Fiscally, we are anti-Keynesian

In the recently presented Budget, India’s fiscal deficit for FY 2017-18 got revised upwards from 3.2 per cent to 3.5 per cent of GDP and the target fiscal deficit for FY 2018-19 is set at 3.3 per cent. Though Moody’s has said that a slight slippage in fiscal deficit has no material impact on overall economic strength, the Indian rupee slid past 64 to the US dollar post-Budget, and bond yields hardened substantially. This begs a question: Shouldn’t government have some space to operate its fiscal policy? I argue that the stringency we are placing on the path of fiscal consolidation makes us anti-Keynesian and I believe that that’s not optimal.

The first subtle and grossly unappreciated point is that expressing the fiscal target as a percentage of GDP makes our policy pro-cyclical or anti-Keynesian. The fiscal deficit expressed as a percentage of nominal GDP can be breached even if expenditure in rupee terms is adhered to but the actual GDP falls short of forecast GDP, based upon which the government plans its budgetary expenditure. To achieve the fiscal deficit target as a percentage of GDP requires that government literally scales back rupee expenditure when economic growth slows down. Is this a desirable fiscal policy? No so! That is what the evidence suggests. 

Source: IMF
Greece is a leading example of what austerity measures could do to the country’s economic growth. Greece has lost 30 per cent of its GDP since 2010 after imposing austerity measures. In fact, as IMF’s recent paper suggests, countries which employed severe austerity plans lost more in terms of GDP growth after financial crises (see graph). When Canada employed massive fiscal consolidation in 1997-98, it was running a four per cent-plus GDP growth rate (which is very high for an advanced economy) and more importantly, had high interest rates. The Bank of Canada could counter some of the negative impacts of austerity by reducing the interest rate.

In India, where inflation is sitting right in the middle of the inflation target band, and where the RBI has limited scope to tinker with rates, fiscal austerity would have a much bigger impact. Even generally, history suggests that countries have resorted to counter-cyclical policies. For example, take the case of the United States. The IMF has made available fiscal data from 1800 for the US. The US experienced a fiscal deficit of 30 basis points higher on average during the worst 30 years in the last two centuries, compared with the best 30 years.   

Let’s flip the side and ask if being-Keynesian helps. A 2011 paper by Auerbach and Gorodnichenko in the American Economic Review and a follow-up paper by Valerie Ramey and Sarah Zubairy both convincingly show that at least in the US, fiscal multipliers in bad times are large, meaning that government expenditure helps in bad times. Richard Koo’s hypothesis also suggests that when everyone in the private sector is deleveraging their balance sheets, the government should not do so, as it will reduce the aggregate demand. In short, evidence supports being Keynesian in bad times. But Auerbach in his 2011 paper also shows that fiscal multipliers can be close to zero or even negative in good times. This can occur because the government can crowd out private borrowers from credit markets by putting upward pressure on interest rates. This implies that it’s important that the government sticks to counter-cyclical policies at all times. 

To achieve the fiscal deficit target as a percentage of gross domestic product requires the government to scale back rupee spending just when growth slows down
The fear most economists have is exactly this — that counter-cyclical policies hardly stay counter-cyclical by the time the economy enters the boom phase. At that time governments find it tough to control spending amidst high tax revenues and a golden opportunity to move towards fiscal balance can be lost. But does India’s case look like that? Since 1990, India has been able to maintain the fiscal deficit in the broad range of two to four per cent, even after undergoing a wave of productive capital expenditure under the NDA government at the turn of the century. 

More recently, we had a very high fiscal deficit in 2009 of roughly nine per cent. The UPA pulled it back to 4.4 per cent by 2014. But they also had good growth years to support fiscal consolidation. From 2014, the BJP-led government has been able to reduce the fiscal deficit further to the 3.2-3.5 per cent range even after having sub-seven per cent growth years. I feel that Indian governments have shown a fiscal record which is credible enough to allow them some flexibility to counter slow growth. 

Observers got a bit worried that the fiscal slippage was led by the revenue deficit rising to 2.6 per cent compared to the planned 1.9 per cent. But many of the government expenditures on education, health and rural programmes is categorised as revenue and to call it wasteful is not really correct.

In summary, I propose that the government should have a long-term plan of achieving fiscal balance. But the glide path should really be a function of the state of the economy that prevails in the future. It should allow for overshooting during tough times but requires undershooting during good times. After all, being Keynesian is not being fiscally imprudent. 

The author is Research Director, CAFRAL (RBI)

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