Two decades ago, Sweden undertook a significant fiscal expansion to counter a growing recession. The cyclically adjusted primary balance went from a surplus of 3.5% of gross domestic product (GDP) to a deficit of 6.5% of GDP in three years. Government debt trebled to 70% of GDP. Conventional Keynesian theory would suggest that a large fiscal expansion would stimulate growth, and have a positive multiplier effect on private demand.
Exactly the opposite happened. Private consumption and investment crashed in response to the fiscal expansion. The magnitude of their collapse swamped the initial fiscal stimulus, resulting in a contraction of output. The fiscal multiplier was negative, and Sweden experienced a contractionary fiscal expansion.
Illustration: Jayachandran / Mint
A few years before, Denmark and Ireland engaged in sharp fiscal consolidations. Far from depressing private economic activity, both consolidations led to a sharp boom in private consumption and investment. In each case, private demand reacted in the opposite direction to the fiscal impulse—contrary to Keynesian theory—resulting in a highly muted or negative fiscal multiplier.
These episodes are not unique or anomalous. Several industrialized countries have experienced negative fiscal multipliers. More importantly, International Monetary Fund (IMF) studies have documented the growing existence of non-Keynesian outcomes even in low- and middle-income countries. What’s driving these outcomes? And why should Indian policymakers care?
Econometric studies have demonstrated that non-Keynesian outcomes typically appear under certain conditions: First, fiscal policy’s impact on growth is highly non-linear. Small, intermittent fiscal impulses generate Keynesian impacts, but large and persistent ones often generate non-Keynesian outcomes. Second, initial conditions matter. Fiscal impulses initiated during “adverse times” (that is, when public debt-to-GDP is high) often have a non-Keynesian impact. Why? There are two primary transmission mechanisms.
The first works through the interest rate. A fiscal expansion typically drives up interest rates (including by increasing default risk premiums on public debt). Higher interest rates typically crowd out private investment and also reduce asset prices— which, in turn, dampens private consumption through a negative wealth effect. Initial conditions, therefore, matter: fiscal expansions in “adverse times” disproportionately push up risk premiums and interest rates.
The second is based on credibility and expectations. If large and persistent fiscal deficits are construed as the start of a more expansionary regime—which will have to ultimately be financed by future permanent tax increases—agents downward revise their expectations of permanent disposable income and reduce current consumption, as a means of smoothing consumption. The same logic holds true for firms’ investment decisions. The size and persistence of fiscal impulses, therefore, matters to the extent that they are symbolic of a fiscal regime change.
So why is this relevant to India? The finance minister (FM) has admitted that the latest stimulus is a “calculated risk”. For it to pay off, it is critical that the stimulus has a strong positive multiplier effect on private demand. Policymakers are banking on the resulting revenue buoyancy.
But is India vulnerable to a highly muted, even negative, multiplier? Are India’s deficits “large and persistent”—symbolic of a regime change? Are the initial conditions “adverse”?
That India’s projected deficit for 2009-10 is large is beyond debate. The Centre’s deficit is estimated at 6.7% of GDP—it is the highest in 16 years. The consolidated deficit (including states, fuel and fertilizer bonds) could exceed 13% of GDP. The Centre plans to borrow Rs4 trillion to finance its deficit—a 300% increase over two years ago. States could borrow Rs1.4 trillion. These are unprecedented numbers.
More importantly, are these deficits perceived to be persistent? Is the FM’s plan to reduce the deficit to 4% in two years credible?
Much of the rise in the deficit is on account of a huge 43% increase in spending over two years. Most analysts feel that none of the big-ticket spending items—interest, defence, subsidies, salaries and pensions, the National Rural Employment Guarantee Scheme and Bharat Nirman— seems either temporary or reversible. On the contrary, entitlement schemes are on the rise in the Budget.
If spending cuts are not politically palatable, will revenue buoyancy bridge the gap? It took four years of almost 9% growth for Central tax revenues to increase by 2.5% of GDP. Unless the goods and services tax is some panacea, it is unlikely this gap will be bridged in two years. Furthermore, a fiscal correction of 1.5% of GDP for two successive years has never been achieved. Clearly then, India seems to be on the cusp of a far more fiscally expansive regime which, given our high debt stock, may eventually have to be financed by future tax increases (unless the deficit is monetized).
What about the second criterion? Is the stimulus being conducted during “adverse” times? The Economist notes that India’s fiscal deficit and debt stock (80% of GDP) are currently the highest of all its emerging market contemporaries. Half the current borrowing is just to pay off interest on current debt. Unsurprisingly, rating agencies have downgraded their outlook on sovereign debt—possibly pushing up default risk premiums on sovereign debt.
This higher risk premium and large quantum of government borrowing have militated against lower interest rates. Yields on benchmark government bonds have increased by 170 basis points since December at a time when the Reserve Bank of India has been engaged in aggressive monetary loosening. Further, just the Centre’s borrowing requirement is 60% of the rise in bank deposits over the last fiscal year. Private investment looks sure to be crowded out.
The sobering conclusion is that India seems to meet both criteria associated with negative multipliers. Will India’s fiscal expansion meant to spur private demand, paradoxically, end up retarding it?
Maybe this extreme outcome will not come to pass just yet. But the evidence from other countries is clear: When temporary fiscal stimuli turn into irreversible fiscal expansions, economic agents rationally modify their behaviour. When this happens, fiscal policy loses potency and often becomes counterproductive.
Sajjid Chinoy is a Mumbai-based economist who has worked at IMF and McKinsey & Co. Comments are welcome at email@example.com