Fiscal Consolidation: The Choice Between Prudence and Progress
The growth projections for 2020-21 are in, and to hardly anyone’s surprise, it does not look good. It is during times like these, that the age-old ‘Growth vs Welfare’ debates are resurrected. However, as the pandemic curves around the globe get close to flattening themselves, it is only pragmatic to acknowledge that once we pass these anomalistic times, both variables will once again walk hand in hand. The ones monitoring the movements of these variables have assigned a downward revision to the targeted estimates. The recovery speculated to be V-shaped, will lead us through a phase of growth rates as low as -3%, as projected by the IMF, under the assumption that the pandemic fades by the second half of 2020. Governments, too politically motivated, cannot engage in conducting indirect bail-outs just yet, in the increasingly left sympathising world. So, the Central Banks around the globe have stepped in to stretch their balance sheets as usual. Besides the regular rate cuts, nations like the US, where rates have reached the zero base, have resorted to heterodox ways of stimulating the stock markets. The indices, taking mixed signals from the $4 trillion QE influx, and the climbing unemployment rate, close to 8%, have managed to rally against the odds. Other nations follow the lead as they ease out withdrawal norms, EMI payments, etc., attempting to bring a disequilibrium to the trade-off between consumption expenditure and investing.
India, while still expected to grow at 1.9%, has not attempted to take up any targeted policy measures, save for the Prime Minister Garib Kalyan Scheme, which isn’t an economically motivated initiative. As a result of lack of productivity, the revenue side of the federal budget has nearly entirely collapsed, with states urging the centre to transfer resources sooner as 70% of the revenue via GST streams has ceased. It is evident that the fiscal deficit target of 3% set under the Fiscal Responsibility and Budget Management (FRBM) Act (2003) will be violated by a bold margin, giving the markets another reason to panic.
The need for a consumption-driven nation like India to keep the deficits in check arises from its reliance on foreign investments, due to the dearth of local savings. This stringency gets rationalised by the validation it receives from the economists grumbling at the nation’s twin balance sheet problem, i.e., both fiscal deficit and a trade deficit, which basically arises from running fiscal deficits by cutting taxes. That causes consumption to rise and thus, savings to fall. A reduction in savings prompts the government to borrow funds from abroad to finance their fiscal expenditure. An influx of investment raises the demand for local currency, which in turn results in its appreciation, and that makes domestic commodities relatively expensive to purchase, thus causing a trade deficit, which transforms into a current account deficit. It can be explained mathematically through a simple equation,
Y = C + I + G + NX can be written as,
(Y - C - Tax + Transfer) + (Tax - G - Transfer) = I + NX, which signifies
Private Savings + Public Saving = Domestic Investment + Net Foreign Investment
Now, imagine a decline in Public Savings, due to cutting taxes and causing a fiscal deficit. This can be offset by:
A Rise in Private Savings: As per “Ricardian equivalence”, tax cuts prompt people to increase savings, because they expect taxes to rise in the future. This, though economically ideal, is unlikely in the real-life context of the non-rational people.
A Fall in Domestic Investment: The crowding-out effect, it’s never good.
A Fall in the Net foreign Investment: The Twin Deficits dilemma
In India’s case 2) & 3) have happened more often than any growing economy would be comfortable with. Several economies that are a member of the twin deficits club are the US, UK, Greece, etc. So, it’s safe to say we’re certainly not in great company since the twin deficits in each of these economies have aggravated the impacts of recessions, even cyclical ones. Though as many believe so, we have not managed to escape a crisis while running twin deficits. The 1991 Balance of Payments (BoP) crisis was essentially that of the twin deficits, owed to years of profligacy and the fiscal crisis of the 1980s. Post the FRBM Act, the deficits did come under targets, but the actual figures remained higher as certain bonds were kept off the balance sheets and remained unaccounted for, rendering the actual adjusted figures higher by 0.5% to 1% from what was reported. However, over the decade, with the combination of FRBM guidelines and the Rajan-era monetary policy, we have restrained the fiscal deficit partially and managed to raise enough Forex reserves to keep the Current Account deficits controlled. Additionally, as we move closer to having a higher proportion of capital expenditures, as compared to the previous budgets, we are setting up a base for investment to crowd in rather than crowd out.
Fiscal consolidation is necessary when the BoP situation is volatile and reliance on international investment is high. However, for an emerging nation like India, it’s irrational to take the 3% target as a divine ordinance. We would only end up creating a psychological benchmark out of it, exacerbating the volatility in exercises over our markets in recessionary periods. Fiscal prudence makes sense in good times to develop a cushion for bad times and allow targeted policies to take over the recovery. Blindly restricting expenditure ends up being counterproductive.
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