"What are the `fundamentals'?", `Economic and Political Weekly', May 1995


                  This is an essay on the on-going reforms, the state of the economy and the Union Budget for 1995-96. Since the greater part of the so-called economic reforms has focussed on the question of macroeconomic stability I confine myself to an examination of the foundations of this, namely the macroeconomic, aspect of the recent policy initiatives.

I Rhetoric and reality in the recent macro-economic policy

A most influential idea in the sphere of macroeconomic policy today is that the `macroeconomic environment', notably the rate of inflation, is the principal determinant of growth. More generally, the idea that the macroeconomic environment matters most has led to the attempt to identify certain crucial variables as representating the so-called fundamentals of an economy. The fundamentals, naturally, are macro variables and the fiscal deficit has found an undisputed place among them. Thus, in a calculated leap, the dictum `get the (relative) prices right' has been replaced by the injunction to get the `fundamentals' right. According to this view the `fiscal deficit' is the lodestar on the macroeconomic firmament, for in its control lies the means to a lower inflation rate and to a reduced external deficit. Undoubtedly, economic policy making here has been influenced by the perceptions of the players in the financial sector who, with increasing cross-border capital flows, now command some attention from governments of market economies. In fact, the leaders of the corporate sector might well have led this move for `the fundamentals' is not an expression one finds in mainstream macro textbooks, at least not as yet. Clearly the Narasimha Rao government is influenced by this idea, for never before have we seen such a devotion to the Indian macroeconomic scene as reflected in the government's policy statements. I look at the performance of the economy in the light of what has emerged over the last four years as the government's view of how the economy works.

The rhetoric

a. The fiscal stance and the balance of payments

The idea that the fiscal and external deficits are related can be generated in two different ways. First, in a Keynesian macro model with exogenous exports and imports related to income expansionary fiscal policy worsens the balance of payments, unless it is accompanied by `expenditure switching' policies. At full employment there is no alternative to the reduction of `absorption'. Of course, in the earliest interpretations, for instance in James Meade's classic analysis of balance-of-payments policy, it was never assumed, that the cut must come in public spending alone. In fact, there was nothing in the `absorption approach' to the b.o.p. to identify the role of the fiscal deficit in generating the external deficit. This has required a different approach, and alas, also the jettisoning of economic theory. The much abused `twin deficits' view may be arrived at by manipulation of the standard identity of National Income Accounting which expresses the equality between income and expenditure in an open economy. Thus:

Y = E may be decomposed into C+S+T+M = C+I+G+X

where `Y' stands for income, `E' for expenditure, `C' for private consumption, `S' for private saving, `T' for taxes, `M' for imports, `I' for private investment, `G' for government spending on consumption and on investment goods and `X' for exports.

This may further be re-arranged to yield;

(M-X) = (G-T) + (I-S)

where the expression on the left-hand side is the current account deficit while (G-T) and (I-S) represent the fiscal deficit and the private-sector saving-investment balance, respectively.

Assuming the private sector's behaviour, represented in this case by the saving-investment balance, to remain unchanged, one can expect the external and internal deficits to move together. This tautology has led to the proclamation that the fiscal deficit `causes' the current account to go into a deficit too.

            There are two problems with this. Not only are we dealing with an identity here, but this fact alone ensures that there are (n-1) possible re-arrangements. Thus Feldstein has pointed out what he claims to be a more meaningful re-arrangement of the original identity as :

S - (G-T) = I + (X-M).

This is done to argue that since the inverse of the fiscal deficit is `public saving' changes in the deficit may, once clubbed with private savings, be interpreted as changes in national savings. Now assuming that the fundamental relation in the economy is that between saving and investment, Feldstein argues that changes in national savings due to changes in the fiscal deficit may well be expected to alter (private) investment rather than net exports. The point of it all is to suggest that the supposed impact of changes in the fiscal deficit on the external deficit cannot be so easily assumed. International capital mobility must weaken the link between national saving and investment in an open economy. However, Feldstein and Horioka show that it has been unable to erode this relationship even in the United States economy where capital flows are prominent.

            An extraordinary feature of the `twin deficits' view of external deficits appears to be that such deficits co-existing with a surplus on government account are no longer a source of concern. After all, under the scheme of things, the `fundamentals', represented by the fiscal deficit are sound. This was one characterisation of the Mexico economy which in January 1995 had an external deficit measuring up to eight percent of GDP and insufficient foreign exchange reserves to pay its debt even while the government budget was in surplus. With hindsight, it is also interesting to note that Mexico and the United Kingdom were examples taken up by Feldstein well before the recent Mexican crisis to point to the lack of efficacy of the fiscal instrument as a cure for b.o.p. deficits. In fact, even at the time of his writing, both these economies were in the red as far as the balance of payments were concerned, despite having a fiscal surplus. The simple point that emerges is that a strong trading position is all about long-term competetiveness and to expect that the problem of poor competitiveness can be overcome by manipulating the government's accounts is to invite the comment about `free' lunches.

b. The fiscal deficit and inflation

The alleged role of the `fiscal' deficit as a cause of inflation is of relatively recent origin. It is to be found implicit in the package of measures for macroeconomic stabilisation ordained by the multi-lateral financial institutions rather than in textbook Macroeconomics. Of course, there has always existed the view that budget deficits are inflationary, but the deficit that was visualised in this case is the monetised deficit rather than the fiscal deficit which encompasses the former. Those interested in the history of macro-economic policy making in India may have noticed that in Indian economic parlance `Budget(ary) deficit' has always meant the monetised deficit. Of course, it does so even today. It is only that references to the fiscal deficit seem to have taken priority since 1991 when India went in for an IMF loan. The new mind-set seems to have taken-over quite completely now, for the government continues to target the fiscal deficit even though Indian macro-economic policy is no longer governed by an IMF `program'.

            As an aside, one might point out that it is inconsistent to hold the `twin deficits' view along with the view that the fiscal deficit is relevant for inflation. For, if the increase in the fiscal deficit inevitably spills over into the excess of purchases over sales in the external sector then it cannot, at the same time, be expected to be inflationary by raising the demand for domestic goods. Where the exchange rate floats and is sensitive to the fiscal deficit, of course, there must occur exchange-rate depreciation. The impact of this on the inflation rate obviously depends on the relative size of the foreign sector. If one is bent on pursuing a theory of inflation originating from government spending, then one might as well to concentrate on the Budgetary deficit which does at least provide a measure of additional purchasing power that is injected into the economy.

            There is, of course, one perspective from which fiscal deficits are inflationary, in fact more so goes the argument than monetised ones. For, when the public debt is ultimately paid off by printing money, the principal plus interest amounts to greater moeny creation than the one-shot printing of money that would occur when the deficit is monetised. this is the so-called `unpleasant moneatarist arithmetic' observed by Sargent and Wallace. If this view is taken seriously, then an argument for the importance of the fiscal deficit for inflation control does emerge. However, that is precisely the point; given its long-term implication - after all, the money gets printed only when the debt can no longer be rolled over - this view can hardly be a contender as an explanation of the everyday inflation rate.

The `Reality': Recent Indian experience

In Table 1 are presented data on the fiscal deficit and the principal macro variables of interest for all years since 1990-91. Starting with the current account deficit, there is little to suggest that the fiscal deficit and the external deficit are twins. There is, of course, a very strong correlation in the first year of the reforms. But that was a year in which the Reserve Bank of India had monitored the b.o.p. carefully, in particular, attempting import compression via the foreign exchange margins on imports. Thus it would not be advisable to infer that the very considerable reduction in the external deficit in that year was due to fiscal contraction alone, not to mention, if at all. Subsequently, there has been no relationship between annual changes in the fiscal deficit and the external deficit. Prima facie there is a case for Feldstein's view that perhaps changes in national savings affect private investment.

Table 1 goes about here


            As far as inflation is concerned, the overall picture that emerges is that no major dent has been made. The trajectory of inflation over the years 1991-92 and 1992-93 is clearly due to the behaviour of agricultural production and cannot be attributed to policy in any way. The significant fluctuation in

foodgrain production and in the relative price of foodgrains (which can be inferred from the Table) provide the ammunition for this view. Since then inflation has hovered around the ten percent level. It would be wrong to draw the conclusion from this that inflation is impervious to any kind of anti-inflationary policy, even if it may not be wrong to conclude that inflation is certainly impervious to variations in the fiscal deficit. The point is that the government conducts its operations in the foodgrains sector quite impervious to its price implications. For one, it is holding more stocks than it ought to be. From an elementary reading of supply-demand theory we know that when, in a market with government intervention and voluntary private sale to government, the intervention price is set above the market-clearing price the grain handling-authority begins to accumulate stocks. This is precisely what has occurred since 1993. I do not, at this stage wish to enter into a discussion of the precise manner in which the government's operations in foodgrains affect the inflation rate. My task here is to examine the efficacy of the fiscal instrument for inflation control. The emerging picture is that of little or no relationship whatsoever.     An altogether more interesting question has to do with the relationship between inflation and growth over this period. A first impression is that the inflation rate has been more or less maintained (now that we know that the reduction of 1992-93 was very likely exogenous to policy and that the inflation rate for 1994-95 is very likely going to be in double digits). Certainly, it has not been purged from the system and whatever reduction has for a point been achieved has come at great cost. In the year just passed there has been a rise in inflation accompanied by an increase in the rate of growth of manufacturing production. While the acceleration in the inflation rate has been noticed it has not been seen in relation to the growth in the economy. It is strange that critics have harped on the rise in the inflation rate while ignoring the one hundred percent rise in the rate of growth of manufacturing production. Two points are at stake here. The first is the criterion for assessing economic performance. To focus on inflation to the exclusion of growth makes little sense when the bottom line in economic assessment must be output growth along with the very likely associated growth of employment. The second point has to do with the relationship between inflation and growth, an age-old question in Economics. Price behaviour in the year just passed, as also the experience of the period since 1991 as a whole, exposes the premature obituary of the Phillips Curve. The idea that lower inflation is both a pre-requisite and a guarantor of growth does not come through with flying colours during this episode. In fact, and this is the message clear, we have had higher inflation in 1994-95 precisely because we have had faster growth. When the rate of growth is stepped up one hundred percent it is rather like the economy shifting gears. Some prices in the economy must rise. It is as simple as that.


III. "Fiscal correction"? Surely you're joking Mr. Singh! A point that I have been trying to argue is that the arguments for the use of the fiscal deficit as an instument are not quite impeccable. However, Public Finance has its own imperatives and the arguments for a sound conduct of an economy's fiscal affairs cannot be exaggerated. However, it is not at all clear that this can be inferred by focussing on the `fiscal' deficit.

            The Finance Minister has taken the view that a `fiscal correction' is needed and that by more or less progressively reducing it the present government has shown itself to be fiscally prudent. The data presented in Table 2 does show that a reduction in the fiscal deficit as a share of GDP has indeed been affected, even though the early resolve seems to have taken a bit of beating. Two aspects of the government's conduct of its fiscal affairs must weaken its claim that it has shown fiscal prudence. Firstly, observe that the reduction of the fiscal deficit as a share of GDP has been achieved by relatively larger restraint on the growth of capital expenditure. Note from Table 2 that over five annual budgets the share of total expenditure that is devoted to capital spending including loans has been reduced by close to one third. The second reminder of the fragility of the claim of fiscal prudence has to do with the continued presence of deficits on Revenue Account. Revenue Deficits imply that a government is either borrowing money or printing it, usually some combination of the two, to finance comsumption. Mr. Manmohan Singh's team of economists have on occasion justified the Revenue Deficit by pointing out that expenditure on Revenue Account does include that on such items as Education. Some perspective is provided, however, when we note that in the Union Budget for 1995-96 expenditure on `Social Services' accounted for less that 4 percent of the total expenditure on Revenue Account. Secondly not even our appreciation of the role of human capital in growth can allow for the excessive spending on items that are not generative of future incomes in an accounting sense. There is no getting away from the fact that the budget is a financial statement, and it should be seen this way. Thus to point to the existence of Revenue Deficits as weakening the government's case, far from being a radical critique is actually very conservative criticism indeed.


Having discussed the macro-economic policy of the government I now look at the Budget for 1995-96. The Budget can be shown to be continuing the earlier practice of the government.

            There are only two aspects of the Budget for 1995-96 that I intend to comment upon. The first, having to do with the Finance Minister's perception of the causes of the current inflation, is a very minor aspect of the Budget no doubt, but in the context of the concerns of this article it assumes an importance. The other aspect has little to macroeconomics. In fact, it relates to the core of the Budget, i.e., the perception of the principal constraint on growth in the Indian economy and the method of alleviating it.

Inflation in 1994-95

There is no doubt that the inflation rate has accelerated in the past year. It's extent may have been exaggerated a little by focussing on the point-to-point measure which in February was running at over 11 percent annually. The average rate for the financial year, on the other hand, was substantially lower and hence the acceleration less. But the fact remains that the inflation rate in the year just passed was higher, and the Finance Minsiter was influenced enough by this to refer to this, and claim to have provided a means to lowering it.

            The Finance Minister's analysis runs as follows:

"This acceleration has occurred because of several factors. One reason is the sharp increase in procurement prices in the previous three years...The persistence of fiscal deficits at levels higher than should be, has also contributed to inflationary pressures."


The reference to the consequences of higher procurement prices over the past three years is puzzling. There is little reason to believe that higher procurement prices have a lagged effect on the price of foodgrains. The increase in these latter in 1994-95 was, in fact, lower. The price of wheat actually declined. If it is argued that rising procurement prices affect foodgrain prices immediately and this in turn affects wages and manufacturing prices with a lag, then we would expect manufacturing prices to be rising at a faster rate in 1994-95. This is indeed the case, though we cannot be certain (as yet, due to the non-availability of data) that this is due to higher wages or due to higher materials prices. The matter can be settled though by observing that the contribution of manufactured goods prices to inflation in 1994-95 was barely higher. On the other hand, the contribution of `primary articles' to the inflation rate is close to 50 percent higher. This completely accounts for the higher inflation rate. For this reason, the Finance Minister's argument that the lowering of excise duties will lower the inflation rate does not address the issue of acceleration, and it is irrelevant whether firms pass on the lower taxes as lower prices, an issue that has been debated endlessly since the presentation of the Budget. As for the the suggestion that the Budget is anti-inflationary because it proposes to lower the fiscal deficit from "levels higher than they should be", from the evidence presented here one cannot credit this measure with much effectiveness.

The growth prospect: Coasting along Singh's way!

Just as the Budget has been influenced by the acceleration in inflation, it has also been influenced by the performance of manufacturing in the year 1994-95. Without doubt, it is the over 20 percent rate of growth of the capital goods sub-sector that has given the Finance Minister the confidence to continue with the process of trade liberalisation, at least as far as the dismantling of the tariff barrier is concerned. The maximum rate has now been reduced further. However, the Budget sends down a more important message, when it identifies the crucial constraint in the economy as: "....the need for much larger investment and much greater efficiency in key infrastructure sectors such as power, roads, ports, irrigation, railways and telecommunications." The Finance Minister has indicated his deep appreciation of the problem when he refers to the issue of efficient maintenance is at least as important as that of the initial investent. However, when it comes to the government's role in alleviating the problem of infrsatucture shortage we can only be disappointed. For all that is contanied in the Budget is "..... a five-year tax holiday for any enterprise which builds, operates and maintains infrastructure facilities in the area of ighways, expressways and new bridges, ports, airports ana rapid mass trasport systems."

            While one can hardly assert that this measure will not yield results, the expectation that the private sector will respond vigourously to the task of creating `public goods' precisely at a stage when the government is withdrawing from the economy is perhaps misplaced. This feature of the Budget, that it signals the drawing-in of the borders of the state has gone somewhat unnoticed. This relates not only to the lower proposed outlay on capital expenditure (excluding loans) in 1995-96 (calculated from the `Expenditure Budget') but also in its proposed allocation across Heads of expenditure. Some information is provided in Table 4. Apart from the reductions for some crucial items such as `Public Works', notice that in the year to come the government intends to invest less on `public health', `water supply and sanitation', `irrigation' and `education' combined than on `information and broadcasting', and more on `atomic energy' alone than under all the preceding heads together. Essentially the government wil spend less on infrastructure. Perhaps the turn to the private sector is meant to make up for this. Of course, in spending less on capital account the government has only continued its earlier practice.

             TABLE 4 GOES ABOUT HERE

            The issue of `infrastructural development' is relatively recent in the minds of economists. One is advised not to take a purely theoretical approach to the matter. Interestingly, an economy for which a relatively greater amount of work exists is the U.S. and some idea of possibilities emerges from examining the history of infrastructural development there. First, even though there exists no measure of the optimal amount of infrastructural investment, it is clear that the Indian economy faces infrastructural famine. Some perspective of the relative role that we might expect of private and public initiative is provided by the information that in 1991 88 percent of structures and 78 percent of equipment in the infrastructural sector (measured as the "tangible capital stock other than in `Defence' owned by the public sector") was owned by government. A more interesting aspect of infrastructural development in the United States is its distribution across constitutional authority even when it is in the public sector. Most infrastructure is owned by the state and local governments while very little (almost all of it `Defence') is owned by the Federal government. This has a bearing on the Indian situation in the following way. At a time when public investment is dwindling, whether by design or by default, that in the United States most investment has been done by the State govenments might appear an irelevance. However, it is not so. The United States experience indicates that even if the public sector invests less, the `responsibility' for infrastructural development has to emerge at the level of State governments. Thus, Centrally sponsored schemes in India, such as the tax holiday in the Budget, have a limited scope. Infastructural development in India requires more nurturing than what the Central government can provide, either politically or in terms of adminstrative capability. A particular aspect of the dwindling political legitimacy of the Indian State is the shrinking reach of the Centre. In such a scenario, a centrally-guided infrastructural development with little actual public investment is of dubious worth. Two problems are certain to loom large. First, there is the question of financing such large initial investments. The financial press, often times inveted with greater prescience than can be found in the groves of India's academe, has pointed to the absence in this country of the appropriate long-term debt instrument. Equity is not likely to attract much funding for projects with long gestation lags. Of course, given that the Indian capital market is quite innovative, the right instrument might just emerge. However, it is unlikely to do so overnight, and financing is going to remain a problem for a while to come. The scond issue is the more troublesome. It has to do with the confidence that the private sector has that it can collect the charges for its services. We are yet to be told whethre the private producer is to sell the services to a public authority or whether it is going to tsell these to the customer directly. If it is to be the former, there is no mechanism to ensure the `efficiency' that the Finance Minister has spoken of as being needed so much. If it is to be the latter arrangement, then it is going to be a first in India, and will require some observation before it can be termed a success.

            It pays to reflect upon the possibility that the rise to centre-stage of the issue of `macroeconomic stability' and an almost obsessive attention to its imperatives is not just the triumph of a new economic view but the denouement of what Myrdal had charactersied almost four decades ago as the `soft state'. The state now concentrates on what it can do rather than on what it ought to be doing but has been incapacitated from achieving. There is no doubt that the issue of infrastructural development is going to dominate the issue of the state of the Indian economy. To actually jettison all responsibility for this while continuing to maintain, indiscriminately, the public sector the State has shown itself to be too timid the face the criticism of vested interests. ------But make no mistake of it. The question of investment and maintenance of infrastructure is far too complex to be taken care of by either of the two extremes, i.e., altering the property relations, a project adored by left-wing governments, or tinkering with the policy regime, a strategy thought to be invincible by the present political dispensation. But returning to the theme I had started with, an economy without `public goods' can hardly be termed `fundamentally sound' whatever the state of the fiscal deficit.



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