Was it just last February that we were congratulating ourselves, our finance minister saying, “It is widely acknowledged that the fiscal position of the country has improved tremendously…not only will I achieve the target for fiscal deficit under the Fiscal Responsibility and Budget Management (FRBM) Act, I have also left for myself some headroom.” Now, with the swift reversal in fortunes, the deficit rose from a budgeted 2.5% of gross domestic product to 6% this fiscal, with an estimated 5.5% for fiscal 2010; the topmost question being—where will all this money come from?
Simply put, fiscal deficit is when the government spends more than it earns. To fill this gap, the government can borrow money, raise revenue—taxes, sale of public sector units, reduce spending, cut subsidies or print money. India used to run up huge fiscal deficits, financed by printing money—one of the reasons for our high inflation earlier. The 2004 FRBM Act aimed at inculcating fiscal discipline, setting deficit targets, prohibiting the Centre from borrowing from the Reserve Bank of India (RBI), etc. However, exceptions are allowed by parliamentary approval. T.V. Somanathan’s article in The Hindu Business Line (July 2004) explained the Act’s essence: “...the overall effect is like a pact between a heavy smoker and his wife, in which the wife (concerned for his health) prescribes the maximum number of cigarettes per day with a gradual reduction to nil; after giving him the agreed number, she would lock away the cigarette box—but leave the key with him in case of ‘emergency’ smoking needs, the only condition being that he should tell her after each emergency. Also, if he really felt bad, she would even amend the ceiling for a while, till he felt better.” And that is precisely what has happened.
Illustration: Jayachandran / Mint
With the slowdown, reducing government expenditure and raising taxes are no options. Naturally, the government’s interim budget has pegged borrowings at the highest ever—Rs3.62 trillion. The government can borrow from the public or it can borrow from the central bank, the latter being monetized deficit. Both options have costs— market borrowing raises interest rates while borrowing from the central bank raises future inflation levels. The options that will keep a lid on interest rates are, as Tamal Bandyopadhyay’s columns in Mint have suggested—floating rate bonds, transferring Market Stabilization Scheme bonds to the government account (RBI just did that), and private placement of bonds with RBI.
Recently, economist Arvind Subramanian explained the benefits and costs of deficit monetization— given the adverse credit environment and large borrowing requirements of the government, interest rates have to be kept low, so monetization is preferred. However, this route raises future inflation levels, sets a precedent in fiscal management and disturbs the relationship between fiscal and monetary authorities by giving the government the right to push the central bank into a corner again. Monetization, therefore, has trade-offs.
The question, should deficits be monetized, must be replaced by, is there an alternative to such high fiscal deficits? Of course, these are exceptional times, but the quantum of borrowing could have been much lesser if we had run a surplus in good times, had more effective programme implementation, reformed our markets to remove pricing distortions that suck up huge subsidies, etc.
While pausing often in our FRBM targets, do we ever pause to wonder why the same issues keep raising their head over the years? For 2005-06, then finance minister P. Chidambaram had suspended the FRBM path, saying he was confident of resuming the process of fiscal correction in 2006-07 and achieving the FRBM goals by 2008-09. Little did anyone know what fiscal 2009 had in store. Now, with deficit numbers going through the roof, the finance minister said, “Conditions in the year ahead are not likely to be normal and, therefore, the high fiscal deficit is inevitable. We will return to FRBM targets once the economy is restored to its recent growth path.” The record shows that discipline is possible only in good years, and, when the going is good, there is little thought of the possibility of bad times. Last month, US Federal Reserve chairman Ben Bernanke, too, fought criticism, saying the Fed was not taking too much risk: “Once the economy turned around, it could nip in the bud any dangerous outbreak in inflation caused by the deluge of money.” But as Wharton’s Franklin Allen warned, “It may get out of control. I don’t think we’ve had nearly enough discussion of that in the public sphere.”
We are in this mess today because no one wanted to contemplate the consequences of cheap and easy money when the boom was on. Now, the path ahead is not going to be all smooth sailing; as Deutsche Bank’s Thomas Mayer noted, till the global economy is fully restructured, growth may well seesaw between recessions and short-term rebounds on the back of fiscal policy stimuli. The industrialized world would need to get used to lower growth and higher inflation, as the middle class in developing economies becomes the new driver for global growth. If we are to play that role with any responsibility, we must be prepared for the consequences of our actions at every step in time.
Meanwhile, go ahead, ramp up the deficit, ramp up the borrowings, use the printing money route if you need to, but remember there are costs—if and when the good times roll, let’s try not to lose our head again.
Sumita Kale is chief economist at Indicus Analytics. Comments are welcome at firstname.lastname@example.org