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


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


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


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



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