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.