A large Budget deficit is like riding a tiger

The government’s budget deficit which is otherwise known as the fiscal deficit, irrespective of the economic development of the country, has been rule based for most of the countries, implying that there is a limit on the fiscal deficit-to-GDP ratio. In line with the globe, India is also under a fiscal rule regime since 2003 with a mandate that the fiscal deficit relative to GDP should be 3% each for the Central and consolidated position of State governments. Amendments in the fiscal rule regime in 2012 and 2018 left this requirement of 3% fiscal deficit-to-GDP unchanged. The debt-to-GDP ratio is mandated at 40% for the Central government and 20% for the State governments as set out in the 15th Finance Commission report.

With the enactment of the fiscal rule, the debate on the fiscal deficit, both from the hawkish (against fiscal deficit) and dovish (for fiscal deficit) stance was put to some rest. However, with the unprecedented havoc caused by the Covid-19 pandemic which quickly turned into a health crisis and subsequently into an unparalleled economic crisis, countries the world over undertook large fiscal actions in response to the pandemic.

Any attempt to record a high fiscal deficit relative to GDP, as evidence suggests, sooner or later results in a vicious cycle of deficit and debt resulting in a high interest rate regime, demand pull inflation, crowding out of private investment and in the open economy context, a spill over to the external sector deficit.  

According to the IMF’s World Economic Outlook, July 2021, the average overall fiscal deficit relative to GDP in 2020 was 10.9% for advanced economies, 9.7% for emerging market economies, and 5.5% for low-income developing countries. In pursuit of their mandates, Central banks in advanced economies and some emerging market economies have lowered policy rates and purchased government bonds, thereby facilitating fiscal responses to the pandemic. In India also, the fiscal deficit (for the general government, Centre and States) was recorded at around 13 per cent of the GDP for 2021 and is estimated at around 10 per cent for 2021-22 (according to the RBI Bulletin, June 2021). Consequently, the debt-to-GDP ratio is estimated at around 90%. Thus, due to the pandemic, the Fiscal Responsibility and Budget Management (FRBM) Act was not adhered to.

As the IMF Fiscal Monitor Report of April 2021 has stated that the “longer the pandemic lasts, the greater the challenges for public finance”, the moot question is:  when to withdraw the fiscal support which has resulted in a large fiscal deficit and debt at an unprecedented level? This is because the continuation of a large fiscal deficit without adequate fiscal space is akin to riding a tiger.

The government should come back to the FRBM target sooner; otherwise, we will face another economic crisis

In the above context, it will not be out of place to delve into the postulates of the Modern Monetary Theory (MMT), the proponents of which call themselves “deficit owls” because owls have “the ability to rotate their heads near-360 degrees.” The MMT protagonists claim that the deficit is good for the economy because the government has the power to print currency (fiat money) to finance spending.  According to MMT exponents, the hawkish views on deficit viz; (i) government should manage deficit like a household, (ii) deficits are evidence of overspending, (iii) deficits will burden the next generation, (iv) crowd out investment and undermine long term growth, (v) deficits make the country dependent on foreigners and (vi) deficits will take the economy toward a long-term crisis, are all myths. All of them consolidated paint a picture of what is in some quarters fashionably called “the deficit myth”.

The essence of the MMT argument is that the size of the budget deficit does not matter as long as the government can print money in the fiat system as the printing of money is no more linked to gold reserves. Furthermore, inflation in the post Global Financial Crisis (GFC) has been recorded in the lower bound, resulting in a lower interest rate regime. MMT postulates are mostly utopian.

On the contrary, the size of the deficit does matter even though the government has unlimited power to print money through the Central bank. Any attempt to record a high fiscal deficit relative to GDP, as evidence suggests, sooner or later results in a vicious cycle of deficit and debt resulting in a high interest rate regime, demand pull inflation, crowding out of private investment and in the open economy context, a spill over to the external sector deficit.  Thus, government budget deficits beyond a threshold are harmful.  

Contrary to the belief of deficit owls that the “deficit is a symptom, not a disease”, country evidences suggest that large fiscal deficits accompanied by high revenue deficits are a disease. 

In the Indian context, the development process began with a large monetisation of the fiscal deficit, giving high priority to the government role and assigning “commanding heights” to the public sector and eventually we landed in the economic crisis of 1991. Since 2004, the government adhered to the fiscal rule through the FRBM Act of 2003, but could not rein in the fiscal deficit because of two factors: (a)downward rigidities of revenue expenditure and (b)lower revenue realisation (both tax and non–tax revenues), which resulted in a persistently high revenue deficit relative to GDP for the general government. During the decade 2012-2022, on an average the revenue deficit was 3.8 per cent (which should have been zero) and in the range between 2.5 per cent (2016-17) and 8.9 per cent (2020-21).  In the government’s attempt to maintain the fiscal deficit at the FRBM Act level, there were cutbacks in capital expenditure, which are the real growth promoting expenditure.

In this context, the RBI study (June 2021 RBI Bulletin) has observed, “there is a greater recognition now than ever before that growth-giving elements of public spending have to be preserved and cultivated. COVID-19 has offered a unique opportunity to redefine fiscal policy in a manner that emphasises ‘how’ over ‘how much’ by strategic repurposing and re-prioritising of public expenditures.”

One argument presented in some quarters is that even with a high fiscal deficit in the period 2001-02 (9.6 per cent), the growth rate of the Indian economy was not adversely affected. That is a misconception. This type of growth is consumption-led and can not be sustained. It is pertinent to note that the period 2004-05 was a period of lower revenue deficit and lower fiscal deficit and the growth rate of our economy was high but we could not sustain this growth as the government lacked fiscal space.  The government incurred a high revenue and fiscal deficit because of a large fiscal stimulus to address the Covid-19 pandemic this time. It necessitated large government borrowings and resulted in a high interest cost (the 10-year government bond yield has gone up to 6.28% on August 14, 2021 as against 5.96% a year ago) despite large scale liquidity support to the tune of 6.9% of GDP in 2020-21 from the RBI through various conventional and non-conventional instruments.

The continuation of a large fiscal deficit without adequate fiscal space is akin to riding a tiger

It is important therefore that the government should come back to the FRBM target sooner; otherwise, we will face another economic crisis. Contrary to the belief of deficit owls that the “deficit is a symptom, not a disease”, country evidences suggest that large fiscal deficits accompanied by high revenue deficits are a disease and potential symptoms are lower growth (or unsustainable growth), demand pull inflation, crowding out of private sector investment, a vicious cycle of deficit and debt having no room for investment spending and a spillover to external sector deficit.

The situation is perhaps best described by the economist Martin Feldstein: “Like obesity, government deficit is the result of too much self-indulgent living as the government spends more than it collects in taxes. And also, like obesity, the more severe the problem, the harder it is to correct.”

(The writer is a former central banker and a faculty member at SPJIMR. Views are personal)