Home / Opinion / Views /  Opinion | A wider deficit is unavoidable to strengthen demand

The dominant consensus on the slowdown in India is that we have a demand problem. Lack of aggregate demand is a phrase that goes back to John Maynard Keynes. He is a ghost who reappears from time to time, however much one tries to bury him. Regardless of whether you are a Keynes devotee or not, his logic is irresistible, both to the policymaker and the common man, or woman. If there is insufficient demand on account of inadequate consumption, investment or exports, it ought to be offset by the government stepping in. That is to say a fiscal push is inevitable. Only once the government creates demand for goods and services through extra deficit-spending will new jobs and incomes be generated, which in turn will create fresh demand for goods and services, setting off a virtuous cycle until the economy can run on its own steam without fiscal steroids.

The idea of deficit-spending divides economists into anti-deficit fundamentalists and “deficits do not matter" shoulder-shruggers who tend to support any amount of fiscal profligacy. Actually, most well-meaning, classically-trained economists fall in the former camp, and they see opposing deficits as a noble duty because nobody else champions the moral cause of austerity or balanced budgets. The libertarians among them oppose deficits also because they don’t trust the government. Conventional theory says that uncontrolled deficit-spending will lead to high debt and interest rates, inflation and ultimately a crisis that will call for debt repudiation. That will lead to a loss of investor confidence and growth. This is the doomsday scenario. But India’s experience of the past three decades has been that despite a relatively high deficit, its economy has grown at a fast pace without runaway inflation, let alone debt repudiation.

For a developing country, deficit-spending makes sense. This is because the growth benefits of that spending accrue over multiple generations, so that today’s benefits are paid by taxes on tomorrow’s unborn citizens. This is sensible both from efficiency and fairness points of view. For, if a bridge or airport is financed through a deficit today, it is a public good that will last for more than 50 years and whose benefits will be enjoyed by multiple generations. So long as the country’s demography is such that more beneficiaries are expected to be born than there are today, the per capita burden of today’s deficit-spending will be lower tomorrow.

India currently enjoys such a demographic profile. Of course, there is such a thing as sustainable debt. Whether it is 100% or 200% of gross domestic product (GDP), one cannot say. The Fiscal Responsibility and Budget Management expert committee has recommended that central debt be capped at 40% of GDP.

Japan has the world’s highest debt-to-GDP ratio, at close to 350%. But its debt is still AAA-rated and nobody has said it is unsustainable, even though its demography is unfavourable because its population is shrinking. The per capita burden of servicing that debt will keep rising for future Japanese generations. One big point in their favour is that most of the debt is held internally. It is like the left pocket owing money to the right. Another favourable point is its near-zero interest rate on sovereign debt. It is as if servicing the debt is almost without cost. In the US, which runs the highest deficit in the world (close to $1 trillion), the big point is that all its debt is in a currency that it can print. So it can earn unlimited seigniorage, inflate and thus erode the real value of its debt. Moreover, the world seems to have an insatiable hunger for US sovereign bonds, so financing the debt seems like a cakewalk. Indeed, long-term yields on US bonds is very low, which has led to an inverted yield curve.

In the Western world, much of the sovereign debt is in negative-yield territory. Central banks are struggling with inflation running below targets. They are also under pressure to reduce rates, but how do they go below zero? Modern Monetary Theory, a new fangled and somewhat controversial framework with a growing following among politicians and a few economists, says that deficit-spending does not matter at all. This is as fundamentalist as opposing deficit-spending altogether.

India’s macroeconomic situation warrants a significant fiscal push. China just announced a $125 billion spending plan, which is five times the cash surplus transferred by the Reserve Bank of India to the Centre. It is experiencing the adverse effects of a trade war with the US, as well as a slowing domestic economy. But the size of its fiscal injection shows what it takes to make an impact. Of course, the quality and destination of the fiscal spending greatly matter. Development of infrastructure, both hard and soft, should be a top priority. But let us not forget that old Keynesian idea of the efficacy of even filling ditches. The National Rural Employment Guarantee Scheme can serve the dual purpose of creating rural jobs and village assets. The scheme accounts for less than 2% of all person-days annually, but sets a wage floor and raises rural earnings overall. It is particularly relevant and imperative in light of India’s rural distress.

While we loosen our fiscal purse strings, we should not lose focus on the revival of export growth, manufacturing, skill-building and agricultural reforms. The extra fiscal bill can be partly funded by the ambitious sale of government stakes in public sector entities. But running a bigger deficit in these times is a must.

Ajit Ranade is an economist and a senior fellow at The Takshashila Institution.

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