Chidu's fiscal legacy debunked: Jaitley and CEA break free with bold new gameplan

The lord be praised! Wisdom has dawned in North Block after two quarters of policy drift and a nondescript NDA budget in July that was no different from what his predecessor, P Chidambaram, would have produced. Not for nothing was it called a “UPA budget with saffron lipstick” by Swaminathan Anklesaria Aiyar.

Finance Minister Arun Jaitley’s Chief Economic Advisor, Arvind Subramanian, the key man behind the government’s Mid-term Economic Analysis for 2014-15 , has essentially said that Chidambaram’s fiscal policies were inappropriate for the current situation, as they were taking the economy downhill. Chidambaram’s former finance secretary and previous Reserve Bank Governor, Duvvuri Subbarao, was also assigned his due share of blame as his monetary policy “lost credibility”.

The analysis points out that under UPA (mostly the last two years of Pranab Mukherjee and two more under Chidambaram), the government followed “pro-cyclical” fiscal spending cuts rather than being counter-cyclical. Pro-cyclical means doing something that will worsen what is already going wrong. If, for example, investment has slowed down, if government cuts public spending to cure the fiscal deficit, it will worsen the slowdown.

Thus the new remedy is simple: reverse the Chidambaram policy by reviving public investment. The analysis says “it seems imperative to consider the case for reviving public investment as one of the key engines of growth going forward, not to replace private investment but to revive and complement it.”

This means going easy on the fiscal deficit target practice that seemed to have become a UPA sport in its last years, when the slowdown was compounded by sharp cuts in government spending towards the end of each financial year.

As I had noted yesterday (19 December) before the government’s own analysis was out, government spending has been cut drastically by over Rs 1,80,000 crore over the last two years of the UPA, and this was accentuated by Jaitley’s promise to stick to Chidambaram’s fiscal targets for 2014-15, which now means further cuts of over Rs 1,00,000 crore by March 2015. In all, a deflationary fiscal policy of nearly Rs 2,80,000 crore over three years. How can growth revive in this scenario?

The mid-term analysis noted: “The deficit target (set by Chidambaram and endorsed in Jaitley’s policy) represented strongly pro-cyclical fiscal policy consolidation when growth was below potential - which is ambitious at the best of times and also unusual amongst the major economies today.”

This is tantamount to saying that Chidambaram’s over-emphasis on a sharp fiscal deficit reduction was bonkers at this time.

As for monetary policy during the UPA, the mid-year analysis noted: “For nearly six years (2007 third quarter to 2013 third quarter), India lost monetary policy credibility, reflected in the fact that real policy interest rates were consistently negative at a time when inflation was persistently in the double-digit territory.”

Policy was wayward not only because Subbarao was a bit behind the curve in raising rates when inflation resurfaced after 2009-10, but also because he had prematurely eased up when the fiscal deficit was simply going out of control under Pranab Mukherjee in 2011-12. The pressure from the ministry was intense, with Kaushik Basu, then the Chief Economic Advisor, advising RBI to “think out-of-the-box” on interest rates. Instead, he boxed Subbarao in.

Chidambaram had a role to pay in building pressure on the RBI at that time. Subbarao was his man in the RBI, and Chidambaram hoped that he would play ball when he returned to the finance ministry after Pranab Mukherjee was elevated as President. But Subbarao declined to make yet another mistake, and Chidambaram was markedly petulant about this. “Growth is as much a challenge as inflation. If the government has to walk alone to face the challenge of growth, then we will walk alone,” he said.

Pressures from the finance ministry were clearly one reason for the lack of credibility in monetary policy, and this credibility was restored only when Raghuram Rajan was made Governor in September 2013. And he raised interest rates.

The last issue on which the mid-year analysis laid the problems at Chidambaram’s door was its explanation for the huge anticipated gap in revenues this year. The document says that the “revenue projections were over-optimistic” and that the “budget was unduly burdened by a legacy of carried-over expenditures.”

In plain words, Subramanian is saying that Chidambaram left his bills for 2013-14 unpaid, and passed them on to the next government, by shifting payments to 2014-15.

The mid-year analysis is unusual for two reasons: it signals a break away from the fiscal policies of the UPA years and is unusually blunt is laying the blame where it belongs, at UPA’s door. It sets the stage from the failed fiscal policies of the Pranab-Chidambaram years, making way for new thinking on the way ahead.

To emphasise what needs to be done, I am reproducing what I wrote yesterday.

When private investment is not picking up, cutting government expenditures by such large volumes can only reduce growth further.

It is time for Jaitley to abandon Chidambaram’s fiscal fundamentalism. This means he should not be wedded to cutting the fiscal deficit by any means, but must focus on cutting only those areas that do nothing for growth - like subsidies or wasteful expenditures. He must cut flab, not muscle.

Rather than set fiscal deficit targets of 3.6 percent and 3 percent of GDP for the next two years, he should set revenue deficit targets of, say, 2 percent and 1.5 percent of GDP as the main goals. (In 2014-15, the budgeted revenue deficit target is 2.9 percent). Bringing the revenue deficit to zero in three or even four years is more important than bringing the fiscal deficit down drastically in the midst of an economic slowdown. Jaitley’s budget had pegged the revenue deficit (at Rs 3,78,348 crore) at 71 percent of the fiscal deficit (Rs 5,31,177 crore).

What is truly inflationary and disastrous is the revenue deficit, which is broadly equivalent to living beyond your means; what is suicidal is to cut productive investments (plan and capital spending, which are the easier bits to cut for any FM), which improve the productive capacities of the economy.

When Jaitley had presented his budget in July, he had projected 13.4 percent growth in GDP (at current prices), assuming higher levels of inflation. Now that inflation is down and the real GDP growth expectation is only 5.5 percent, the overall GDP (at current prices) may not grow by more than 10 percent (5.5 percent real growth plus around 4.5 percent inflation). (The mid-year analysis puts nominal growth at 10.5 percent, marginally above what I had mentioned yesterday before I read the analysis)

The shrinkage of GDP growth in current terms from the 13.4 percent level envisaged in the budget implies revenue shrinkage. In this situation, to be tied to a very sharp cut in the fiscal deficit means the government is facilitating a further slowdown at a time when the economy is anyway sluggish after three years of spending cuts of the wrong kind.

In this scenario, it actually makes sense to throw the bookish knowledge on fiscal deficits out of the window and maintain government expenditures at budgeted levels, never mind the miss in the fiscal deficit target. Government spending must act counter-cyclically till private investment picks up the slack. Especially when interest rates are not going to come down in a hurry.

Chidambaram’s fiscal fundamentalism has been a major contributor to the continuing slowdown. Arun Jaitley must rework his fiscal deficit roadmap by shifting the focus to revenue deficit. Once this is fixed, fiscal deficit will follow.

Jaitley should not put the fiscal deficit cart before the revenue deficit horse if he wants the economy to revive.