The damages of high fiscal deficit

Shyamal Banerjee/Mint


Rajesh Kumar: Mint Money :  Wed, Dec 26 2012. 08 31 PM IST

          Delay in fiscal adjustment does not reflect well on the government’s economic management abilities.

Government deficit is possibly the most dominating issue in the global financial markets these days. While the euro zone is under constant threat of falling apart because of large accumulated debt and high fiscal deficit in a number of countries, lawmakers in the US do not see eye to eye on any deficit reduction plan. As a result, the country is on the verge of witnessing forced reduction in government spending, which can lead to a recession in the US economy with global consequences and also cause significant volatility in the financial market. 

The situation in India is not very different. India faces the serious threat of being downgraded to junk status if the deficit is not quickly brought under control; the government is targeting a fiscal deficit of 5.3% of the gross domestic product (GDP) in the current fiscal. But why is high deficit such a big problem?

Theoretically, there is not much agreement among economists on whether the issue of financing government expenditure by running a deficit is good or bad. Any standard text on the subject will typically take you through three schools of thoughts. 

First, the Keynesian view, which favours large government expenditure through deficit financing in order to employ unused resources. Second, the Ricardian view, which basically argues that it doesn’t make a difference as consumers cut expenditure in anticipation of higher taxes that will be levied later in order to pay off the debt. Third is the neo-classical school of thought, which has been a dominating view on the subject in the way it has been approached in the recent years.

The neo-classical economists principally argue that high government expenditure has a negative impact on savings, which affects growth. A high government deficit leaves little for the private sector for investment and puts upward pressure on interest rates—also referred as crowding out. 

But in an open economy, the country can always import capital to naturalize the impact of reduced saving because of higher deficit. But, again, import of foreign capital would result in appreciation of the currency, affecting exports and growth.

Interestingly, a 2003 paper, The Economic Effects of Long-Term Fiscal Discipline, written by William G. Gale and Peter R. Orszag, analyzing the situation in the US concluded that if the budget deficit increase by 1% of the GDP, the long-term interest rates go up by 50-100 basis points. But things can change quite dramatically. The US is currently running a record deficit and enjoys record low interest rates. Therefore, variables can always respond differently in different circumstances. Do not forget that the Federal Reserve is determined to keep interest rates low and the US dollar remains the unchallenged reserve currency.

The Indian scenario

The conditions in the US and India are not comparable, except for the fact that both are running “unsustainable” levels of deficit. However, the ill effects of running high deficit are far more visible in India and the need for correction is a lot more urgent here. Apart from the threat of a ratings downgrade, high fiscal deficit is the source of most of the problems that the Indian economy is facing today.

 Higher deficit since FY09 and higher borrowing has resulted in lower savings and lower growth in the economy. In FY09, at the gross level, fiscal deficit jumped to about 6% of the GDP compared with 2.5% in the previous year. In absolute terms, the deficit went up by about 2.6 times and has grown significantly since then and crossed Rs.5 trillion levels in the last financial year.

Let us assume that the government deficit was contained at around Rs.2 trillion, leaving Rs.3 trillion in the banking system to lend to the productive sector. Naturally, the cost of money would have been lower and production and growth would have been higher. It is no coincidence that high growth years, up till FY08, saw lower deficit, which even declined in absolute terms. 

Higher deficit, as argued by neo-classical economists, also results in decline in savings rate—the gross domestic savings has declined from the level of 36.8% of the GDP in FY08 to 32% in FY12. Inflation has also been sticky and has remained way above the comfort level, simply because of the demand push being generated by higher government expenditure. Further, higher demand is getting leaked to the outside world and is not allowing imports to adjust the way exports do in response to the shift in global trade. 

As a result, in the last fiscal, the current account deficit (CAD) swelled to a record high level of $78 billion and is not expected to come down in a hurry. CAD of this magnitude poses serious financing challenges and creates enormous uncertainty on the external front. Therefore, for a country like India with so much downside risk, it is important that government finances are kept under control.

End note: Far more than the impact captured through numbers, it is the impact on the business confidence that further affects investments. 

Delay in fiscal adjustment does not reflect well on the government’s economic management abilities. It also reduces the capacity of the state to lend any support to the economy in case growth slips. 

Therefore, bringing down the deficit should be the top priority of the government and at no point should comfort be drawn from the fact that higher deficit is a global phenomenon. Indian conditions are different and comparisons on this subject are unwarranted.