remarkable rate of twenty plus — that too in a situation of international uncertainty.

Foreign exchange reserves are at an all time high of $74 billion. Inflation is also quite low at 4.8 per cent.

In spite of these strengths, the economic health of the government is deteriorating. This is because the government is spending much more than it is earning.

When this happens, the deficit starts rising. This is precisely what is happening in the Indian economy. There are important reasons why a government may need to engage in fiscal deficits of high order.

One is to beat the slowdown in the economy, as a counter-cyclical measure. In such a situation, the government spends more and more, which increases demand and gives a boost to the economy, increasing the rate of growth of the economy and taking it back to the full-employment levels.

This is the Keynesian argument in favour of fiscal deficits, where it does not matter even if the government is `digging holes and filling them up'. Developing economies such as India, which are far away from full-employment levels, have also effectively engaged in fiscal deficits to increase the economic growth rate. Though, since 1997 the government has been reconciled to high fiscal deficits, the economy has been in a slowdown.

Thus, one of the expected, positive results of the deficit has not been occurring. (Of course, it also needs to be remembered that the share of revenue expenditure has been rising and that of capital expenditure falling).

Let us now look at some of the other expected consequences of deficit financing. The first is that an increased fiscal deficit means increase in the money supply. This, in turn, is expected to lead to a higher rate of inflation.

The second impact of increasing fiscal deficit is to increase the rate of interest. This is because the government borrows from the market and the increase in the demand for funds leads to increase in the price of funds i.e. the interest rate. Third, it has also been found that an increase in the fiscal deficit leads to increase in the current account deficit.

This is because as the demand in the economy rises, some of it gets converted into increased import demand.

It is interesting to note that India has not been affected by any of these negative implications. Thus, fiscal deficit is not leading to higher inflation, nor higher interest rates and not even higher current account deficit — in fact, we have a current account surplus this year!!

Further, it is not even very difficult to explain each one of these. The rate of inflation is low because food stocks are adequate and the economy has been in a slowdown , so there is no real demand.

Interest rates are low because, in a situation of slowdown, the private sector is not showing any investment demand. So there is neither `crowding-out' nor any increase in interest rate.

The current account is not under any strain because, again, the economy has been in a slowdown and, consequently, the demand is low for imported capital goods and raw materials (which is what India's imports mainly consist of, and these goods are much more liberally allowed in the economy).

That exports have done well this year is a welcome feature. But last year also, when the exports rose only at 2 per cent, there was no great current account shortfall.

This brings us to the uniqueness of the situation, which is that in the Indian economy the extremely high fiscal deficit has been coexisting with low rates of growth for last four-five years, since 1997. Thus, the high fiscal deficit is neither leading to a positive effect viz. high growth; nor did it result in any of the three negatives mentioned above. In such a situation, where is the incentive for the Finance Minister to decrease the deficit? It is pertinent to remember that in 1991, the fiscal deficit was controlled only because it led to the balance of payments crisis.

Otherwise, during the late 1980s, we consistently had deficits higher than in 1991 and no one lifted a finger. But, then, that was also a period of very high growth.

Thus, for the fiscal deficit to be controlled, it needs to have some negative impact on the economy. Only then it is politically feasible for the government to control expenditure and raise the revenues.

Such a fiscally fragile situation cannot go on forever. There is no doubt that the country's fiscal state is dangerous, to say the least. At some point it will start affecting the economy.

But when this will start, and when the crisis will occur, is a question which neither the theory nor any ex-post empirical analysis can answer satisfactorily.

As far as the policy-makers are concerned, they will avoid taking the hard decisions until they are forced to. That is, they will put off increasing the revenues (raising taxes) and decreasing expenditure (cutting jobs, subsidies and capital expenditure).

In other words, until the fiscal deficit has negative implications, policy-makers usually postpone taking the hard options. The sequence of events of 1991 illustrates this point aptly.

If we look at the data, we find that the fundamentals were quite bad for many years preceding 1991. But no crisis occurred in those earlier years, though we were sitting on a volcano.

However, it was the combination of the increasingly fragile situation, along with some other shocks, such as the Gulf war and its economic fallout, the assassination of Rajiv Gandhi, and so on, that made the volcano erupt. So it was only after a crisis that major policy changes were announced.

Currently, what we are seeing is a period of `slack' in policy-making. If the negatives in the economy are not hurting directly, the government would rather keep new policies aside. With the elections in the air, there is no need to upset the apple-cart.

The Government has got away with a high level of deficit for the last couple of years, and it may well do so for the next two years — which is the most important period, politically speaking.

The current government is banking on that. It may well be successful. For who can really say that 5.6 per cent is a high deficit and 4.9 per cent is not?

(The author is Head, Department of Economics, University of Pune.)

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