Hanoi rats, Goodhart’s law and the quality of our fiscal deficit4 min read . Updated: 10 Jan 2021, 09:30 PM IST
India must change its accounting methods to capture the deficit correctly and end manipulation
In 1902, the city of Hanoi in Vietnam was ruled by the French and the wealthy parts of the city had a French-style sewer system. The sewer system had become a breeding ground for rats, leading to fears of the spread of a disease like the bubonic plague.
In an effort to get rid of these rats, the city offered a bounty for each rat tail that was delivered to the colonial offices. The rat tails started pouring in. But very soon, tailless rats were seen in the sewers.
It made sense for the rat catchers to just cut off the tail of a rat and present it to the officials and collect the reward. This ensured that the rats continued to live and reproduce, thus ensuring a steady supply of rat tails for the rat catchers.
Carl T. Bergstrom and Jevin D. West recall this very interesting story in their book Calling Bullshit: The Art of Skepticism in a Data-Driven World. The authors use this example to illustrate the Goodhart’s Law, named after the economist Charles Goodhart, which basically states that “when a measure becomes a target, it ceases to be a good measure."
Or, as the authors explain it: “If sufficient rewards are attached to some measure, people will find ways to increase their scores one way or another, and in doing so will undercut the value of the measure for assessing what it was originally designed to assess."
Examples of this phenomenon are everywhere. A business school I used to work for had dozens of journals, without much quality control, to drive up its rankings.
Another example of this is how factories in the Soviet Union operated in the absence of a market price mechanism. The central planners set a target for glass production in terms of weight, and this led production managers to produce the heaviest type of glass just to meet their target. Hence, there was always a shortage of the type of glass that was actually required by people.
When it comes to India’s economy, a measure which has become a victim of Goodhart’s Law is the fiscal deficit figure of the Union government. Fiscal deficit is the difference between what a government earns and what it spends during a particular year, expressed as a percentage of the country’s gross domestic product (GDP).
In February every year, when the finance minister presents the annual budget of the central government for the next financial year, a fiscal deficit target is set. But this target has been gamed for more than a decade now.
The accounts of the government work on a cash basis. This means that an expenditure is recognized as one only when money leaves the bank account of the government, irrespective of when it has been incurred. This allows the government to game the fiscal deficit figure.
Take the case of Food Corporation of India (FCI), which buys rice and wheat directly from farmers and then sells it at a subsidized price. The government compensates it for the difference.
In 2019-20, the total food subsidy to be claimed by FCI was estimated at ₹3.18 trillion. The government’s total allocation towards this food subsidy was ₹1.09 trillion and not all of it would have gone to FCI. Hence, clearly there was a gap of more than ₹2 trillion. This is money that FCI had already spent.
So, where did this money come from? Some of it was lent to FCI by banks. Banks lend to FCI simply because it is backed by the central government. Also, as of 1 April 2020, FCI owed the National Small Savings Fund (NSSF) ₹2.55 trillion. Collections under various small saving schemes, net of withdrawals, during a financial year, form the sources of funds for the NSSF. In the last few years, NSSF money has been lent to FCI and other state-owned companies like National Highways Authority of India and Air India.
In the past, there have been instances of the government not paying the fertiliser subsidy on time as well.
In this way, the government ensures that money doesn’t leave its accounts and is not recognized as an expenditure, even though it has been incurred. The forthcoming budget gives the government a very good opportunity to set this practice right.
The accounting of subsidies should be moved to an accrual basis, where any expenditure is duly recognized as an expenditure in the very year it is incurred, and not when the government pays for it.
Of course, there’s a problem of the money that the government owes FCI and other companies for expenditure that has already been incurred. This repayment can be spread over the next few years.
There is also the case of money being moved from one part of the government to another by getting one public sector enterprise to buy another public sector enterprise. This too needs to stop.
Only if this is done will the gaming of the Centre’s fiscal deficit figure stop. At the end of the day, it is worth remembering that the annual budget is primarily an exercise in presenting the right set of financial accounts of the central government, irrespective of all the other hype built around it. And this means that the quality of the country’s fiscal deficit needs to improve.
Vivek Kaul is the author of ‘Bad Money’.