1966 or 1991? Two lessons from history for FM Sitharaman before Budget

Finance Minister Nirmala Sitharaman presents the Union Budget on February 1.
In seven days from now India’s first woman finance minister will present her second budget. She does so from a position of extraordinary fiscal weakness. There have been two previous years when the government found itself in such dire straits. 

The first was in 1966 when three wars in the three previous years, and a massive drought in 1965, had laid India as fiscally low as it is now. 

The second was in 1991 when a major balance of payments caused by a massive fiscal deficit had knocked the bottom out of the budget. 

So in 1966, when she became prime minister, Indira Gandhi was faced with an economic crisis of unprecedented dimensions. Two-thirds of India was hit by drought.  Relief works were costing the exchequer dear. The economy had stopped growing for the first time in two decades. Tax receipts were down about 30 per cent of estimates, industrial production was expected to grow by only 6 per cent. Exports were not growing. Prices were rising and the states were being starved of development funds. The fiscal deficit stood at over 7 per cent of GDP. 

The government had refused to acknowledge the crisis all through 1965.  So when the crisis came it took everyone by complete surprise. No one knew quite what to do. Since Keynesian pump priming orthodoxy hadn’t taken hold yet a severe fiscal contraction was the only way out. 

Indira Gandhi wasn’t much interested in the economy because she didn’t understand economics. So she was content to leave the running of the economy to civil servants while she busied herself with the party, the forthcoming general election and foreign policy. 

In the absence of a clear political direction the civil servants made the best of a terrible situation. Their response was typically bureaucratic: batten down hatches and foster a siege mentality.

This led to further controls and limitations on freedoms of economic action which, when new external shocks came, made it harder for the economy to adjust quickly on its own without further interventions by the government. 

India turned into a virtual autarky and out of sheer fear the government tightened its hold on the economy to an absurd extent. This approach continued till 1991 when a second massive crisis struck. 

The response to the 1991 crisis was the exact opposite to the crisis of 1966. Controls were relaxed. The government accepted that it has to allow economic agents far greater freedom of action. After 1991 India slowly rejoined the world. Policy became more business friendly than it had been since 1967. 

In purely economic terms, if the response to the 1966 crisis had been to control aggregate demand, the response to the 1991 crisis was to enhance aggregate supply. 

Now that India is once again in severe fiscal crisis, we have to see which is these two approaches the finance minister will adopt in the forthcoming budget. Contrary to the received wisdom that she should take steps to increase demand, I think she should do what was done in 1966 for exactly the same reasons: being broke. No fiscal boosters to artificially increase demand. 

That said she should also do what the 1991 budget did: free businesses from random, illogical and counter-productive controls. 

In short, we need a sensible combination of the1966 and 1991 approaches, namely, deep fiscal prudence (1966) and a withdrawal from the economic stage (1991).

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