The premise underlying the report of the Committee is that the fiscal deficit is the key parameter affecting all other macro-economic and growth variables, and that its control is absolutely necessary for the realisation of all economic objectives of the government.  "To sustain and accelerate the high growth, to maintain inflation at a low level, to avoid vulnerability on the external balance of payments front and to nurture the growth of a vibrant financial sector including the banking system, it is absolutely imperative to reverse the current fiscal stance towards greater fiscal rectitude." (Report, page 5) In addition, fiscal consolidation is seen as necessary to lower interest rates and therefore to encourage higher private investment.
 
Such an axiomatic understanding is not one that can be justified either by newer theoretical work or by recent international experience, which actually point to very different causal relationships. Let us consider each of these explicit assumptions in turn.
 
First is the argument that lower fiscal deficits lead to higher and more sustained growth. This need not be the case on either theoretical or empirical grounds. If the deficit is dominantly in the form of capital expenditure, it contributes to future growth through demand and supply linkages. Also, since there is a strong positive correlation between public and private investment, which is now accepted even by institutions like the World Bank, more such public spending would stimulate more overall investment and thus growth. The "crowding in " effects of public investment are now generally acknowledged to dominate over "crowding out" effects in developing countries in particular.
 
Indeed, the deflationary effect of lower fiscal deficits is one that is widely and openly recognised by most governments even in Europe, although they may be forced to try and curtail their deficits because of other reasons such as financial sector pressure. So, both in the short term, where there is an immediately obvious trade-off between a lower fiscal deficit and higher growth, and in the medium term, reducing deficits may well have depressing effects on economic activity.
 
Second, it is wrong to argue that large fiscal deficits necessarily lead to higher inflation. Inflation is caused by the excess of aggregate expenditure over aggregate income, which may come from public or private sectors, and is reflected in either inflation or current account deficits in the balance of payments. It is quite possible for a large public deficit to be entirely financed by a private sector savings surplus, as was the case in Italy for more than a decade, where fiscal deficits of as much as 9 per cent of GDP were met by positive private savings-investment balances of equal proportions. Similarly, there can be large balance of payments deficits or higher inflation in countries with low, zero or positive fiscal accounts, when the private sector spends more than it earns - this was the case in many Southeast Asian economies before the crisis, and is currently true of the United States economy.
 
Third, external vulnerability now has less to do with the observance of fiscal rectitude, and more to do with the degree of financial openness of the economy as well as a range of perceptions of international finance. Thus, countries can face external crisis and capital flight because of large current account deficits led by private profligacy in the context of trade and capital account liberalisation, or because other areas are suddenly seen as more profitable by financial investors, or even just because of geographical proximity to another country in crisis.
 
It is important to remember that in 1997, when the financial crisis engulfed Southeast Asia, among the two worst affected countries, Thailand had a government budget surplus of 3 per cent of GDP while South Korea had a smaller budget surplus of 1 per cent of GDP. Their current account deficits reflected not fiscal irresponsibility but excess private spending in the very liberalised environment desired by international finance. In another part of the world, Argentina has faced speculative attacks on its currency despite obsessive deficit control and even a fiscal responsibility law, simply because of geographical proximity and an open capital account, first during the Mexican crisis of 1995 and more recently during the Brazilian crisis of 1998-99.
 
This in turn means that the argument that fiscal rectitude is sufficient to enable low interest rates in a world of relatively open capital markets, is not one that can be sustained. In fact, while it is true that finance in general dislikes large fiscal deficits, it is quite prepared to tolerate them if they are associated with higher economic activity. Witness the high state of "investor confidence" in South Korea currently, even though the government deficit is now around 6 per cent of GDP, because the expansionary fiscal stance is the main reason behind the recovery in economic activity.