The importance of being fiscally responsible

Written by Ila Patnaik | Updated: Aug 1 2006, 05:30am hrs
Should a government spend as much as it likes without worrying about the size of its deficits Keralas new finance minister has questioned the principles of fiscal prudence and expenditure control by states. Some econo-mists have criticised the constraints the Fiscal Responsibility Act has imposed upon the central government. Considering the large spending programmes that the Common Minimum Programme has imposed upon the United Progressive Alliance, it would be very convenient for the Centre 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 Centre, 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 these 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 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 banks.

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.

Deficit financing not feasible; Centre cannot print money it wants to spend
If India has huge deficits, foreign equity inflows are also deterred
Large deficits and inadequate foreign investment can also mean a BoP crisis
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 crisis 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.

Moreover, 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 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 growth.

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 collected.

We are, right now, enjoying a remarkable macroeconomic boom. A big factor driving this is the rise in investment, from 23% of GDP in 2001-02 to 30.1% in 2004-05. One major factor underlying this was a shift in public sector saving, from -2.0% to a positive of 2.2% of GDP: giving a 4.2% of GDP gain. If we get back to irresponsible fiscal policy, then this gain will be squandered.