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18.02.2001

Fiscal Responsibility - To Whom?

In the 1990s, legal restraints on government fiscal behaviour became something of an international fashion. As in much else in the world at the moment, this fashion was set by the United States, where in the mid-1980s the Balanced Budget and Emerging Deficit Control Act (Gramm-Rudman-Hollings Act) required a steady decline in the federal government's deficit to zero within a stipulated and fairly short time frame.

Such a provision is of course extreme by any standards (although some countries have pursued balanced budget policies without legal stipulation) and few other countries have opted for such an extreme measure. In any case, the special circumstances of the United States, which have allowed its economy to expand despite the more conservative fiscal stance, on the basis of large private investment-savings deficits financed by the rest of the world's savings, could not be replicated elsewhere. This meant that governments putting such firm constraints on fiscal policy would have to reckon with the possibility of deep and severe recession/deflation as a corollary to such fiscal conservatism.
 
Thus other such legislation as has taken place elsewhere has generally been more circumspect, allowing a little more flexibility to governments and emphasising that deficits can change over the course of the cycle in any case. Even the IMF, long one of the most vociferous opponents of large government deficits, increasingly recognises that fixed and rigid limits are neither feasible nor desirable and has recently allowed quite large deficits in some countries under its supervision.
 
Nevertheless, in some countries, most strikingly in the European Union, there have been similar, and self-imposed, restrictive constraints on fiscal policy in the 1990s. The Stability and Growth Pact, which was part of the Maastricht Treaty, declared that there should be a limit of 3 per cent for the total fiscal deficit to GDP ratio and a limit of 60 per cent for the public debt to GDP ratio. This was also made a condition for joining the European Monetary Union in January 1999. Just before that, it was interesting to see how suddenly a number of countries that had been showing much higher levels of the government deficit to GDP ratio (such as Italy, France and Germany) managed to get to the required level. There is more than a suspicion of widespread "creative accounting" that allowed this sudden decline in these countries.
 
The urge to have legal limits on government deficits and public debt is one that has stemmed from the greater political clout of finance in all these countries, as the financial groups that benefited from government borrowing also sought safeguards to make sure that these debts were sustainable and would be repaid. It is still very much the fear of adverse investor reaction, which would be most severely expressed by open capital flight, which dominantly drives the obsession to contain fiscal deficits across the world.
 
However, the fashion for regulating the extent of government deficit and public debt by law is one that is already rather passé. Suddenly, even in the centres of the developed world, and certainly among the countries of Europe, the virtues of government deficits in spurring growth and employment, creating important infrastructure and smoothing business cycles, are being rediscovered. And more and more developing countries are recognising that, while finance capital may desire and welcome such legally determined restraint, it is something that goes very much against the material interests of the majority of citizens.
 
The trouble is that our own economists and policy makers in India have tended to retain some of the more simplistic and actually wrong ideas even when much of the rest of the world has already discovered how problematic they are. What else can explain this government's urge to table a Parliamentary bill on "fiscal responsibility" that would incorporate some of the more restrictive features of such laws in other countries, and even go beyond them in setting conditions with highly deflationary implications?
 
It is true that financial interests in India and abroad have been proposing such legislation for some time, although even they may have been surprised at the alacrity and zealousness with which their cause has been taken up by the government. The background to the present proposed bill, and its theoretical justification, come from the Report of the Committee on Fiscal Responsibility Legislation, set up with the then Expenditure Secretary as its Chairman, which was submitted in July 2000.
 
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.
 
Also, since finance may respond negatively to other factors, as mentioned above, in periods of speculative capital outflow it becomes necessary to raise domestic interest rates to ward off further capital flight, whatever the condition of the public exchequer. In the internationally acclaimed models of Thailand and Argentina, despite more than "responsible" fiscal behaviour, interest rates had to be raised to historic highs in excess of 50 per cent during the periods of speculative attack on currencies, and real interest rates have remained quite high in these countries. Similarly, in sub-Saharan Africa, governments, which have been beaten into almost total fiscal submission by the combination of severe external dependence and strong conditionality, have seen no reduction in real interest rates as a result.
 
All this suggests that the axiomatic basis of the new proposed legislation on fiscal responsibility in India is flawed in the extreme. But what is more startling is that these questionable assumptions are then used to suggest a time-based framework of fiscal tightening which is so extreme and severe as to be absolutely breathtaking.
 
Consider the main operational provisions of the bill. It is proposed that the government should commit itself to taking "appropriate measures to eliminate the revenue deficit and fiscal deficit and build up adequate revenue surplus". In particular, the Central Government is required to meet the following extremely demanding criteria :
 
(1) to reduce the revenue deficit by an amount equivalent to one-half per cent or more of the estimated GDP at the end of each financial year beginning on 1 April 2001 ;
 
(2) to reduce the revenue deficit to nil within a period of 5 financial years beginning from 1 April 2001 and ending on 31 March 2006 ;
 
(3) to build up surplus amount of revenue and utilise such amount for discharging liabilities in excess of assets ;
 
(4) to reduce the fiscal deficit by an amount equivalent to one-half of one per cent or more of the estimated GDP at the end of each financial year, beginning 1 April 2001 ;
 
(5) to reduce the fiscal deficit for a financial year to not more than 2 per cent of the estimated GDP for that year, within a period of 5 years beginning from 1 April 2001 and ending on 31 March 2006.
 
(6) to ensure within a period of 10 financial years, beginning from 1 April 2001 and ending on 31 March 2011, that total liabilities (including external debt at current exchange rate) at the end of a financial year do no exceed 50 per cent of the estimated GDP for the year.
 
In fact, the only contingencies which would allow higher revenue or fiscal deficit are described as "the grounds of unforeseen demands on the finances of the Central Government due to national security or calamity". Presumably, economic recession, high poverty or low employment generation (for example) would not qualify as adequate reasons. In any case the actual reasons would have to be explained to both houses of Parliament as soon as possible after such "unforeseen" expenditures have been made.
 
It is worth noting that these conditions are actually far more stringent and restrictive than even the European Union's infamous Maastricht criteria, which allow 3 per cent of GDP for the fiscal deficit and 50 per cent of GDP for the public debt. They are even more stringent than the recommendations of the Committee on Fiscal Responsibility Legislation, which also suggested fiscal deficit limits of 3 per cent of GDP.
 
Of course, the particular relevance or sanctity of the 3 per cent figure has never been adequately explained, even by its most ardent supporters. It is clearly an arbitrary rule of thumb criterion that has somehow met with some degree of wider approval, among financial markets in particular. But a much lower limit of only 2 per cent, in a developing economy with structural constraints on growth, is even more strange and difficult to explain. What considerations prompted the Finance Minister to choose this very low figure as an upper limit for one of the most critical instruments in the hands of the state for promoting investment and growth?
 
Note also that this provision makes no concession for the cyclical nature of deficits (the fact that fiscal deficits tend to increase during the downswing and decrease during the upswing) or for estimating a "structural deficit" which would take account of this. This makes it even more rigid and inflexible than similar fiscal responsibility legislation in other countries, and totally constrains the ability of the government to respond to downturns in economic activity through a more reflationary fiscal stance. While this may comfort financial markets (although even this is debatable) and those obsessed with balanced budgets, it is difficult to see how domestic economic agents, including industry, could possible welcome it, since it would leave them completely unprotected over a recession.
 
In addition to these alarming conditions that have to met, the bill requires that Central Bank accommodation to the government should be minimised. Thus there is a stipulation that " the Central Government shall not borrow from the Reserve Bank" except by way of temporary ways and means cash advances to be settled over each financial year. This, too, is an extraordinary provision, which completely misses the point about the functions of central banking.
 
The reasons for this provision are explained in more detail in the Report of the Committee, which points to "the necessity of insulating the central bank from the pressure of the Government" and argues that otherwise two unfortunate and negative effects may arise. First, the government may be tempted to use deficit financing (that is money creation) to finance expenditures, which it is argued would create an "inflation tax" on the country. There is no basis for believing this, since the increase in base money does not create inflation, which as mentioned earlier results from the excess of aggregate expenditure over aggregate income.
 
Second, and even more tellingly, the Committee argues that " given the trade-off between price stability and output in the short-run, (there is) the risk of the Government sacrificing price stability in favour of higher output levels." (Report, page 11) Could there now be any doubt as to whose interests such legislation serves? The possibility of higher output, creating more employment and income for the citizens of the country, is to be sacrificed at the dubious altar of the price stability beloved of finance, which is (mistakenly) supposed to result from the curtailment of RBI credit to the government!
 
All these quite arbitrary and incredibly stringent rules are presented, both in the Committee's Report and in the final proposed Bill, as if they are easily justifiable and even completely natural. The truth is that they are both unwarranted and unnecessary, and if implemented they would actually be substantially detrimental to the material interest of most of the Indian people. This is because such measures would not only force deflation on the economy, but also involve reductions in public expenditure to meet these very severe criteria, so that public expenditure which is important and necessary for growth and welfare would not be made.
 
It is sad to think that these considerations were not recognised by the Committee or the subsequent framers of the bill, whose concern seems to have been essentially to impose those measures which are viewed as necessary to placate or impress finance capital, both domestic and international. The only honourable exception to this within the Committee appears to have come from the unlikely source of the office of the Comptroller and Auditor General of India.
 
The C&AG's  representative had to make the obvious point that "no fresh legislation of the FRA type was required since a ceiling on borrowings by the Government could be prescribed by law under Article 292 of the Constitution, or through annual legislation as part of the budget, and other medium or long term fiscal measures could be declared by Government in a policy paper." This office was also forced to remind the rest of the Committee of the final authority of Parliament in our democracy, even and especially in matters relating to the public fisc, and to point out that "setting up a Fiscal Management Review Committee through statute (as proposed in the Report) ... goes against the basic structure of the Constitution."
 
The undemocratic nature of the proposed legislation is hinted at by the office of the C&AG. It is further disturbing to realise that such legislation could be framed in a macroeconomic context of slowdown which urgently demands significant public intervention to lift industry out of recession, to clean up the mess with respect to public foodgrain stocks and provide more food to those in need of it and through productive public employment schemes, and to address the major problem of decelerating aggregate employment generation.
 
The Committee uses the increasing trends in government deficits - described in Chart 1 - to justify its concern with fiscal consolidation and control. But one major reason for the large deficits is precisely the much greater share taken up by interest payments, which is shown in Chart 2. In the last five years, not only have interest payments reached historically high levels as percent of GDP, but they amounted to around 30 per cent of total government expenditure and more than 36 per cent of revenue expenditure.



It is a mistake to believe - as is continuously suggested by Government and repeated in the Committee's Report, that this is due entirely to the burden of past debt. A substantial role has also been played by financial liberalisation measures which have raised the cost of Government borrowing and caused both the interest payments and the total public debt to be much higher than they otherwise would have been. This is particularly clear from Chart 3, which shows that public debt as a share of GDP actually declined in 1996-2001, even though interest payments continued to rise to their highest ever levels.

Meanwhile, of course, capital expenditure by the Central Government continues to decline as a share of GDP, as evident from Chart 4. And this decline is not just over the past ten years; it has been especially marked during the tenure of the BJP-led government, which has been remarkable in suppressing plan and capital expenditures well below even their budgeted outlays in each year in power.

This trend continues into the current year, as can be seen from Chart 5. Thus, over April-December 2000, while revenue receipts increased by more than 15 per cent in current prices over the corresponding period in the previous year, both plan and capital expenditures have increased only marginally in current prices. Given the rate of inflation, this implies that they have actually fallen in constant price terms.

The most misleading thing about such Committee Reports and such legislation, is that they present their assumptions and conclusions as technocratic necessities rather than blatant political choices. But in fact, such decisions about overall expenditure, its distribution and deficit control, are deeply political and reflect the choice of favouring certain economic groups in society - especially finance - over others.
 
Indeed, the act as framed does seem to recognise certain political realities. For example, Section 10 of the Act provides immunity to the Central government and its officers for anything done in good faith under the Act. And, most blatantly, the Act leaves the current Finance Minister, its mover, almost totally outside the discipline it purports to impose. Thus, sub-section (1) of Section 5 imposes the commandment that the "The Central Government shall not borrow from the Reserve Bank". But sub-section 5(3) says "Notwithstanding anything contained in sub-section (1), the Reserve Bank may subscribe to the primary issues of the Central Government securities during the financial year beginning on the 1st day of April. 2001 and subsequent two years" (emphasis added).
 
Similarly, section 12, the final section of the Act reads: "If any difficulty arises in giving effect to the provisions of this Act, the Central government may, by order published in the Official Gazette, make such provisions not inconsistent with the provisions of this Act as may appear necessary for removing this difficulty: Provided that no order shall be made under this section after the expiry of two years from the commencement of this Act" (emphasis added).  In other words, the Act makes itself practically inoperative for the next two years and would thereafter only hobble governments which are unable to amend the relevant sub-sections. This government therefore wants to win kudos from international investors for its supposed fiscal sobriety, while passing on the real discipline and costs of such control to future governments. It is not only based on poor economics, it is also deeply undemocratic in denying future governments the capacity to respond to felt social requirements.
 
The essentially political and distributive features of such legislation which is supposedly "neutral" in being determined only by objective economic realities, becomes very clear in a story narrated by the well-known American economist Joseph Stiglitz. When he was Chairman of the Council of Economic Advisers to the President during Clinton's first term, there was a motion moved by a Republican legislator to provide policy independence to the Federal Reserve, the United States' central bank. The reasons proffered were very similar to those cited in the Report being considered here. Stiglitz persuaded President Clinton to announce that this would be made an election issue. Within a matter of a few days, the proposed legislation was withdrawn, as the Republicans realised that voters would react against a measure that would reduce democratic accountability of an institution with crucial economic clout to affect economic activity and jobs.
 
Stiglitz ended his story with the clear statement that monetary and fiscal matters are essentially about politics, because they determine income distribution outcomes. It is important that this message gets across equally clearly to our voters and political parties as well, so that such an attempt, as is being made in this proposed legislation, to privilege the financial class over the interests of all other citizens cannot succeed.

 

© MACROSCAN 2001