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| 'Do fiscal deficits hurt economic growth?' |
| Business Standard / New Delhi Jul 08, 2009, 00:39 IST |
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It boils down to whether greater government spending makes up for lower private consumption or whether, through higher interest rates or inflation, it hurts it.
 Dharmakirti Joshi
Director & Principal Economist, Crisil Ltd
‘Higher deficits may be needed at various points in time, but you have to separate the structural component and rein that in’
The unprecedented discretionary fiscal stimulus, put into action to fight the current economic downturn, has bloated expenditures and taken government deficits to new highs across the globe. In India too, the discretionary stimulus as well as some populist moves, pushed the fiscal deficit to a budgeted 6.8 per cent of GDP in 2009-10. This reversed all the fiscal gains made since 2003-04. These developments have brought the age-old debate on the merits and demerits of deficits, which remains one of the most contested economic issues, to the fore.
There is nothing wrong with the government running a deficit per se. The government has to incur deficits to finance its revenue and expenditure mismatches and also to finance investments. The problem arises when the deficit level becomes too high and chronic. The ill-effects of high deficits are linked to the way they are financed and the use they are put to. The fiscal deficits can be financed through domestic borrowing, foreign borrowing or by printing money. While excessive domestic borrowing can lead to a hardening of interest rates, too much of foreign borrowings can culminate in an external debt crisis. Printing money stokes inflationary pressures.
The bloated domestic-borrowing programme of the government is currently putting pressure on domestic government-bond yields. This complicates the implementation of a soft-interest rate policy by the central bank as the G-sec yields act as the benchmark risk-free rate in the economy. When growth picks up and demand for funds and the opportunity cost of banks from investing in gilts increase, a high deficit is bound to crowd out private investment. Another way to assess the impact of the deficit is to look at the use it is put to. The same level of deficit can have different implications, depending upon how it is used. For instance, a fiscal deficit used for creating infrastructure and human capital will have a different impact than if it is used for financing ill-targeted subsidies and wasteful recurrent expenditure. The sustainability of the deficit will be suspect in the latter case as the use it is being put to doesn’t augment the ability to pay back the debt. The implications of deficits are, therefore, contextual and need to be accordingly analysed.
Fiscal policy is an important tool of short-term demand-management. The ill-effects of excessive high deficits notwithstanding, strict fiscal targets need to be relaxed in extraordinary times as prevail today. Government spending was the fastest-growing component of GDP in 2008-09 and did indeed cushion growth from falling further. While staying alert to the pitfalls of deficits, especially if deficits have been used to fund unproductive spending and, importantly, if the limits dictated by the Fiscal Responsibility and Budget Management Act (FRBM) have been breached, the Government may do well to take a pragmatic stance. As is evident, during a downturn, government revenues shrink and expenditures shoot up which bloats the deficit. The reverse happens during a boom. I am of the view and as has also been suggested in this year’s Economic Survey, the concept of targeting cyclically-adjusted deficit would be the appropriate stance to adopt. Cyclically-adjusted deficits take into account changes in business cycles to work out the underlying deficit, which is a normal-year deficit. This will also allow one to separate the structural component of the deficit, which is usually more chronic and persistent in nature and needs to be reined in.
(The views are personal)
 Amit Mitra
Secretary General, Ficci
‘Deficits result in higher GDP growth and more taxes — so they are self-correcting. Our deficit is less structural than that of the US’
Let us look at the various kinds of arguments made against deficits. The monetarists argue that deficits crowd out private borrowing, raise interest rates and cause inflation. So, they advocate you should not try and stimulate the economy but, over a 5-8 year period, look at a steady and sustainable increase in money supply, and economic growth will follow. This post-Friedman approach has been discredited after the financial meltdown, since the whole question of money supply has fallen flat on its face. Liquidity vanished, banks failed and various federal authorities were taken by surprise at what was happening in the world of finance capital. If the simplistic monetary theory has failed, we have no option but to stimulate in the fiscal domain, which is what is happening in the US and Europe.
Which brings us to the question of how much of a fiscal stimulus is bearable. The US fiscal deficit is now likely to be 12.3 per cent of GDP in 2010 (the earlier prediction was 9-10 per cent); it is 15 per cent for the UK; six per cent for Germany; seven per cent for Italy, Spain and France. So how are these countries able to live with such high fiscal deficits?
Look at their 2009 and 2010 growth projections and that’s where the answer lies. For calendar 2009, the US economy will shrink 5.5 per cent, Germany 6 per cent, Italy 4.2 per cent and so on. In 2010, the projection is that the US will be positive, UK 1 per cent, Japan 1.2 per cent … so we will have 0.5 to 2.5 per cent growth in the developed world in 2010. With growth, the fiscal deficit will be taken care of. But why doesn’t the same logic apply to India, after all our growth which is down to 6.7 per cent will also go back up to the 7-7.5 per cent range. The answer comes from Standard & Poor’s. According to S&P, India has a structural deficit (due to the fertiliser- and fuel- subsidies), while the west has a transient one caused by the stimulus, and that will go. But S&P does not talk of the US social security, medicare and other such social security … all of these increase during a downturn when government revenues are strained. So the S&P argument that the US deficit is not structural is flawed. The US can’t reduce unemployment benefits or increase the age-limits for medicare so easily — how is that any less structural? In India’s case, we have just increased the price of fuel, so we are trying to tackle our structural deficit.
S&P also argues that two things can help — funding the deficit through disinvestment and a situation where the deficit generates demand. The fact that India’s growth is 6.7 per cent as compared to the 4.5 per cent projected by the IMF would suggest the stimulus has indeed been demand-creating. In the last five years, direct taxes grew 29 per cent — so, when economic growth is high, tax collections respond very well. Hence, the cure is demand-stimulating fiscal deficits. Economists also talk of a built-in stabiliser in countries like the US — if the economy tanks, welfare payments rise and tax payments fall significantly as people move down tax brackets, and that ensures increased demand that acts contra-cyclically. Since this doesn’t happen in India, we have no option apart from fiscal stimulus.
Indeed, while India has a huge space to tackle deficits through disinvestment and the additional revenues guaranteed through high growth, the west does not have this space. The developed world does not have the tools to tackle its deficit, we do.
(as told to Sunil Jain)
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