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Reviving Fiscal Activism

Surajit Das (dasurajit@gmail.com) teaches at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi.

Fiscal Consolidation, Budget Deficits and the Macro Economy by Lekha S Chakraborty, Sage, 2016; pp xix +197, 750.

 

In the book under review, Lekha S Chakraborty has made a serious attempt to reopen the debate regarding the macroeconomic consequences of fiscal deficit in the Indian context. Many in the policymaking circle in India believe that this is more or less a resolved debate: fiscal deficit is necessarily harmful for the health of the economy. However, this is an ongoing debate, for at least more than a century, whether fiscal deficit would necessarily cause crowding out of private investment or whether or not it would necessarily be inflationary. Chakraborty has mainly adopted empirical analysis as the tool to test these hypotheses, with the help of sophisticated econometric techniques like Hsiao’s asymmetric vector autoregression of the stationary time series data and so on.

There are total nine chapters in the 200-page book that include an introductory chapter on linking the work with part of the existing literature and a concluding chapter along with policy implications. In the second chapter of this book on fiscal deficit and macroeconomic activity of central and state governments, the long-term trends of various deficit-related indicators have been depicted and the subnational-level disaggregated data has been plotted separately for the pre- and the post-FRBM (Fiscal Responsibility and Budget Management) Act era.

In the third chapter on fiscal deficit, capital formation, and crowding out, theoretical linkages are discussed between fiscal deficit, capital formation and private investment. The econometric results suggest that private investment has a complementary relationship with public investment rather than public investment substituting the private investment. But, the real rate of interest affects the private investment significantly in the Indian context. To explore the deficit–interest rate link and to explore the possibility of crowding out, in the fourth chapter, appropriate econometric tests have been carried out. The results clearly suggest that fiscal deficit does not cause a rise in the real interest rate. Another interesting result that emerges in this chapter suggests an asymmetric vector autoregression (VAR) based Granger causality from the expected inflation to the real rate of interest.

The fifth chapter of the book deals with monetary and fiscal policy coordination and concludes that fiscal rules have effectively become macroeconomic rules, as an additional policy decision of shifting of deficit financing by seigniorage to bond financing has also taken place in India.

The sixth chapter discusses the concept of fiscal seigniorage, which is a wider concept than the traditional monetary seigniorage. The next chapter deals with the empirical estimation of the linkage between fiscal deficit and seigniorage. The results from the asymmetric VAR interestingly suggest that fiscal deficit neither causes seigniorage nor causes increase in money supply in India.

Before proceeding to the next chapter on fiscal deficit and inflation, the author cautions the readers that despite having no effect on money supply, fiscal deficit still may have inflationary potential. The empirical results suggest that money supply as well as fiscal deficit cause inflation in India. If I have understood the interpretation of aforementioned results correctly, they suggest that the fiscal deficit may not cause inflation in India following the typical monetarists’ route (by increasing the money supply); however, it may directly cause inflation through increasing the aggregate demand in the economy. The policy takeaways are discussed in the final chapter of the book. The book finally argues in favour of the revival of fiscal activism in India.

Evidence of Crowding-in

To summarise the arguments, the book successfully maintains, with the help of econometric analysis of time series data, that fiscal deficit does not have any adverse impact on the economy in Indian context. It neither causes crowding out of private investment by raising the interest rate nor inflation by raising the money supply. In fact, there exists empirical evidence in favour of crowding-in phenomenon, that is, some kind of complementarity between public and private investment in India. As opposed to the arguments of the fiscal conservatives, this book actually argues that the two main concerns about larger fiscal deficit—namely, possibilities of crowding-out and inflation—should be ruled out in the Indian context.

To extend the discussion further, the book claims that fiscal deficit may have a direct inflationary potential by raising an aggregate demand (although, I am not very clear); however, that might be true if any of the components of aggregate demand rises.

For example, if there is a rise in exogenous export demand or even if there is a rise in the aggregate investment demand, for some reason, ceteris paribus, the aggregate demand in the economy would increase. In the Indian context, many have argued that inflation rate is closely linked with international food and fuel prices, which are largely exogenously given. There is, at least, a theoretical possibility that the food and fuel subsidy bill of the government might also move together with the movements in their international prices under non-deregulated or partially regulated regime. In fact, in my view, it would be interesting to see what happens to the empirical results after incorporating international oil price as an exogenous variable in the asymmetric VAR structure. Moreover, in my view, a demand-pull inflation is unlikely to take place in a consistent manner in the context of a demand-constrained economy with persisting unemployment and underemployment together with unutilised capacity at the aggregate level.

Other Concerns

Apart from main concerns regarding crowding-out (growth) and inflation, many have raised two more objections to fiscal deficit: (i) consideration of sustainability of public debt; and (ii) concern about Moody’s rating, and flow of international finance capital. Along with other documents, the recent report of the FRBM Review Committee, 2017 has also emphasised on the issue of sustainable level of public debt in India.

Also, our finance ministers of successive governments have, on record, reiterated the issue of dependence of India’s rating on fiscal deficit to gross domestic product ratio. Although, both these arguments may have little empirical support, yet they are probably worth mentioning in order to engage with the counterarguments. Everything cannot be covered in a single book; however, it would be interesting to know Chakraborty’s take on these issues in the future.

Keynesian, post-Keynesian, and Marxist economists have argued for decades that there is no reason to believe that fiscal deficit would necessarily cause crowding-out or inflation under a demand-constrained situation in an economy operating well below full employment and full capacity level of output at the aggregate level. The book under review engages well mainly with the so-called “mainstream” neoclassical, monetarist, new-Keynesian literature of macroeconomics and counters their arguments by citing empirical evidence from the Indian economy. Without challenging their framework of analysis directly, this book chooses to argue in favour of the revival of fiscal activism under a demand-constrained situation, on the basis of pure data analysis.

Fiscal conservatism was primarily imposed by a structural adjustment programme of the International Monetary Fund. In the name of “fiscal prudence” and “sound finance,” absolute conservatism was brought in worldwide. Fiscal rules were imposed everywhere so that the deficit cannot rise under any circumstance. Fiscal deficit was considered to be necessarily harmful for the health of an economy, irrespective of the level of aggregate demand in the economy.

Chakraborty has also engaged with arguments regarding monetary dominance. On top of fiscal policy rule, the rule-based monetary policy (inflation targeting) also imposes more stringent restrictions on the autonomy of fiscal authorities. In the author’s own words, “central bank autonomy is at the heart of unpleasant fiscal arithmetic” and “the recent agreement between Government of India and central bank in March 2015 towards CBI (central bank independence) and inflation targeting is a consensus towards unpleasant fiscal arithmetic regime.”

The book ends by raising a pertinent question: whether a new macroeconomic consensus is reached in India! In 2001, former governor of the Federal Reserve Board of United States, Laurence H Meyer claimed that some kind of a “consensus” has been arrived regarding the policy of inflation targeting based on a model including an aggregate demand equation, a Phillips curve, and a [Taylor (1993) type] monetary policy rule. Given that fiscal deficit does not have any adverse macroeconomic consequences, implementation of fiscal rules as well as inflation targeting rules in India seem to suggest that some kind of “consensus” exists at least in the present policymaking circles. This book rebels against that.

It is an important reading because today in India the government is continuing to take conservative stance for quite some time despite acute unemployment. Large-scale unemployment and underemployment across skill levels along with the coexistence of unutilised capacity is visible in almost every sector. Expected rate of return on investment has relatively come down, business confidence is relatively low, investment rate is falling, non-food credit offtake is not growing, non-performing assets are piling up in the commercial banks, and job opportunities are shrinking at aggregate level in India today. Social sector gaps are widening day by day.

Despite this, a reduction in capital expenditure and planned social sector expenditure as a proportion to GDP is witnessed without any thought of an expansionary fiscal policy path in the true sense because of self-imposed FRBM restrictions and inflationary considerations. In this context, Chakraborty’s book shows empirical proof in favour of fiscal deficit not having any negative macroeconomic consequences. Therefore, the ongoing fiscal conservatism cannot be justified at least in the Indian context.

The book argues that revival of fiscal activism (as opposed to fiscal conservatism) is the need of the hour. And protecting the autonomy of fiscal authorities from the monetarists’ onslaughts is also equally important. I cannot agree more with the author vis-à-vis these two broad points of the book under consideration.

Reference

Taylor, J B (1993): “Discretion verses Policy Rules in Practice,” Carnegie–Rochester Conference Series on Public Policy, Vol 39, pp 195–214.

Updated On : 4th Jun, 2018

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