Components of fiscal deficit

Dr Bharat Jhunjhunwala
Finance Minister P Chidambaram stressed during presentation of the budget that fiscal deficit should be kept in control in order to attain high growth rates. He has not made large increases in outlays in order to keep the fiscal deficit under control. The Government is much concerned that international rating agencies may downgrade India if fiscal deficit is not kept under control. A downgrade may lead to the foreign investors fleeing and that would bring the UPA crashing down. The Finance Minister has kept expenditures under control because of this constraint.
Surely, low fiscal deficit is seen by investors as an indicator of good governance and can help in attracting large levels of private domestic and foreign investment. However, it also limits the capacity of the Government to make investments in ports and roads, which, in turn, hurts private investment. More particularly, the government has to cut expenditures in order to rein in fiscal deficit and this hits at the government’s ability to create more employment in the economy.
In the fifties and sixties the Philips curve showed there was an inverse relationship between inflation and unemployment. More inflation meant less unemployment and vice versa. The underlying idea was that when government prints notes to make dams and roads, it leads to two consequences simultaneously-the rate of inflation goes up and unemployment goes down. Thus, the mantra of control of fiscal deficit is often seen as being anti-poor who are deprived of jobs that could come from increased Government expenditures.
This thinking is contra teachings of famous economist John Maynard Keynes. The American economy was in deep depression in the late thirties. President Truman was following the policy of balanced budget or zero fiscal deficit. The slowdown in the economy was reducing the tax receipts of the Government and President Truman was cutting Government expenditures in the same proportion. The economy was sinking as a result. Both private- and government demand were declining and there was a steep increase in unemployment. In this grim situation Keynes suggested that the American Government must print notes and increase demand in the economy just as a dying person is put on the respirator. President Truman accepted Keynes’ advice and soon the American economy started looking up.
We have before us two opposite viewpoints on the efficacy of fiscal deficit. Modern economists consider it harmful while Keynes considered it to be a legitimate tool of the economic management. Professor Edmund Phelps of Columbia University has tried to solve this puzzle for which feat he was awarded the Nobel Prize for Economics in 2006. Phelps suggests that Keynes’ strategy can possibly be useful in the short run but not in the long run. The beneficial impact of an increase in government expenditures occurs only if the prices do not increase in tandem with an increase in fiscal deficit.  Say, the total government expenditure at present is Rs 50 billion and the daily wage of the worker is Rs 100 per day. The Government decides to print notes worth Rs 5 billion and the total expenditure increases by 10 percent to Rs 55 billion. Now, the total employment will go up if the wages remain at the previous level of Rs 100; but not if the workers start expecting an increase in prices of food, clothing and housing and start demanding a wage of Rs 110 per day. The number of jobs would remain unchanged then. The same 500 million man days of employment will be created by a government expenditure of Rs 50 billion at a wage of Rs 100 before fiscal deficit was incurred; and by government expenditure of Rs 55 billion at a wage of Rs 110 after fiscal deficit was incurred. Thus, Phelps said, that expectation of the people regarding inflation can undo the beneficial effects of fiscal deficit. Since, in the long run the people are sure to anticipate an increase in price, therefore, in the long run the strategy of liberal fiscal policy will be ineffective. Phelps was warded the Nobel Prize for this insight.
Yet another factor against a liberal fiscal policy is its impact on the domestic currency. High fiscal deficit will lead to an increase in domestic prices and correspondingly the value of the deficit-ridden currency will decline vis-à-vis others. The decline in the value of domestic currency leads to high cost of imports and, at least, partially undoes the benefit of increased Government expenditure. Of course, the high fiscal deficit will take some time to translate into a decline in the value of domestic currency and in this short period alone it may be beneficial.
It is clear that fiscal deficit-led growth strategy as advocated by Keynes is beneficial only in the short run. What then of the American experience of the thirties then? Actually, the depression was broken by the start of the Second World War and the generation of demand for armaments and other supplies from Europe. The mantra of fiscal deficit suggested by Keynes only triggered this change of gears. It only provided a short run trigger to unleash a long term growth that was propelled, in the main, by the Second World War. The revival of the economy in the long run was wrongly ascribed to Keynes’ formula, I think.
Yet another factor is the quality of Government expenditure. Say it takes six months for the impact of fiscal deficit to translate into rising expectations and declining value of the currency. Now if the Government makes such investments that lead to increased production in, say, three months, then the fiscal deficit will not lead to an increase in prices. If the Government provides assistance, for example, to rickshaw pullers to buy auto rickshaws, the benefits to the economy will accrue almost instantly and such expenditures may not lead to an increase in prices. The production will increase by the time the impact of fiscal deficit is felt in the economy. Crux of the fiscal deficit is to incur it in such expenditures that provide quick returns.
In conclusion, then, it appears legitimate to use fiscal deficit as a tool to jump start investment as it happened in the late thirties in the United States. Thus the Finance Minister must incur fiscal deficit only for expenditures that quickly lead to an increase in production. Unfortunately the Finance Minister has not applied his mind to the quality of government expenditures. He has tried to reduce all Government expenditures-both good and bad. This is unfortunate. Actually he should have got a study done of the impact on production of various components of the fiscal deficit. He should have cut expenditures on low-impact heads and increase the same on high-impact heads. In this way the economy could be revived without making an increase in the overall fiscal deficit.

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