BackFiscal deficit arises from state action
It’s not profligate spending, but the state playing a financial intermediary that’s pushing up the fiscal deficit
PremiumPhoto: Ramesh Pathania/ Mint
(Ramesh Pathania/ Mint)
A fiscal deficit is simply the excess of government spending over its revenue. Spending minus taxes. G-T, national income accounts wise. G-T is positive when the government runs a deficit and negative when it runs a surplus. Beginning with the standard macroeconomic identity that:
Y (expenditure) = C (consumption) + I (investment) + G (government spending) + NX (exports minus imports)............ (1)
Private sector savings (S) are private sector disposable income not consumed.
S = Y(income)-T(taxes)-C(consumption) .............(2)
Combining (1) and (2) gives S = I + G - T + NX. Or, (S-I) = (G-T) + NX.
This rather simplistic identity goes by the name of the sectoral financial balances (SFB) approach, with Wynne Godley, a British economist known as the Cassandra of the Fens for his bleak and accurate predictions about the UK economy, being its foremost exponent. Among other things, Godley was among the first to warn that the euro zone—a currency union without a fiscal union—would be disastrous in the medium term and would collapse before too long. Given the accuracy of his predictions, the raging debate around fiscal deficits, current account deficits etc., it is time to take a closer look at SFB.
The macroeconomic world has been split up into three seemingly autonomous sectors—government, private and foreign. It seems scarcely believable, but playing around with this identity seems to give some heterodox theorists additional analytical edge and real-world relevance over mainstream macro-theory. Witness, for example, Martin Wolf, a former World Bank economist and the premier finance and economics journalist in the world. How in the world does a definition add insight?
Well, here it is. S-I is the net private sector financial surplus. G-T is the fiscal deficit. NX is the net foreign sector surplus. At a given level of NX, a private sector surplus is necessarily matched by a fiscal deficit. Read that carefully, again. A private sector surplus is matched by a government deficit. Ceteris paribus, or all other things being equal, an increase in government deficits increases the private sector surplus. A decrease in government deficits crashes the private surplus. The government (and net exports) creates financial wealth for the private sector. Most importantly, if your NX is negative, i.e., you have a current account deficit like India, you cannot possibly have a private sector surplus unless the government runs a deficit. Read that again too. A government deficit is almost a foregone conclusion if you want to invest sustainably (through domestic savings) in the face of a current account deficit.
Now let’s back out a bit. This can’t possibly be true. It does violence to our carefully built intuitions. Private sector wealth should not be positively related to government deficits. All our received wisdom says otherwise. And yet, there it is, an arithmetic identity, the last thing in the world which can be jaundiced by ideology. So what’s going on? Obviously, ceteris is not paribus.
The equation is true at all levels of Y, I, C etc. It says nothing about the evolution of those quantities over time. Arguments against government spending and deficits must have some implicit behavioural assumptions that affect the course of these quantities over time. G-T creates S-I, sure. But does it boost S (good) or crash I (bad)? Does it hold NX constant, or does something happen to crash NX while G was increasing? The equation does not say. Ultimately, what that equation reveals depends on other equations implicit in your mental model. But just as in the Friedman quote on inflation, even if not particularly edifying when taken literally, the sectoral financial balances approach gives us pause. It makes us understand that one plausible role of the state is that of a financial intermediary. Government deficits may be helping the private sector achieve its desired levels of savings and investment, letting the household sector and the corporate sector make their spending and saving decisions independently while soaking up any gaps (or absorbing any excesses) to ensure that the plans of neither sector are frustrated.
So again, what does all this arcane theory of government finances have to do with India’s current woes?
For one, let’s get out of the mode of ‘twin deficits’. Even the Reserve Bank of India governor mentions this in his speech, but while it’s an OK phenomenon to invoke when analysing currency price movements narrowly—both a fiscal deficit and a current account deficit point towards a weaker currency—it does not add much value to a discourse on overall macroeconomic stability and performance. A country with a current account deficit will almost always have a twin deficit.
Second, recall that the fiscal deficit is typically split up into two parts—the primary deficit, and interest payments. The primary deficit is the main measure of the sustainability of a government’s revenue balance—e.g. do our taxes cover for the salary payments of our armed forces? Interest payments are on the outstanding government debt. They are nominally fixed. They will spike only if G-Sec (government securities) investors believe that the government is running a Ponzi scheme, and thus each rollover of government debt will imply a worsening fiscal situation. Otherwise, any inflation only helps to bring the fiscal balance under control, by reducing the real value of government debt payments.
Now, India’s total public debt (state plus central) is 68% of GDP. The average maturity of that debt is 10 years. The benchmark 10-year G-Sec yields 8% per annum, but the average interest payment is of the order of 7% as this debt was contracted when yields were somewhat lower. Seven percent of 68% is 4.7%. (All figures from here.) The interest payments of the Indian state are thus in excess of 4% of GDP. India’s total fiscal deficit is around 6%. India’s primary deficit is thus less than 6% - 4% = 2%. Round that up to 2%, and read that slowly again. India’s fiscal deficit is being driven largely by its interest payments. Of course, there’s also a primary deficit, so that reducing the interest payments themselves unilaterally by simply not rolling over the debt is not immediately feasible. But go back to the concept of the state as a financial intermediary. The Indian state is taking on debt mostly to pay interest on debt. That sounds like a Ponzi scheme! So, what exactly is the government doing here?
The government is creating a pool of credit-risk-free financial assets at all maturities of the term structure. The government is creating the way in which you and I are able to park our funds in two-year, five-year, 10-year fixed deposits. It is creating the source of income for closed-end mutual funds. It is running a Ponzi scheme, albeit one that is perfectly sustainable as long as the expected growth of the economy is in excess of the interest rate on government securities. This is the state as a financial intermediary, what the Columbia University monetary economist Perry Mehrling calls a social mutual fund.
Now you may wonder—how in the world did a bunch of poorly incentivized bureaucrats and politicians come up with such a fantastic, commercially viable role of the state. I don’t want to push the point, but the answer perhaps lies in Hayekian spontaneous order. We don’t have to be well meaning and in possession of a master blueprint to organically stumble upon beneficial arrangements, and beneficial arrangements need not be restricted to ‘the market’. Perhaps, we copied the advanced states. Perhaps, some regulator just gave in to some market pressure for kick-backs and asked for a new and improved term structure of government debt. Who knows?
The point to remember is—yes, fret about the fiscal deficit, but recognize the fact that it mostly arises not from profligate spending, but from the state playing a financial intermediary. Arguments challenging the viability of the latter will take a very different form than those that challenge the viability of the former. For one, the key variable to look at is not inflation, but interest on benchmark 10-year government debt versus the growth rate of the economy. With yields at 8% and growth rates at 15% (both nominal), the operating space that the Indian government has on this front is rather large currently.
The writer is a London-based consultant. This is the second of a five-part series in which Ritwik Priya examines the macroeconomics of inflation in India through the lens of the fiscal deficit, NREGA, tax policy and investment.
“These are the author’s personal views."
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