Fiscal Deficits can be aBlessing

Readers are often told by economists that a high fiscal deficit is disastrous. In fact, given India’s political economy, high deficits are in some quick ways proving a blessing.

Is India’s high fiscal deficit leading it into a debt trap? Yes, say reformers, including RBI governor Rangarajan and member-secretary of the Planning Commission Bimal Jalan. Not at all, say Indian Leftists, who think only the revenue deficit matters, not the fiscal deficit.

What is the difference? The fiscal deficit is the net borrowing of the Union governments (as also of the state government and public sector units, if we take the wider economic definition). The revenue deficit is the gap between the government’s revenue and current spending. Everybody agrees that it is suicidal to borrow for current spending (wages, defence, subsidies) since such spending yields no returns, and loans taken for this purpose cannot be repaid with interest.

The dispute, therefore, relates to borrowing for public investment. The Left wants to increase government borrowing for investments it regards as fundamental. Reformers say that not matter how high-sounding the principles claimed for public investment, borrowing must be limited to the government’s capacity to repay these loans with a investment, and that means cutting borrowing from the current high level of 10 percent of GDP for Union and state governments and PSUs.

To judge these issues more clearly, get away from the government. Ask instead, which private sector groups have the biggest fiscal deficit (net borrowings) in India? The answer is the Tatas, Birlas and Ambanis. And, strange to say, their fiscal deficits have helped make them the biggest and richest groups in India.

To Judge these issues more clearly, get away from the government. Ask instead, which private sector groups have the biggest fiscal deficit (net borrowings) in India? The answer is—the Tatas, Birlas and Ambanis.

Why then are fiscal deficits bad for the government? Mr Micawber could have told you the answer. If you borrow at 10 per cent and get a return of 13 percent, you will soon get very rich (like the Tatas, Birlas and Ambanis). But if you borrow at 10 per cent and get a return, say 7 per cent (like many governments), you will eventually go bust. Such governments can put off the evil day through additional taxation and borrowing, but this will be unsustainable because of their underlying inability to service loans.

This then is truth about deficits. Borrowing by itself is neither good nor bad, it all depends on what you do with the money. If you use it productively, borrowing is a boon. If you use it poorly, you will go bust.

In theory, the state can invest efficiently. In some countries in East Asia it has indeed done so, and such countries have a fiscal surplus. But in India, public investment has so obviously been inefficient that it needs no elaboration. So it should be no surprise that deficits have been rising in India, especially revenue deficits. Had the huge sums invested in the public sector yielded decent returns, revenue would have come pouring out of the ears of state governments. Instead they are bust.

For decades economists and journalists have exhorted politicians to create reforms to increase efficiency, but in vain. The political class had its own agenda of creating patronage networks, and additional taxation and borrowing allowed it to put off the day of reckoning for quite some time. But ultimately rising deficits led to the high inflation and financial crisis of 1991. Only then did the political class decide. And bankruptcy, instate governments drove reforms there too.

India went bust in 1991 because the state no longer had enough cash for the two pet obsessions of politician’s subsidies and public sector spending. The politicians had to choose, and (across party lines) chose the former. So subsidies remained high while they cut public investment. This in turn obliged them to liberalise private investments. In this manner, bankruptcy has driven the reforms process.

The reforms have made India more efficient. With no increase in the investment rate, our GDP growth rate accelerated from 5.5 per cent annually in the 1980s to 6.5 per cent in the last three years. Another sign of efficiency comes from lower inventory growth, which averaged annual 3.2 per cent of GDP in the 1970s, 2.2 per cent in the 1980s, and is now just 0.63 per cent. Clearly, we are getting more out of less.

None of this would have been possible, but for the large fiscal deficits which led to bankruptcy. Please note that most politicians are still nostalgic for the old days of patronage networks and total control. Only the pressure of a continuing high deficit has forced them to reform.

Borrowing by itself is neither good nor bad, it all depends on what you do with the money. If you use it productively, borrowing is a boon. If you use it poorly, you will go bust.

Seen from this viewpoint, a high fiscal deficit is not a problem but a solution. End fiscal profligacy and you may end to the profligacy. Our politicians are intent on spending money till they get to the very brink of bankruptcy, and this will keep them on the reforms path. So we will gradually get more efficient, not because we remain imprudent.

Come off it, say some critics, how can you be happy with such brinkmanship? In many African and Latin American countries, high deficits have led to hyperinflation and deep misery. How can you be sure that in India it will merely spur further reform and efficiency?

The answer, I believe, lies in the fact that we are a well-established democracy where voters rebel if inflation exceeds 10 per cent. Every politician knows this, and so fear of inflation places a limit on political excesses in spending. This democratic pressure is more powerful by far than any conditionality of the World Bank or IMF.

By contrast, Authoritarian regimes have traditionally ruled in most of Africa and Latin America. Authoritarian rulers never worried about a voter revolt, and so merrily went for policies that often produced 100 per cent inflation or more. Some of these countries have recently turned democratic, but old traditions of high spending and high inflation are deeply entrenched and will not go quickly. Voters in these countries are so used to inflation and misery that they are slow to revolt.

This, then, is why fiscal deficits should be a force for the good in India, spurring reform rather than hyperinflation. They are by no means and optimal solution. They will yield results much inferior to those produced by fiscal prudence and responsible governance in East Asia. But the results will be better than the mess we have lived with in India in past decades.

What do you think?