Whenever there is debate on budget, fiscal deficit, by default, occupies the centre-stage. However, this year it found a special mention in Finance Minister’s budget speech.
- Finance Minister Arun Jaitley, in his speech, said that “there is a suggestion that fiscal expansion or contraction should be aligned with credit contraction or expansion respectively, in the economy.” This statement hints at a paradigm shift in how to determine fiscal deficit.
What is ‘Fiscal Deficit’?
The difference between total revenue and total expenditure of the government is termed as fiscal deficit. It is an indication of the total borrowings needed by the government.
How is it set currently?
Currently, the Fiscal Responsibility and Budget Management (FRBM) Act insists on a blanket 3% arithmetical limit on fiscal deficit.
What is FRBM Act?
Fiscal Responsibility and Budget Management (FRBM) Act was enacted by Parliament in 2003 to progressively cut fiscal deficit to 3% levels by 2008.
- FRBM Act put limits on the fiscal and revenue deficit of the country by setting targets for both.
- These targets were to be monitored through the year by setting mid-year targets.
- The government was to provide make a medium-term fiscal policy statement, fiscal policy strategy statement and macro-economic framework statement to Parliament.
- The Act, however, provides exception to government in case of natural calamity and national security.
How fiscal deficit limit was set to 3%?
The 3% limit made its debut in the famous Maastricht Treaty to form the European Union (EU) in 1992.
- The treaty prescribed four criteria which EU members had to comply to be eligible to adopt the Euro as the common currency. One criterion was the 3% fiscal deficit limit — the others being limits on inflation, long-term interest rates and public debt.
Why did the EU treaty mandate the 3% limit?
EU members like Greece and Italy were operating on high fiscal deficits while Germany and France had much lower numbers. In the tussle between prudent and profligate EU members, the limit emerged as a negotiated rate after give and take.
- However, there was no objective economic basis for it. Besides, many EU states could keep up the promise. Ten of the 12 EU members breached the 3% limit over 12 years, from 1999 to 2011 — Greece, every year; Portugal, 10 years; Italy, eight; France, seven; and the strongest one, Germany, five.
The Indian context:
It was an open secret that the FRBM Act enacted in 2003and implemented from 2004, had adopted the ready-made EU limit of 3%.
- But, according to another theory, this limit was set by an expert committee. However, some experts argue that such committee never existed.
- Faced with criticism that the EU rate of 3% was carbon copied into the FRBM Act, some convoluted arithmetic was devised retroactively to explain the logic of the magic figure of 3%.
- The explanation went thus: the time-series household financial savings of India plus external savings was 13%; out of that, 5% would go to private sector corporates; of the balance 8%, 2% would go to public sector undertakings, leaving 6% for Central and State governments to be shared between them (50:50), that is 3% each, to fund their deficits.
What’s the problem with the above explanation?
The expert view rested on two basic assumptions-
- One, the financial savings would ever remain at 13%, neither rise nor fall.
- Two, obeying the experts, 5% of it would go to private corporates.
But, what if the private sector refused to take part of it? That is, if the credit offtake goes down, as it has in the last few years in India? And what if the financial saving rises? Or falls? The experts committee never answered these questions. Hence, it is argued that the fake explanation for 3% was intended to hide the copycat fiscal economics written into the FRBM limits.
What the Finance Minister said in his recent budget speech?
Finance Minister said that “fiscal expansion or contraction should be aligned with credit contraction or expansion respectively, in the economy.” With this it appears that he has recognized the possibility of an inverse correlation between fiscal deficit (fiscal expansion) and bank credit (monetary expansion).
What is “Inverse correlation”?
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 logic of correlation between credit expansion and fiscal deficit has five sequential limbs:
- Money is the blood of economic growth.
- Most money that fuels the economy is created by banks, not by government.
- Banks and financial institutions fund business and others, and it is that credit money which drives the economy.
- 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.
- 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. This ensures that growth does not decelerate for want of enough money circulating in the economy.
Where the FRBM Act has failed?
The FRBM law has ignored the fourth and fifth limbs of the logic and fixed the 3% fiscal deficit as inviolable. The FRBM Act also ignores the possible inverse link between monetary and fiscal economies.
- Banks create and control most money stock in the economy. This constitutes the monetary economy which isentirely under the control of the Reserve Bank of India. The revenues and expenditure of the government constitute the fiscal economy.
- If the government spends more than its income, then deficit arises, which it has to finance by borrowing money created by banks. The FRBM Act says it cannot borrow more than 3% 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.
- However, it is unanimously agreed that money is critical for economic growth. Without adequate money, GDP growth will suffer.
The economic debate on the money-growth link dates back to the Great Depression of the 1930s.
- While the celebrated Nobel laureate, Milton Friedman, talked about inadequate money supply as the cause of the Great Depression, James Tobin pointed to inadequate demand for money (credit) as the cause. That is even if there is money, a lack of business confidence or high interest may reduce the demand for money.
- There is no doubt that both — lack of money supply as well as lack of demand for credit — weaken growth.
From 2012-13 to now, i.e. 2015-16, the Indian economy seems to have been experiencing both the Milton and Tobin effects — shrinking money expansion and credit demand shrinking even faster.
- Money supply growth had averaged 17.8% between 2006-7 and 2010-11. It began declining later. It declined from an average growth of 16.5% in the two years ending 2010-11 to an average growth of 13.5% in the three years ending 2013-14. In 2014-15 its growth had come down to 11.5% — a fall in growth of 45% as compared to 2010-11. The money supply growth is less than the growth of nominal GDP for 2014-15.
- The year-on-year growth in bank credit too more than halved from 16.7% in 2009-10 to less than 8% in 2015-16. As a proportion of the growth of nominal GDP too bank credit growth has fallen. The credit growth, which had equalled the growth of nominal GDP in 2010-11, almost halved in 2014-15. The credit expansion as related to GDP too fell to 5.6% in 2014-15 and to 4.4% in the nine months of 2015-16, from 11% in 2009-10.
- This establishes that, in the last six years, both money supply growth and credit expansion have halved absolutely and in relation to GDP growth. Even the combined fiscal deficit (fiscal expansion) and credit growth (monetary expansion) as a percentage of GDP has halved from 17.4% in 2009-10 to 8.8%, which is less than nominal GDP growth.
The time has come to rationally fix the fiscal deficit limit and have a relook at the FRBM Act.
It’s time to align the monetary and fiscal economies. If bank credit growth falls, fiscal deficit may need to go up. If bank credit growth rises, fiscal deficit should reduce. This is particularly true for a growing economy like India.