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Home > Business > Columnists > Guest Column > Sudhir Mulji
Why deficit finance works
April 22, 2004
Stan Fischer, in his inaugural lecture, to celebrate the formation of the joint research venture between the Brookings Institute and NCAER, pointed out that in the flood of positive economic news about India since the 1980s, the one unexplained mystery is the uncontrolled fiscal deficit.
In the orthodox view these deficits should have had, and probably have had, a negative effect on the Indian economy without yet culminating into a crisis.
The avenues that will make fiscal deficits lead to an eventual disaster have been variously described. Prem Jha argues that the calamity will emerge when "sooner or later confidence in the (appreciating) rupee will snap", (Financial Express, April 13) that in any case the appreciation is primarily due to foreign inflows attracted by high Indian interest rates; these abnormal rates are a direct consequence of the government's excessive borrowing to finance fiscal deficits, and that when this is realised it will provoke a panic among foreign investors, eventually causing a catastrophe.
Swaminathan Aiyar, on the other hand argues that foreign inflows have "offset the crowding out impact of high fiscal deficits" but reforms particularly the elimination of financial repression has greatly increased the cost of government borrowing and thus the cost of fiscal deficits.
The moral argument against fiscal deficits is understandable; there is something reprehensible about a lack of budgetary restraint on irresponsible politicians who do nothing to control government expenditure.
However for those of us who are more phlegmatic about deficit finance and treat it as similar to corporate borrowing, the fact that we have in the last two decades had the worst fiscal deficits combined with the highest growth rates and the strongest balance of payments and the steady accumulation of foreign reserves, makes us reluctant to condemn the continuation of fiscal deficits.
Further the intellectual argument against fiscal deficits is somehow unconvincing. There seems no causative logic that spells out precisely how fiscal deficits will lead to catastrophe.
The general argument flows from the Sargent Wallace paper that if the growth rate is less than the real interest rate, the burden of national debt will be unsustainable.
But the use of the phrase "real interest rates" when the national debt is generally paid for in nominal rates makes one suspicious. Is this one more of those tricky economic arguments that should be handled with caution?
After all Thomas Malthus first expounded the universal economic truth that population grows in geometric proportions while production advances in arithmetic proportions.
The mathematics of this implied disaster; but 200 years later we have survived in spite of Malthus's justified forecast of catastrophe. Are these warnings against fiscal deficits, one more red herring that economists confuse us with?
To illustrate the verbal confusion consider the argument deployed by Bajpai and Jeffrey Sachs in "Fiscal Policy in India's Economic Reforms" (OUP, 1999).
Bajpai and Sachs argue that "budget deficits imperil national savings rates thereby reducing overall aggregate investments...most directly low levels of public investment have rendered India's physical infrastructure incompatible with large increases in national product".
We can all agree that low levels of public investment have hampered the improvement of physical infrastructure but what has that got to do with too much deficit financing?
Logically at least, one could argue exactly the opposite proposition that low public investment has been hampered by insufficient government finance to pay for government expenditure; and that this low level of investment is a prima facie case for justifying higher fiscal deficits.
Further Sachs and Bajpai justify low public investment on the grounds that India's public expenditure has been much higher than neighbouring countries. They show that in 1995 Indonesia, Thailand, Republic of Korea and Malaysia had a far lower government percentage of expenditure than India.
It is ironic that they do not mention the fact that the countries they refer to are also the four countries who suffered dramatically from the contagion of currency crisis that India escaped from, not perhaps as Bimal Jalan imagines by superior currency management, but by a willingness to run fiscal deficits outside the norms set by economists.
What are these norms? Essentially they are sustainability and solvency and fortunately we have two economists in Ashok Lahiri and Kannan who are prepared to define both sustainability and solvency in their scholarly article "India's fiscal deficits and their sustainability" (OUP, 2004).
Sustainability they say "is to endure without breaking down" and "solvency, on the other hand, means to be able to discharge one's obligations in the long run". Leaving sustainability for later argument let us consider first solvency.
Here Lahiri and Kannan abandon the link to their own definitions to arrive at some peculiar conclusions. They write, "Evidently a government running a primary deficit (that is a deficit even after netting out of interest payment) in every period forever is not solvent."
Why is such a government not solvent? And what does running a primary deficit for ever have anything to do with the capacity to discharge one's obligations in the long run? If the obligations undertaken require payment in domestic currency, it is always possible for the authorities to pay off the debt by printing money to keep themselves solvent.
Indeed Milton Friedman in his Essays on Positive Economics had suggested, "the monetary authorities should adopt the rule that the quantity of money should be increased only when the government has a deficit and then by the amount of the deficit and should be decreased only when the government has a surplus and then by the amount of the surplus" (footnote 3 Friedman, "Fiscal and Monetary Framework for Economic Stability"). Thus by manipulating the supply of money Friedman proposed a rule that would leave public debt unchanged.
Lahiri and Kannan have not considered this degree of monetisation in their paper; instead they have mainly concluded that the authorities must borrow to pay for their deficits and that therefore they would be forced to play an indefinite Ponzi game to repay old debts and current primary deficits with rising borrowing.
It is a pity that they have not looked at the details of the original Ponzi scheme which depended not on borrowing new money to pay off old but on a complicated international arbitrage on postal stamps where the price had been arbitrarily fixed by governments.
The need for excess borrowing came about only when Ponzi realised that to make sufficient money he would have to play the arbitrage on so large a scale that he could only sustain it with extraordinary fundings.
But leaving the Ponzi digression to one side, the fundamental difference to the merit or otherwise of deficit finance cannot and should not be analysed by the simple theory that apply to a modernised version of a barter economy.
It is relevant to note that Lahiri and Kannan acknowledge that an excess supply of money which additional monetised deficit finance would represent, will if it spills over into commodity markets lead to an "increases in prices or output".
Assuming the word "or" is used conjunctively, the increase in output is surely highly desirable and precisely the purpose of deficit financing; nor are relative price changes undesirable if they encourage better resource allocation.
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