The puzzle of the fiscal deficit

By S. Swaminathan

From the time when Dr. Manmohan Singh began to focus on fiscal correction as the main instrumentality for macro-economic stabilisation (in 1991), successive finance ministers at the Centre have sworn by the mantra of deficit reduction. The received wisdom ran more or less on the following lines: Fiscal deficit represents the draft being made by the state on available savings to the disadvantage of the entrepreneurial community (The ``crowding out'' phenomenon). It causes an overall scramble for investible resources thereby pushing up interest rates. To the extent that the fiscal deficit also involves government borrowing from the banking system and particularly from the central bank, it leads to monetary expansion - a principal factor causing inflation. That a long period of fiscal deficit inevitably causes the public debt to swell is another dreadful consequence is also part of this received wisdom.

What underlies this argument is the premise that government expenditure is essentially consumption-oriented rather than capable of creating remunerative assets which, over a period, would generate revenues for the state. From whichever angle one looks at it, fiscal deficit represents the grossest violation of the canons of public finance, regardless of whatever transitional virtues the Keynesian economists could have identified with it, either for a depression-ridden industrial economy or for a developing economy suffering from under-utilised resources.

Recent Indian record

The accompanying Table sets out the major parameters at work in the Indian economy during 1994-2000. Even if theorists would shudder at the thought that any direct causal relationship can ever be established between the level of fiscal deficit of the Government and the growth rate of the GDP, the data afford interesting if heretical insights into how the phenomenon of fiscal deficit has defied the postulates of the ``fundamentalists'' of fiscal orthodoxy who are ever prone to see in fiscal deficit the worst calamity that can befall an economy.

The highest fiscal deficit of 6.4 per cent of the GDP in 1998-99 did not result in any damaging deceleration in the growth rate even if a lag factor (of one year) can be imputed. Contrarily, of course, the lowest level of fiscal deficit in 1996-97, of 4.9 per cent of the GDP, did not bring about an acceleration of GDP growth. In 1996-97, the GDP increased at 7.5 per cent while it slumped to 5 per cent in 1997-98 despite the small reduction in fiscal deficit.

Overall, there is no statistical evidence to support the view that a rising level of fiscal deficit is necessarily followed by a downturn in the economy.

The performance in the real sectors of the economy is evidently predicated on a host of other factors which have nothing much to do with the orientations of fiscal policy.

The ``crowding out'' effect

Both in 1995-96 and 1997-98, gross capital formation in the private sector stood at 19.5 per cent of the GDP. In 1997-98, the fiscal deficit had been higher than in 1995-96. In 1996-97, the year of the lowest level of fiscal deficit, capital formation in the private sector was of the order of 17.6 per cent of the GDP representing a slowdown. Given the fact that capital expenditure of the Government has been declining in real terms over this whole period, it is difficult to conclude that the slowdown in capital formation in the private sector in 1996-97 followed from any significant increase in the fiscal deficit.

Barring 1994-95 when the trio - high level of fiscal deficit, monetary expansion and inflation - operated together, the entire period, 1994-2000, seems to have nullified the hypothesis that fiscal deficit steers monetary expansion and thereby the inflationary process as well. In fact, the remarkable containment of inflation since 1996-97 notwithstanding the fiscal deficit and the growth in M3 would appear to suggest that supply management (meaning agricultural performance and capacity utilisation in industry) has a greater bearing on the price-level than the monetary factor. It is perhaps equally important to acknowledge the productivity and cost improvements in a wide spectrum of industry as the supplementary factors which have operated as the restraining influences on the price front.

Cost of credit and growth rate

The evidence is all too clear that it is the fiscal policy that has posed the main challenges in the area of monetary management. The question whether in the earlier period (1992-94) an unduly restrictive monetary policy, intended to serve as a foil for fiscal extravagance, actually resulted in a lacklustre growth performance, does not belong to the current discussion on whether concern for fiscal correction ought to be converted into an obsession, magnificent or otherwise. What is relevant however is that the cost of credit which had for long remained within the jurisdiction of the Reserve Bank of India has now been deregulated for all practical purposes.

Yet it cannot be denied that the continued deployment of the cash reserve ratio (CRR) and the stipulations regarding refinancing at the hands of the RBI ensures that the cost of credit is not freed from the discretionary judgment of the RBI. To what extent the level of the fiscal deficit affects the judgment of the RBI in this matter is but an ``unknown quantity''. All that apart, the Indian record seems to demolish the negative mythology about the fiscal deficit!

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