Union Budget 2013 - 2014: Look at the Components of Fiscal

Deficit, Mr Chidambaram
Sunday 10 March 2013, by Bharat Jhunjhunwala

Finance Minister P. Chidambaram stressed during presentation of the Budget that the 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 the 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 the fiscal deficit and this hits the governments 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 simul-taneouslythe rate of inflation goes up and unemployment goes
down. Thus, the mantra of control of the fiscal deficit is often seen as being anti-poor who
are deprived of jobs that could come from increased government expenditures.
This thinking runs counter to the 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 a

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 the 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 govern-ment expenditures occurs only if the
prices do not increase in tandem with an increase in the fiscal deficit. The total government
expenditure at present is, say, 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 per cent 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 mandays of
employment will be created by a government expenditure of Rs 50 billion at a wage of Rs
100 before the fiscal deficit was incurred; and by the government expenditure of Rs 55
billion at a wage of Rs 110 after the fiscal deficit was incurred. Thus, Phelps said that
expectation of the people regarding inflation can undo the beneficial effects of the 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 a liberal fiscal policy will be ineffective. Phelps was awarded
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--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 the 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? 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 the 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 rick-shaws,
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 the fiscal
deficit is felt in the economy. The crux of the fiscal deficit is to incur it in such expenditures
that provide quick returns.
In conclusion, then, it appears legitimate to use the 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 the 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 govern-ment expendituresboth 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 increased the same on high-impact heads. In this way the eco