Fallacy 2: A large fiscal deficit is necessarily harmful
There are three possible adverse consequences
of a fiscal deficit (I am excluding such consequences as "lowering
investors' confidence", since they arise only in a particular
regime, of "liberalisation", which itself has no sanctity).
First, it may generate excess demand pressures in the economy, giving
rise to inflation and/or a current account deficit on the balance
of payments. Secondly, a fiscal deficit generates wealth inequalities
in society. An excess of expenditure over income of the government
must be matched by an excess of income over expenditure of the non-government
sectors (i.e. of the private sector and the "rest of the World").
We have already mentioned the problem of enlarged foreign debt (which
arises from a larger current account deficit on the BOP); so let us
leave the "rest of the world" out. Financing government
expenditure through larger domestic borrowing implies (relative to
either not having this expenditure at all or financing it through
taxes) larger private wealth. Since the propensity to save is larger
among the rich, this necessarily means larger wealth in their hands;
wealth inequalities therefore increase. What is particularly bizarre
is when fiscal deficit causes inflation: here inflation squeezes out
forced savings from the poor and working people, but these savings
add to the wealth of the rich (Keynes had rejected such "deficit
financing" in How to Pay for the War). Thirdly, deficit-financed
expenditure (relative again to either tax-financed expenditure or
to no such expenditure) sets up a debt-service obligation upon the
government, which may aggravate fiscal strain in the future.
In a demand-constrained system the first
of these adverse consequences would be inoperative (such a system
may still experience a current account deficit following a fiscal
deficit, since imports increase with output, but this is not specifically
related to the fiscal deficit; any other way of enlarging output by
a similar magnitude would have generated an equal current deficit).
The other two adverse consequences of course would still remain. But
this means that in a demand-constrained system, while it may be better
to finance enlarged government expenditure through taxes (provided
they do not nullify expansion) rather than through a deficit, it may
still be preferable to have a deficit rather than not expand expenditure
at all. A large fiscal deficit need not be shunned in a demand-constrained
system.
But the matter appears in an altogether
different light when we use the term fiscal deficit in the conventional
sense in which it is used in India. Here fiscal deficit refers not
to the deficit of the government sector as a whole but only to the
excess of expenditure over income in the government budget. Since
a large part of government activity is not covered in the budget,
it is perfectly possible that the fiscal deficit as revealed in the
budget is matched by a corresponding surplus not in private hands
(we leave out the external sector for the moment), but in the hands
of the non-budget sector of the government itself. If this happens,
then the concern over private wealth inequalities and possible future
fiscal strain (owing to debt-service payments) need not be serious.
If the economy in addition happens to be demand-constrained, then a fiscal deficit need have no adverse consequences at all.
Indeed in such a situation curtailing government expenditure in the
name of keeping down the fiscal deficit would be a foolish policy
to pursue, because it would perpetuate the demand constraint which
could have been removed "costlessly" (i.e. with no adverse
consequences). The foolishness would be truly astounding if, even
in the presence of idle capacity located within the government sector
itself, not only is fiscal deficit, which would have generated demand
for using up this capacity, kept down, but "shortage of rupee
resources" is simultaneously invoked as an argument to invite
foreign investment to set up plants with the import of the very equipment
whose production capacity is lying idle within the government sector.
In India, regrettably, fallacy 2 has become
the cornerstone of official macroeconomic thinking; what is more,
government policy even pursues the "astoundingly foolish"
course just mentioned. Let me give two examples to illustrate my point.
At present there are over 32 million tonnes
of foodgrain stocks of which at least 13 million tonnes are surplus
stocks. These surplus stocks should be used to alleviate poverty and
hunger through an employment-generation programme, which, if properly
conceived and executed, can have the additional advantage of giving
rise to rural capital formation. Even if this programme is financed
entirely through deficit financing, this would have no adverse consequences:
the money spent would accrue to the FCI (ignoring for simplicity the
non-food component of the employment-programme), which in turn would
use it to repay bank-credit locked up in stock-holding. The government's
net indebtedness would not have gone up; its total interest payment
obligation would not have gone up (would have even come down if government
borrowing costs less than FCI borrowing); and yet rural poverty would
have come down through the elimination (even if temporary) of the
irrational spectre of unused rotting foodstocks in the midst of mass
hunger. True, the fiscal deficit shown in the budget would
have gone up, but attributing economic significance to this fact per
se is precisely the fallacy we are talking about. The current
budget however undertakes no such programme. On the contrary it does
the very opposite: it attempts to bring down this wrongly-conceived
notion of deficit by raising food prices for all and by virtually
winding up the public distribution system for the so-called "above
poverty line" population which actually includes vast numbers
of the poor.
My second example relates to the power
sector. There is an almost unanimous view in government and media
circles that India desperately needs foreign capital to develop its
power sector. But this need cannot be for technology (which we have)
or for foreign exchange (which would not be required in the first
place if domestically produced equipment is used). The only possible
argument in support of this view can be that MNCs bring finance,
that if they were not entrusted with the task then the government
would have to finance these power projects from its budgetary resources,
which typically would mean a larger fiscal deficit.
In short, power projects are being entrusted
to MNCs in order to avoid a larger fiscal deficit. But, as long as
unutilised capacity owing to deficient demand exists in the power
equipment and its feeder units belonging to the public sector itself,
to talk of the government's experiencing a shortage of finance for
power investment is meaningless. If the government borrowed Rs.100
and spent it on a power project then the bulk of it would come back
as operating surplus to BHEL and other public sector enterprises,
so that the net indebtedness of the government would not increase
despite the apparent increase in the fiscal deficit. But by invoking
a financial constraint where none exists, the government not only
succumbs to MNCs' demand for their "pound of flesh" (including
guaranteed rates of return on inflated capital costs), but also perpetuates
the demand constraint faced by the public sector units. What is more,
this perpetuation would be used as an argument for declaring these
units to be "sick" and for privatising them 'for a song".
The most charitable interpretation one can place on government action
is the one I have placed, namely that it betrays "astounding
foolishness".
