Who’s afraid of fiscal deficit?

Why this obsession with fiscal deficit, a layperson tuning into talk shows on the Budget may well wonder.

She would have been surprised by the emphasis on fiscal correction in an election year — a government apparently disinterested in winning elections and focusing on book-keeping niceties instead!

If our layperson had followed Budget discussions over the years, she would have been struck by auto and telecom industrialists ‘expressing concern over fiscal deficit’. Has fiscal deficit (the difference between total government expenditure and total receipts, excluding borrowings) become an intellectual fetish, or is there something more to it?

The Finance Minister said in his Interim Budget, “Analysts and rating agencies had acknowledged our efforts (in containing the ‘twin’ deficits — fiscal and current account) some months ago and no longer speak about a downgrade.”

The statement betrays both a sense of relief and intent to pursue further fiscal correction in future Budgets, so that the ‘global investor’ hangs in there. Why is the global investor fixated about fiscal deficit?

The global investor fears a higher fiscal deficit for its assumed impact on inflation, interest rates and, finally, the domestic currency.

First, she feels that higher government expenditure will drive up interest rates by squeezing the availability of funds for private investors — the ‘crowding out’ effect, in other words. As an equity investor — and there is more foreign money coming into equities than debt — she would be worried about the impact of high interest rates on profitability.

The second fear is of public spending directly causing inflation by injecting money without the matching output, leading not just to an erosion in real returns in the present but also the fear of further erosion in the future. The latter is seen to impact ‘business confidence’.

The third fear is of inflation and general chaos due to a chain effect: higher public spending driving up demand for imported goods and services, widening the current account deficit and depreciating the currency -- impacting dollar returns on every rupee invested.

Hence, a steep fall in the rupee hurts the equity market, as foreign institutional investors expecting a further fall pull out, raising prospects of currency panic as in mid-2013. On the real economy side, inelastic energy imports add to the trade imbalance. In sum, we might be left with a negative spiral in both the real economy and the financial sector.

This is the twin deficit hypothesis — a higher fiscal deficit leads to a higher current account deficit and higher costs for the economy as a whole, besides a sense of uncertainty. Therefore, the industrialists at talk shows, and the FIIs and rating agencies, fear a higher fiscal deficit for its possible impact on inflation, interest rates and the exchange rate. How valid are their concerns?

Whether public spending leads to ‘crowding out’ or actually spurs private spending (‘crowding in’) depends on the nature of such spending. Alok Sheel, a member of the Prime Minister’s Economic Advisory Council and a reformist like any other, observes that public spending in infrastructure will spur private investment. This could relieve inflation caused by supply constraints.

The belief that public spends in India vanish into a black hole, creating money but no goods, need not always hold true. The improvement in the network of national highways did spur the economy in the Tenth Plan by crowding ‘in’ investment.

If supply-side bottlenecks are addressed, the demand generated by public spending could generate investment, jobs, growth and higher taxes without much of a time lag, thereby ensuring that a higher fiscal deficit in one period is recovered in the next.

So, there is no reason to assume that a deficit will turn into a looming threat. Besides, to forgo the benefits of more jobs now for a vague dread of the future does not seem tenable.

The twin deficit hypothesis is open to question. A higher deficit on government account may not translate into more imports, if the people choose to save rather than spend.

A paper by Suparna Basu and Debabrata Datta (Does Fiscal Deficit Influence Trade Deficit, Economic and Political Weekly , July 23, 2005) shows that the two deficits have not moved together in India between 1985 and 2003. While our savings rate has fallen in recent years, raising twin deficit concerns, the decline can be arrested by generating jobs and keeping food prices in check. An economy where the growth of savings exceeds that of investment will not face a twin deficits problem.

Now, we come to the fear of the future — that we don’t know how a high fiscal deficit could impact us later, even if we are fine with it right now; hence the erosion of ‘confidence’.

It is this undefined dread that drives the ‘austerity’ argument in the US and Europe — and it was taken apart by economists such as Paul Krugman, Robert Pollin, Arjun Jayadev and many others.

Even Sheel observes at a recent lecture at IIM-B: “The last thing that policymakers should do is aggravate an economic slump by cutting back government demand when private demand is slack in an attempt to keep the nominal fiscal deficit unchanged.”

It does not end here. There are crucial ethical and ideological debates to be considered. One side argues that government spending alone can reduce inequality (a view in the US), while the other maintains that public spends are unproductive.

There is an ethical and even economic case — the demographic dividend argument — for prioritising outlays on health and education on the same footing as ‘infrastructure’, as Amartya Sen has argued. The Interim Budget does not reflect this philosophy at all.

The mainstream discourse on fiscal deficit is largely confined to the expenditure side. The government is attacked more for raising expenditure on ‘populist’ heads than for its inability to lift the tax-to-GDP ratio. The revenues forgone by announcing tax exemptions run into lakhs of crores.

Are our panelists on the TV show tuned in to all this?