Behaving responsibly

The Fiscal Responsibility Bill has run into problems as the opposition has been protesting against any cutback in public investment for ensuring fiscal prudence.

The bill seems very sensible at first sight. The government is spending too much. Especially on itself. Its spending should be curbed. Especially when it starts borrowing to finance its current expenditure. There should be automatic mechanisms in place to make sure that if it starts borrowing more than a certain amount, it just has to stop. The bill aims to put limits on the amount the government can borrow whether to finance its current expenditure or to invest.


The reason why economists worry about the size of the deficit today is that when the government borrows from the market it raises the demand for funds and pushes up interest rates in the economy. This lowers private investment. In other words, fiscal deficits 'crowd out' private investment.

So keeping deficits low will allow interest rates to remain low. And that will raise private investment. The market will ensure that investment flows into areas that are profitable and this will bring about growth.

So, why oppose the bill? Why oppose cutting deficits? Because, there is an unstated assumption in the crowding out argument made above. And, for the bill to be good for the people it is necessary that this assumption is true. The assumption is this. That the market will fulfil the needs of the people better than the government would have done. Otherwise, why move away from government and towards the market?

Thatís very fine for those like me. The market provides me with all those facilities that once used to be considered the domain of the government. I depend on Bisleri and Aqua Guard for clean drinking water, on Group 4 for security, on my invertor for uninterrupted power supply, on Maruti car for transport. My daughter studies at Springdales, a private school. And we go to a private clinic when someone at home is ill.

But a large part of the population is outside the market. Still depending on the government not just for water, electricity, power and transport but also for health and education. With inadequate resources to purchase these utilities in the market, how will a lowering of interest rates and an increase in private investment fulfil their needs. Indeed, this remains the most powerful reason why it is difficult to reduce the size of the government and consequently of fiscal deficits.

In developing countries like India this problem is even more acute. This is because not only does the government undertake the provision of public goods, as do government's in developed countries, it also has the job of building the basic infrastructure needed for industrial and agricultural development.

The last ten years of reform have seen a slowdown in the growth of public investment while private investment in areas of infrastructure has not been forthcoming. The plight of the country's infrastructure today is not something to be terribly proud of. And, most people agree that there are still innumerable problems to be overcome before private investment comes rushing into the area, removing the need for further public investment. But till that happens, the role of public investment remains crucial.


Also, there are no immediate causes of worry. Even though today the combined fiscal deficit of the centre and the states stands at nearly 10 per cent of GDP. This is because the usual reasons economists worry about the size of the deficit are not very pressing in today's circumstances. These reasons are as follows.

First, that deficits can be inflationary. This happens because government spending raises demand for goods and services. But given the current low levels of core inflation (inflation rate minus the increase in oil prices) this is not the major concern today.

Second, they can lead to an increase in imports. A higher fiscal deficit can result in a higher trade deficit. But again, that is not a major worry today because imports have actually been declining and the trade deficit is very low.

The lessons are clear. One, fiscal prudence should be achieved not by cutting spending as such without clearly putting down on what items the cuts have to be made. Two, it will be very difficult to achieve a reduction in deficit by an emphasis on cutting expenditures. Unless a huge amount of effort is put into raising revenues, it is unlikely that attempts to cut deficits will be successful.