"Wrong time to be fixated about the fiscal deficit", 'Business Line', February 4, 2015

Economic Objectives and Fiscal Imperatives

Arun Jaitley finally has the opportunity to showcase his abilities in the form of the first budget he has been given time to prepare. What should be its thrust? While there are many aspects of budgetary and economic policy to consider, I focus on one. Currently, growth is depressed in relation to what it was till about five years ago. The Modi government has stated that it intends to revive it. A non-ideological approach to fiscal policy now becomes necessary. We are facing sluggish private investment and slowing global demand. We are also facing declining inflation driven largely by declining oil prices but also by slowing output growth, particularly the growth of industrial output which was marginally negative in 2014-15. In such a situation, there is a case for the government stepping in to bolster aggregate demand. While it matters little for the level of output what goods the government spends on it matters much for growth. For, we have reason to believe that government spending on capital formation has a greater effect on growth than equivalent spending on consumption goods.

The suggestion to hike spending on capital formation is based on the evidence. The trajectory of growth in the past decade is closely tied to the trajectory of public capital formation, with the period of fast growth over 2003-08 being one of exceptionally fast growth of public capital formation. Similarly, the slowdown since is associated with a precipitous decline in the latter. It is not widely known that the decline in private investment has not been anything as dramatic. The public discourse has been dominated by the narrative of ‘policy paralysis’ contributing to a dampening of private investment but no one has cared to tell us how this may have played out. There is econometric evidence that growth in India is linked closely to public investment but not to private corporate investment. We also find that it is public investment that drives economic growth rather than the other way around. Either ignorance or ideologically imposed blinkers has led to a blocking public investment out of the story. The point is that growth in India has since 2008 contracted more than in the rest of the world, with the US economy actually growing faster than it did prior to the global financial crisis. So it is domestic demand that must largely account for the slowing of India. The decline in public capital formation is an important factor here, and the need to raise its level obvious. What remains to be discussed are the areas in which it should take place and how it is to be financed. We certainly don’t want it to be taking place in ill-thought-out projects which are often merely dynosaurs made of steel. We want to focus on areas of the economy where the multiplier effects are likely to be the greatest. And this is the infrastructure sector. Rural roads would be a good place to start. The Pradhan Mantri Gram Sadak Yojana is widely seen as having been successful. Not only should its benefits be spread but also the funds should be used to re-surface existing roads that are very likely fraying at their edges. A general point needs be made though. In all central schemes the government must take on an approach that is calibrated to local needs. India is a land of diverse geographies and central schemes weaken their impact by dogmatically adopting the once-size-fits-all mode.          

Secondly, public capital formation needs to be financed. While recommending greater public spending on infrastructure one needs to recognise that the Government of India is on a path of fiscal consolidation. The point, however, is that greater public spending on capital formation need not compromise fiscal consolation in the long run. So long as there is a feed-forward impulse, the current state of the economy influences its future. This has been referred to as the ‘shadow of hysteresis’, a concept from the physical sciences which recognizes  memory as a property of physical objects. Thus a magnetised iron rod retains a magnetism even after it has ceased receiving an electric current. The parallel for the economy is that when it is depressed, or as in India now when growth has slowed, its present condition is shifted into the future. That is, other things remaining the same, a buoyant economy could remain buoyant while a depressed one remains depressed. Hysteresis in an economy has been deconstructed as working via the reduced skilling of labour and of entrepreneurial exploration.

But what if the government is committed to a declining target for the fiscal deficit? Thus Mr. Jaitley’s government has stated that it will stick to the UPA’s target of 4.1 percent for the current year. First, it is not clear where this target has appeared from. Secondly, it has been announced that it has already been breached by now. It would be foolhardy then to slash plan expenditure, code for capital formation, to pay lip-service to it. A temporary deviation from the announced path for the fiscal deficit would be inevitable as the deficit initially expands due to increased public investment. But so long as there exist a government-spending multiplier and a shadow of hysteresis, and the government’s tax revenues may be expected to not only increase as the economy expands but also to be higher than what it would be in the absence of the fiscal expansion the fiscal balance not only improves in the future. This proposition has been dubbed the fiscal free lunch. It requires that the interest rate does not rise as the government borrows, which is what a so-called ‘accommodative’ monetary policy is meant to ensure, i.e., support an economic expansion.

There is no virtue in sticking to pre-announced fiscal deficit targets when enhancing growth is the objective. In fact, in the presence of the feedforward mechanism represented by the shadow of hysteresis, pursuing fiscal-deficit targets as the economy becomes sluggish can worsen long-term fiscal balance. What is being argued here is akin to the balancing of the budget ‘over the cycle’, it being allowed to go into deficit in the recession and trimmed to be in surplus during  upswing. So, we must pursue fiscal stability as an objective but allow the pace of progress towards it to be determined by what is needed according to the current state of the economy. In the theoretical literature in macroeconomics the trope of ‘rules versus discretion’ has been adopted to argue against discretionary fiscal policy. In India over the past decade the government, in a bid to garner votes by increasing consumption subsidies, has lowered growth by allowing public capital formation to slide. But this does not per se imply that we should now tie the economy down by yoking ourselves to a pre-announced fiscal target. To take an example from world history, should Napoleon have continued ploughing through the snowy wastes of Russia even after being told that Moscow had been set on fire? Obviously not! He should have retraced his steps. Similarly in India today we need to pursue sustainable fiscal policies, including statesmanly allocation of public expenditure and a most careful accumulation of the public debt, but we must avoid a dogmatic fiscal stance.