Do fiscal deficits matter?
Debate in Business Standard, 5 September 2006
Do fiscal deficits hurt? Yes.
From 1991 onwards finance ministers Manmohan Singh, P. Chidambaram, Yashwant Sinha, Jaswant Singh and then P. Chidambaram engaged in a mighty battle with the fiscal deficit. Why should India grapple with the fiscal deficit?
In 2001-02, saving of the public sector added up to a loss of Rs.46,377 crore. In 2004-05, this had swung around dramatically: the government and public sector enterprises saved Rs 69,390 crore. This was a shift from -2.0% of GDP to +2.2%: an enormous swing of 4.2% of GDP. In parallel, India also got an additional 1.6% of GDP by switching from a current account surplus (i.e. export of capital) to a more sensible current account deficit. Overall, we got an investment rate in 2004-05 which was 30.1% of GDP - the highest ever in India's history. Investment in 2004-05 was a full 7% of GDP bigger than the level in 2001-02.
This sharp rise in investment is our first fruit of the resolve of four finance ministers over 15 years. It is a key source of the remarkable GDP growth rates of the recent few quarters. Fiscal consolidation is no longer all pain with a promise of future gain. We have tasted the results: we have seen how fiscal consolidation yields higher investment, and higher investment yields higher growth.
The irresponsible fiscal policies which are being advocated today are increasingly dangerous in this age of globalisation. Globalisation has transformed India's growth opportunities. But at the same time, we can be punished by high real interest rates and expensive equity capital if the world perceives that our house is not in order. A particularly lethal combination would be a high fiscal deficit coupled with an exchange rate that is manipulated by the RBI: this could yield a classic third world currency crisis.
As Martin Feldstein observed in Bombay in 2004, a country with a high fiscal problem is like a fat man. Obesity hurts in an insiduous way through diabetes, blood pressure or heart disease. But the irresponsible fat man always says that he is fine, and one more helping of icecream never seems to hurt. In a similar situation, it is all too easy for an irresponsible politician to peddle one more big expenditure program, despite accelerating inflation.
India is approaching a point of explosive growth owing to demographic factors and the gains from globalisation. If the FRBM is violated, it will be an enormous loss of credibility for India's institutional capacity, and this unique opportunity can be squandered. What we need most at this juncture is the fiscal policy used in England when they were a developing country: this involved running a surplus every year, except in times of war.
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