Relook at the mantra of fiscal deficit

The fiscal deficit consists of the money borrowed by the government to finance its expenditures beyond its income. The BJP and the Congress agree that the fiscal deficit should be reduced.

That is, the government must not borrow to finance its expenditures. This mantra has its origins in the corrupt governments of Latin America in the eighties. The leaders were borrowing money from the World Bank and the International Monetary Fund (IMF). They were also printing notes leading to double-digit inflation.

The money borrowed and printed was being siphoned off to their personal accounts in the Swiss Banks. In this circumstance, the United States government called a meeting of the World Bank and the IMF and arrived at an agreement known as "Washington Consensus."

It was decided that instead of lending monies to the developing countries, they should be asked to seek private investments. It would then not be possible to siphon off the monies.

Also, they should be asked to control their fiscal deficit so that they could not siphon off the monies printed by their own Central banks. The mantra of fiscal deficit, therefore, was created to prevent the corrupt governments from siphoning off public money.

The mantra was not created for "development" policy of an honest government. The mantra was made for controlling corruption by the developing country governments. In accepting the mantra, then, the government concedes that it is corrupt.

Plenty of evidences are available that fiscal deficit is a good policy if the money is used for investment. A study by Institute of Social & Economic Change, Bengaluru, on the relationship between fiscal deficit and economic growth in India from 1980 to 2013 says, "If the fiscal deficit money is spent on capital formation, it supports growth…" A study by Dillard University, New Orleans, the United States, on the impact of fiscal deficit on economic growth of Bangladesh says, "It can be assumed safely that to some extent fiscal deficit is good for economic growth if the borrowed money is spent on beneficial projects."

Another study by Australian National University for Sri Lanka concludes that fiscal deficit leads to inflation only if the money is used to pay huge salaries to government employees. The link between the two "becomes weaker in the absence of the public sector wage expenditure."

In other words, the money raised by fiscal deficit does not lead to inflation if is used for investment instead of government consumption. This can be understood by an example. Let us say a shopkeeper borrows money to buy a bike so that he can reach the shop early in the morning. His fiscal deficit has increased. He has spent more than his income.

However, the bike enables him to reach the shop in time, he makes more sales and is able to repay the loan. Such fiscal deficit for investment is good. But let us say the same shopkeeper uses the same borrowed money to make a foreign pleasure trip. His income remains the same as previously but now he has to repay the loan.

Such a fiscal deficit pulls his finances into a downward spiral. The same happens to a country's economy. Money spent for investment is good even if it leads to an increase in the fiscal deficit.

There are two components of fiscal deficit—capital deficit and revenue deficit. An increase in fiscal deficit to buy a bike is capital deficit while that for making a foreign pleasure trip is revenue deficit.

The mantra of fiscal deficit remains silent on whether the deficit is incurred for buying a bike or making a foreign pleasure trip. Even the rabid supporters of the mantra cede that an increase in fiscal deficit can be good. A paper by two former Governors of Reserve Bank of India — C Rangarajan and D Subbarao — argues vehemently for the control of fiscal deficit but also says that "for sustainable growth, we need to balance our books on the revenue account and use borrowed funds only for investment."

No wonder, economists do not find a relationship between control of fiscal deficit and economic growth. Economists at Birla College, Kalyan, studied the impact of fiscal deficit on to economic growth in India from 1992 to 2014 and "found that there is no significant relationship between fiscal deficit and economic growth in Indian economic perspective."

A study by World Economic Forum concludes that "the empirical association between fiscal adjustment and economic growth is 'fragile.'"

The problem is not that we have incurred fiscal deficit. The problem is that we have incurred fiscal deficit for increasing government consumption instead of increasing government investment.

This is borne out by the facts reported by the Economic Survey 2017-18 published by the Ministry of Finance. The share of development expenditure in total expenditure remained at 57 percent from 2010 to 2014 during the last four years of the UPA.

The share declined from 57 percent in 2014 to 52 percent in 2016 during the present NDA government. In other words, the quality of fiscal deficit remained stagnant during the UPA and deteriorated during the NDA government.

There are two roads that we can follow from here. The road chosen by the Congress and the BJP is to control fiscal deficit. In practice, this means that the capital investments by the government will continue to be reduced.

There is no commitment by these parties that revenue deficit or government consumption will be reduced. These parties want to treat the same path of controlling fiscal that we have followed in the last decades irrespective of the fact that our growth rate has remained stagnant around 7 percent. The fiscal deficit has not led to inflows of foreign investment for two reasons.

Conclusion is that fiscal deficit is good if it is used for investment and bad if it is used for consumption. The World Bank and IMF have tricked us into reducing our capital expenditures in the guise of controlling the fiscal deficit.

Their objective, in my view, is to discourage the governments of developing countries to make investment by borrowing so that they become more dependent on the multinational corporations who are the masters of these institutions.

The alternative for both the BJP and the Congress is to throw the mantra of fiscal deficit into the dustbin and replace it with the mantra of controlling revenue deficit.

Let the government borrow and increase the capital investments and allow the fiscal deficit to increase while revenue deficit is controlled. That will jumpstart the economy and take us to double digit growth rates.

Unfortunately, the ruling bureaucracy is loath to make this change lest it expose its true character.

(The writer is formerly Professor of Economics at IIM Bengaluru)