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The humbug of fiscal deficits

January 01, 2004

Every year, almost as a ritual, economists descend upon India from Washington to warn us that control or at least reduction of the fiscal deficit should be our major priority.

This year is no exception, and such is the universality of this advice that it flows in an even stream whether it comes forth from foreign trained economists like Anne Kreuger or Indian born and trained economists like Dr Raghuram Rajan.

This distinguished alumnus of Indian Institute of Technology-Delhi and Indian Institute of Management-Ahmedabad, and now economic counsellor of the International Monetary Fund, has once again warned us that "the fiscal deficit will come back to haunt India".

He has softened the admonition somewhat by admitting that "the beauty of India's fiscal deficit is that somehow the consequences of the lack of fiscal prudence are not showing up. But, that said, we would be making a mistake not to deal with the fiscal issue on a priority basis" (Financial Express, December 15).

The trouble perhaps is that we have been following this ruinous path for so long, apparently since the 1980s, that we have got accustomed to living in this imprudent fashion.

Indeed, perhaps like an alcoholic, we might find the cure too painful to attempt; particularly when such is the beauty of our wayward ways that the consequences do not show up.

This is particularly off-putting when the imprudence we display is also characteristic of China and the US, the two countries, which Dr Rajan describes as the engines of world growth.

Chinese deficits are not governmental but show up as non- performing assets concealed in their banking system; but as John Stuart Mill argued in his Principles, it is the extension of credit that has an influence on prices.

Having to write off as a matter of inevitability, unpaid loans made by government owned banks is a form of fiscal deficit under a different name.

As for the other engine of growth, the US, its deficit as a per cent of GDP, though not half as monstrous as the Indian one, is in absolute terms quite substantial and persistent. Thus far it has only been reflected in higher growth rates.

It would be useful if those like Dr Rajan who preach against deficits were able to demonstrate with greater precision how these debits will actually land us into trouble.

Dr Rajan warns that those who say "that deficits have ceased to matter argue as if the laws of economics don't hold any more" (Economic Times, December 19).

That would indeed be a foolish attitude, but in order to be dissuaded from propagating such views it would be useful to know what particular law of economics one is defying.

There is no law of economics that lays down the proposition that fiscal deficits should never be undertaken. Admittedly, persistent fiscal deficits are expected to be unsustainable, but no particular law of economics tells us precisely when that day of doom will arrive.

Those of us who uphold the argument that fiscal deficits do not matter, perhaps concentrate too much upon immediate consequences; if there is unutilised capacity or if there is a tendency for population to grow thereby creating newer potential capacity, it seems sensible to allow domestic demand to grow to ensure that capacity is utilised.

There certainly seems no merit in having unutilised capacity and unsatisfied demand persisting simultaneously. That this can happen, and has happened in the past, and may indeed be happening in China and India today cannot be dismissed by the propagation of unknown laws of economics.

In earlier controversies it was argued by disciples of Keynes, like Joan Robinson, that unutilised capacity and unsatisfied demand could co-exist because of the "humbug of finance".

Indeed historically it was precisely to overcome this humbug that the international institutions like the IMF that Dr Rajan counsels, were established.

The idea was that the insufficiency of international capital of debtor nations could be met by lending; the additional demand would be mutually beneficial to poorer and richer countries by satisfying the needs of the poor with the surplus of the rich.

This notion has now been neatly finessed by poorer countries building up their own reserves. The problem now is not that they do not have the wherewithal to buy but persuading them to use these surpluses to push growth and demand into their economic system. Fiscal deficits are a way of creating this additional demand.

Having said that, no one would wish to argue that when resources are fully employed, fiscal deficits are desirable.

It would clearly be ideal to leave market forces to sort out the specific needs of society. No one pretends that governments are more capable of getting things done well than the private sector but that does not mean that the private sector can take the place of governments in all respects.

For one thing private sectors do not invest in projects that at the outset are expected to spend without any calculable benefit, as is the case with public health or education.

That such socially beneficial projects are not undertaken, we are told, is because of the persistence of fiscal deficits.

But one could turn the argument on its head by suggesting that it is the fear of the apprehensions voiced by economists like Dr Rajan that prevents the authorities from investing in areas with only long-term returns, and that the inactivity in development has emerged as a consequence.

Perhaps the time has come to move away from cautionary slogans towards a more detailed analysis of the impact on the economy of fiscal deficits.

It is relevant to point out that in economies like India and China, the liability of the national debt is not to foreigners but mainly to its own residents.

The analogy that most readily comes to mind is that if my profligacy is financed by my brother, our joint wealth is unaffected if my brother's financing is achieved by IOUs issued by me to him.

The economic lesson of this simple tale must be not that I incur unsustainable debts, for I only incur them to my brother who may be willing to tolerate them as he grows richer; nor is my expenditure necessarily wasteful, for one would have to discover how he would have spent the same money in order to arrive at a suitable comparison.

If we both chose to spend on the same goods for our joint consumption there would be nothing to choose between which of us should bear the burden of the debt.

If the deficits incurred by governments are of the kind that I have described then we should not be muddled by the humbug of finance.

The quandary that anti-deficit advocates must resolve is to find a suitable explanation for why the three fastest growing countries of the world also have some of the largest and most uncontrollable deficits.

The real economic issue is do fiscal deficits lubricate the wheels of growth even when such seemingly profligate behaviour is morally reprehensible? If fiscal deficits merely redistribute income arbitrarily among future generations that in itself may not be a sufficient reason for curbing their size.

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