2015 is not 2012: The fiscal deficit shouldn't be FM's main worry now

It is said that every general is preparing to fight the last war. The same could apply to some macroeconomists and economic writers as well.

At a time when growth is flagging and private investment is hard to come by, it is obvious that public investment has to step up to the plate. While everybody accepts the logic of this assertion, they are inclined to hedge this with talk about the dangers of a higher fiscal deficit.

We should worry about the fiscal deficit – but later, after growth revives. Right now, the issue is a further tapering down of growth in a deflationary external environment.

Swaminathan Anklesaria Aiyar, writing in The Economic Times yesterday (7 January), accepts the logic of increasing public investment in India, but says that this should only be done by raising extra money from disinvestment and spectrum auctions, not by raising the fiscal deficit. This, even though he himself accepts that India’s government debt has been falling as a share of GDP to 68.5 percent, thanks to past inflation.

A Mint editorial also warns against easing up on fiscal targets, even though it does not disagree with the need for more public investment to revive growth. Quoting from the Mid-Year Economic Analysis, which makes a case for “a counter-cyclical but counter-factual” fiscal policy due to relatively low debt-to-GDP ratios, the editorial argues that while debt may have been deflated by inflation, “the argument is a bit weaker when it comes to fiscal deficit. If higher fiscal deficits don’t matter, then surely the central bank should not have worried about credible consolidation in 2013-14 when it stoutly refused to lower policy rates. The fact is that even the United Progressive Alliance (UPA) government, hardly a paragon of fiscal virtue, was forced to reduce expenditures even if revenue and tax targets were beyond its reach by that hour.”

Clearly, economists worry about whether the government is going to cut loose on fiscal deficits next year. And certainly, it is no one’s argument that fiscal deficits do not matter at all. They do. The question is: do they matter as much right now when the objective conditions have changed dramatically from the time UPA was forced to acknowledge it and cut plan spending drastically for three years in a row, reducing growth?

The answer is a clear no.

What’s different from the situation in 2011-12 and now are the following.

One, inflation was raging at that point. Not now.

Two, oil and commodity prices were very high, and impacting our current account deficit. Now, it is the other way around.

Three, two years ago, the world economy seemed to be stabilising. Not now. The world is now in the throes of possible deflation, especially in Europe and Japan, and central banks are busy turning on the money tap to prevent inflation from turning negative. Countries are keeping their currencies down to remain competitive.

Four, in a scenario of collapsing world growth and potential deflation, it is unlikely that India alone will see a return to higher inflation by easing up on fiscal consolidation. In fact, the battle against inflation has probably been won, thanks not just to cheap oil, but the moderation in minimum support prices (MSPs) of late. Economist Surjit Bhalla argues in The Indian Express that the decline in MSP inflation, which also impacts inflation in milk, fruits and vegetables (which has been our bugbear so far), is the reason why overall inflation is now under control. He noted: “A long historical analysis (since the late 1970s) suggests that each 10 percent increase in MSP increases headline inflation by 3 percentage points……The decline in MSP inflation between 2013 and 2014 was 10.2 percentage points. And 30 percent of this decline is 3.1 percent - i.e. on the basis of MSP alone, headline inflation should have declined to…7 percent. Actual observed year-on-year inflation January to November was 7.4 percent! It is time that RBI declared victory on inflation.”

Five, if external (export) growth prospects are going to be low, it stands to reason that India must find its growth drivers within. This is the logic of increasing public investment, since no one else can step into the breach.

Six, in a situation where many countries are trying to keep their currencies down in order to avoid an export disadvantage, India cannot be an outlier by trying to be tight both on the monetary and fiscal fronts. After two years of money tightening, Indian real interest rates are already very positive. The fiscal tightness imposed by UPA (the right thing to do in 2012) is now strangling growth.

The west too has seen too much monetary accommodation and too little fiscal expansion, especially in public infrastructure and productive areas, says Nouriel Roubini, professor at NYU’s Stern School of Business. In a recent column , he wrote: “The cause of the latest currency turmoil is clear: In an environment of private and public deleveraging from high debts, monetary policy has become the only available tool to boost demand and growth. Fiscal austerity has exacerbated the impact of deleveraging by exerting a direct and indirect drag on growth. Lower public spending reduces aggregate demand, while declining transfers and higher taxes reduce disposable income and thus private consumption.”

The only logical way forward in a situation where growth cannot be led by exports is to inflate back home. This does not mean letting the fiscal deficit rip, but merely slowing down the future deficit cuts. A large slashing of fiscal deficits will kill growth and make the fiscal deficit larger in future, not smaller. No growth means not enough tax revenues. Even spectrum sales and disinvestment proceeds will fall in such a scenario.

The war against a bloated fiscal deficit was yesterday’s war; today’s war is about reviving growth. The time to worry about fiscal deficits is later, when growth revives, unused capacities are used up, and inflation starts creeping up. But in a world going down the tubes, that seems less of a risk than a further slowdown.

Time to reflate, carefully.