Why Arun Jaitley should not develop a fiscal deficit obsession in budget 2015-16

Consider this quiz: if you have two glasses, one filled with hot water and another with cold water, and you want to drink it at a temperature that is somewhat in-between, what should you do? Should you pour half the hot water into the glass with cold water, or pour the cold water into the hot one?

What a silly question, you may say. Obviously, both kinds of mixing will deliver similar results. In global economics, unfortunately, this is precisely the kind of silly question that is not being asked.

The hotter economies (the ones with stronger currencies and growing current account surpluses, like Germany) are asking the colder economies to cut their fiscal deficits, borrow less, save more, and cut their external deficits. It has not occurred to them that they can also do the opposite and achieve the same result. You can cut your trade partner’s current account deficit either by asking them to buy less, or by buying more from them and saving less yourself.

The net result of this flawed adjustment policy has been a eurozone where growth and inflation are both weak, and there is an over-reliance on monetary policy to revive growth, says Nouriel Roubini, professor at New York University’s Stern School.

Our own Finance Minister Arun Jaitley should take the right message on fiscal remedies for growth instead of relying too much on interest rate cuts.

But let’s stay with Roubini for now. He writes in a Project Syndicate column : “Globally, the asymmetric adjustment of creditor and debtor economies has exacerbated this recessionary and deflationary spiral. Countries that were overspending, under-saving, and running current-account deficits have been forced by markets to spend less and save more. Not surprisingly, their trade deficits have been shrinking. But most countries that were over-saving and under-spending have not saved less and spent more; their current-account surpluses have been growing, aggravating the weakness of global demand and thus undermining growth.”

Though Roubini does not spell out who these countries are, the obvious reference is to Germany and some Nordic countries in the European Union, who have been forcing fiscal restraint on poorer southern Europe, worsening unemployment and growth prospects for everyone. At the same time, their own current accounts are becoming stronger as they are not spending enough to rescue the rest of Europe.

The same can be said about China, which, in its pursuit of export-led growth, is cutting interest rates in order to keep the renminbi yuan weak against the dollar so that exports do not drop off. What China should do, given its nearly $3.9 trillion in forex reserves, is buy more from the rest of the world. But it is worried that buying more from abroad will dent production back home, and thus is busy weakening the yuan.

Japan, in its own way, is also pursuing a monetary stimulus to weaken the yen, raise inflation, and boost growth by exports. Similarly foolish policies have been followed by the Swiss and other countries that don’t want their currencies to strengthen and affect domestic economic growth.

It is only the US, with its ever-strengthening dollar, that is playing the right role of pulling the world economy out of the muck by attracting imports from all over the world. However, this is happening by default. The US is not lifting the world by spending more fiscally, but by printing more currency - or, at least, it was till recently.

The betting is that as Japan eases money, and China follows suit, and Europe does so early next year, the US will also put off raising interest rates and, at some point, even opt for more quantitative easing if the economy slips again.

The world is going down a barrel on the basis of bankrupt monetary easing that, far from lifting growth, is actually lifting only asset prices. This is increasing the wealth of the wealthy even while doing little to boost growth and jobs.

The right remedy, Roubini says, is the opposite: the world must ease fiscal policy and countries must spend on infrastructure instead of trying to use only monetary policy to lift demand and growth. Infrastructure spending helps boost growth both by creating demand and improving supplies.

Does all this have any bearing on what Arun Jaitley must do in his next budget? Or even how he must handle spending in the current year (during the last four months)?

Not directly, but indirectly. The world can go to hell in its own way, and it is helping us by keeping oil prices low. But there is no need for us to follow in its footsteps and shoot ourselves in the foot.

The answer is don’t look to monetary policy (rate cuts, etc.) to lift growth. Rather, use fiscal policy to boost both demand and improve supply. In a world that is rapidly going down the tubes, India can ease the pace at which it is cutting its own fiscal deficit, and instead focus on cutting non-merit subsidies and spend the savings on capital investment. This will both boost demand and supply - and growth and jobs.

We too have to give up fiscal deficit orthodoxy and focus on the revenue deficit. A higher fiscal deficit is okay if it is used for investment at this stage. Monetary policy will chip in at a later stage, once inflation is licked.

In plain words: he should stay with the 4.1 percent fiscal deficit for 2015-16 in his budget and focus on reducing the revenue deficit instead. The cash saved should go into higher government capital spending.