High risks in high deficts

Indian Express, 27 July 2006

Consumer prices in June 2006 were 6.5 percent higher than in June

2005. Last year in June price rise over the previous year was less

than 4 percent. The government has tried to combat the sharp increase

in inflation by a combination of supply side measures and higher

interest rates. Undoubtedly, the impact of these steps is more direct

and visible, while that of fiscal policy is not. But when the

government is trying to restrict private expenditure by raising

interest rates, is there not a case for it to restrict public

expenditure too?

Ironically, what we find is that even in these taxing times when there

is acute pressure on prices to rise, arguments are being made to

abandon even the legitimate restraint that Parliament places on

government through the Fiscal Responsibility and Budgetary Managment

(FRBM) Act.

Considering that inflation is only one of the dangers of large fiscal

deficits, where external indebtedness, inflation, large interest

payments, reduced private investment and debt default are some of the

others, this is a very unwise argument.

One option is that the government finances additional expenditures by

simply printing money. India has tried it in the past, suffered high

inflation and then wisely put an end to this option. The central

government no longer has the power to print money to spend. What it

can do, instead, is to borrow money from the public and from

commercial banks.

But if the government's deficit exceeds the amount the domestic

private sector lends to it, the country as a whole now spends more

than it produces. It imports more than it exports. The additional

spending has to be financed by capital inflows like FDI, FII or

foreign debt. For any given domestic savings rate in an economy, if

the government borrows from the public, then either domestic investors

get to borrow less and investment goes down, or the sum of borrowing

by the government plus private investors must be met by capital

inflows from abroad, or foreign savings. Foreign capital inflows like

FDI and FII happen when the economy is doing well. Foreign equity

inflows are deterred when India runs large deficits. So large deficits

tend to go along with large offshore borrowing.

The Indian government ran large deficits in the 1980s and ended up

hugely indebted to foreign lenders by 1991. Now again, if we raise

deficits and if foreign investment is inadequate to meet our deficits,

foreign debt could build up.

Morevoer, the goverment often gets preferential treatment as a

borrower both from public sector banks and from those with a lower

risk appetite. Private borrowers have to compete for a smaller share

of savings as the government pre-empts savings. It thus "crowds out"

the private sector by pushing up interest rates and reducing private


Further, high fiscal deficits mean high public interest

liabilities. The more the government borrows today, the greater are

its committed interest liabilities in the future. This reduces the

flexibility it has with spending. Last year interest payments took

away two-thirds of taxes collected. If the state of public services is

poor today, then the blame partly lies on the fiscal profligacy of the

previous governments. If the state of infrastructure is poor, if roads

are badly maintained, if the government has not had the money to

invest in new airports, ports or power plants, the problem is not

unrelated to the size of past deficits. If we run higher deficits

today we are tying down the hands of future governments who will end

up using all their tax collections to pay for our expenditure today.

As the government continues to run deficits and borrows more and more,

there comes a time when the government is borrowing only to repay its

debt. It starts running a "Ponzi scheme" named after the innovative Mr

Ponzi who ran a nice little racket, borrowing from B to pay A and from

C to pay B and so on. As the size of the debt increases this could

lead to a situation in which the government thinks it is better to

default on its debt. In India we have not yet worried about the

possibility of default, but the current level of the public debt is

very high by world standards. As it rises further, there would be

fears about the government defaulting on its debt obligations. Not

only will millions of households lose their savings in post-offices,

National Saving Scheme, PPF, GPF and RBI bonds, the banking system

which holds about 85 percent of government debt will lose

heavily. This would hurt millions of households across the country.

It is very easy today for the government to spend crores of rupees on

welfare schemes financed by deficits. The voter is unable to

comprehend that he is paying for them through higher prices. Yet,

while doling out borrowed money to win votes might seem to be an

attractive option, it should be remembered that the inflation

tolerance of the Indian consumer is low, and the end of the day high

deficits may prove to be very costly.


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