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Deficit: Sticky questions, no easy answers

S. Balakrishnan

MUCH wailing and chest-thumping have ensued after the Budget over the size of the fiscal deficit. There is a huge and growing negative on revenue account, say the doomsayers. Even the Finance Minister is unable to hide his agony over the state of the fis c; he is reduced to abjectly justifying increasing taxes and revenue not on economic grounds but merely to help Government bridge the budgetary gap.

A major beneficiary of fiscal discipline is expected to be interest rates. This is the ``crowding out'' theory _ if the Government borrows less, there is that much less demand for funds and supply of debt, which will lead to lower interest rates. In a di fferent context, Keynes pointed out that this is not necessarily true. He strongly advocated public expenditure financed by borrowings arguing that this would activate idle capacity in the system.

If the economy is in a ``liquidity trap'' excessive pessimism deters investment and consumption even at zero interest rate (the quandary facing Japan today) there is no risk in monetising Government debt.

After nearly a decade of `liberalisation', public expenditure still drives our economy. It is the Government that is the largest employer. It is the Government that provides the education, health and food safety nets. It is the Government that dominates spending on infrastructure. The much-expected and hoped for private investment in this sector has turned out to be so much hype.

Given the yawning gap between its expenditure and income, the Government has inevitably been forced into borrowing. How has it handled the situation? On the one hand, banks and insurance companies have been compelled to invest in Government debt ensuring a captive investor base and on the other, the Reserve Bank of India has stepped in extensively to accommodate the Government's short-term and long-term needs. In effect, monetary policy has been subordinated to the imperative of financing the Government .

Some interesting issues crop up here. Could monetary policy have been less expansionary if the fiscal house was in better shape? Would the considerable softening in interest rates have still taken place? There can be no clear-cut answers to these questio ns.

While reduced borrowing by Government is, ceteris paribus, interest rate benign, the RBI would have, nevertheless, found it necessary to inject liquidity through OMOs to bring about the desired alignment between interest rates and sharply falling inflati on.

Another aspect to be reckoned with is the ownership pattern of public debt. The fact that the banking system, which holds most of it, is more or less completely in the hands of the Government means a significant downsizing of the deficit is implicit in t he Budget.

Finally, we have Government dis-saving reflected in the large household savings in IOUs from Government, through the intermediation of banks and mutual funds. As Government and Government enterprises are by far the largest employers in the country, in a sense this amounts to paying employees and borrowing back from them. The inflationary potential of the

process has so far been minimal.

This is not to scoff at the seriousness of the debt trap in which the Government finds itself. Some prescriptions suggest themselves in the light of the above _ for example, a steep reduction in the interest rates on safe and secure havens, such as PFs a nd public savings. The measures initiated in this regard need to be carried much further.

Beyond the obvious, the Government has to apply the quality test to its massive Budget. If this exercise is done seriously and genuine asset creation from capital expenditure is accorded paramount importance, the deficit will solve itself.

FINANCIAL SCAN