GS-3, Indian Economy, Uncategorized

Relation between fiscal deficit and bank credit

There is  an inverse correlation between fiscal deficit (fiscal expansion) and bank credit (monetary expansion). That is, if credit growth falls, fiscal deficit may need to rise and if credit rises, fiscal deficit ought to fall — to ensure adequate money supply to the economy.

The FRBM Act says it cannot borrow more than 3 per cent of GDP — even if banks do have money, even if the private sector does not take it, and even if the economy needs it for growth.

The money may lie idle in banks, and yet the law will not allow the government to borrow! This is perverse economics. The economists world over unanimously agrees that as money is critical for economic growth, without adequate money, GDP growth will suffer.

The logic of correlation between credit expansion and fiscal deficit has five sequential limbs.

One, money is the blood of economic growth.
Two, most money that fuels the economy is created by banks, not by government.
Three, banks and financial institutions fund business and others, and it is that credit money which drives the economy.
Four, if, for whatever reason including lack of business confidence, the bank credit to the economy does not adequately grow, like it did not in the last few years, economic growth will suffer for want of adequate money.
Five, that is when the Budget needs to step in, to pump money into the economy by incurring deficit (spending more than the income), and, for the purpose, borrow the money lying with banks or even by printing more money, if that is needed.

The fifth limb ensures that growth does not decelerate for want of enough money circulating in the economy. Otherwise, it will. The FRBM law has ignored the fourth and fifth limbs of the logic and fixed the 3 per cent fiscal deficit as inviolable. The time has come to uncover how far its intents match with the reality and how rational its fixation with the 3 per cent limit is. The working of the FRBM law, particularly in the last few years, needs a reality check.

Road Ahead

So, there is a  possibility of adopting a target range rather than a specific number. The argument is that this would give the necessary policy space to deal with dynamic and volatile situations such as the one India currently faces — global economic and financial market uncertainty, a slowdown in China, and tepid private investment demand domestically.

And the Government need to ensure that any resources freed up from a fiscal reset, when that happens, are spent imaginatively for an economic stimulus, and primarily on the creation of long-term public assets.

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