Obsession with fiscal deficit is affecting long-term growth

Farm loan waivers have reignited concerns of fiscal deficit (FD), which is essentially the difference between the government’s revenues and its expenditure. While the focus on FD reaches its zenith just before the Union Budget, it is a core element of our economic narrative. Is 3.5 per cent too high, or 3.2 per cent? From rating agencies to economists to pundits, FD has assumed divine dimensions, with a 0.2-per cent slippage deemed blasphemous.

The question is, how important is FD to growth and welfare? Textbooks are divided. Neoclassical theories frown upon FD like plague, Keynesian theories privilege FD as a preferred policy tool, and Ricardian theories preach complete indifference to the concept itself!

The neoclassical view, the source of most punditry on the subject, base FD’s divinity on four basic canons.

One, debt (incurred to fund FD) growing faster than income (GDP) is unsustainable. Two, excessive debt leaves us vulnerable to foreign investors pulling out, triggering an economic crisis. Three, high FD causes an increase in interest rates, increasing the cost of capital for the private sector. And four, the moral argument of burdening our children to finance our consumption today.

Not trusting “irresponsible politicians” to protect the holy covenants, a Fiscal Responsibility and Budget Management (FRBM) law was enacted in 2003 to enforce discipline through prescribed targets. Unfortunately, this has meant elected representatives are constrained on a key policy tool to react to economic distress — because of technocratic limits.

Beyond the point of (democratic) principles, obsession with FD is untenable on multiple grounds. To start with, the divinity canons are tenuous in the Indian context. The Government of India (GoI) doesn’t borrow overseas (from foreign investors) to fund FD. It is funded entirely out of domestic savings. With capital account controls, GoI bonds represent the highest-quality investment for the domestic investor. Ergo, GoI can run high levels of FD without triggering a currency crisis. This is the exact opposite of oft-quoted examples — Russia, Argentina, Greece — where high FD triggered economic crises. In all these cases, governments depended heavily on foreign investors to fund FD.

When the basic issue is a lack of demand, the antidote has to stimulate demand. Private sector investment decisions are not predicated on a 1-per cent higher (or lower) interest rate, but capacity utilisation and expected future demand. Obsession with an incremental 0.5-per cent FD jeopardises growth and ability to service debt in the long term.

A hard FD target acts as what Harvard professor Lawrence Summers calls a harmful ‘repression of budget deficit’. To meet the target, the government imposes arbitrary spending cuts on maintenance and critical investments in social and physical infrastructure. The result is a lowering of national productivity, leading to lower long-term growth. We have seen this with distressing regularity in India, where FMs have cut investments to meet FD targets.

Currently, the biggest challenge confronting the economy today concerns jobs. Boosting job creation by 3-4 per cent (and nominal GDP by a bit more) will do a lot more to balance the FD in the future (after all, FD’s real relevance is as a percentage of GDP) than targeting a sacrosanct number today.

Above all, causality between low FD and growth is extremely tenuous in terms of data in India. High growth has typically been a result of higher demand creation. Without supporting data, to base policy on ideology is simply bad policy-making.

The bigger philosophical question though is the usurping of sovereign democratic powers by an unelected technocratic elite. The FRBM Act was a primer. Recently, the NK Singh Committee appointed to recommend improvements to FRBM has suggested setting up of an autonomous Fiscal Council (staffed by technocrats) to administer and monitor FD targets set out in the law. This would represent a further erosion of political authority to tackle a political economy question.

The author is Managing Partner of ASK Wealth Advisors. Views expressed are personal.