The importance of being fiscally responsible
Financial Express, 1 August 2006
Should a government spend as much as it likes without worrying about
the size of its deficits? Kerala's new Finance Minister has questioned
the principles of fiscal prudence and expenditure control by
states. Some economists have criticised the constraints the Fiscal
Responsibility Act has imposed upon the central
government. Considering the large spending programmes that the CMP has
imposed upon the UPA, it would be very convenient for the central
government to renege on its promises of fiscal prudence. But would it
be a wise thing to do?
Why not run larger and larger welfare programmes and populist schemes
financed by borrowing and win votes in the bargain? Why did Parliament
try to restrict the deficits of the central government, and the
Twelfth Finance Commission try to restrict the deficits of the state
governments, when such restrictions are clearly unpopular?
The answers are well known to every student of economics. They lie in
the dangers posed by large fiscal deficits: the dangers of external
indebtedness, inflation, large interest payments, reduced private
investment and bankruptcy. It is worth reiterating them since they are
particularly relevant today.
Suppose 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. 'Deficit
financing', is no longer feasible. The central government no longer
has the power to print money to spend. What it can do, instead, is to
issue bonds and borrow money from the public and from commercial
banks.
When the government spends more than it collects in taxes, it creates
additional demand not backed by production in the economy. This can
lead to the country importing more than it is exporting, and
therefore, running a trade deficit. This 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 by the government or PSUs.
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,
a balance of payment crises could build up. Is that a risk worth
taking again?
As the trade deficit rises, it puts pressure on the currency to depreciate,
which makes imports more expensive, a fiscal deficit can lead to an
increase in prices. In the current scenario there is already a
pressure on prices from the supply side. The upward movement in
international commodity prices including oil is already raising
domestic prices. A further rise in inflation is not desirable. It is
well understood that inflation hurts the poor and the salaried
consumers disproportionately.
Morevoer, now private borrowers have to compete for a smaller share of
savings as the government pre-empts savings, thus "crowding out" the
private sector. Interest rates are already on their way up. In
addition to lower investment, this time there is an additional
uncertainty. India has been riding her first retail credit boom in
recent times. We do not have historical evidence to tell us what will
be the impact of higher interest rates on consumer spending and GDP
growth.
High fiscal deficits also mean high interest payments. 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.
We are, right now, enjoying a remarkable macroeconomic boom. A big
factor driving this is the rise in investment, from 23 percent of GDP
in 2001-02 to 30.1 percent in 2004-05. One major factor underlying
this was a shift in public sector saving, from -2.0 percent to a
postitive of 2.2 percent of GDP: giving a 4.2 per cent of GDP gain. If
we get back to irresponsible fiscal policy, then this gain will be
squandered.
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