Fiscal deficit is the excess of payments over receipts of the government. The quantum of fiscal deficit in budgets in India is fixed by law — the Fiscal Responsibility and Budget Management (FRBM) law enacted in 2004 by ABV government in order to balance the budget. The FRBM law has mandated that, in every budget from 2005, the fiscal deficit should keep coming down till the 3 per cent limit is achieved by budget 2009. But because of the global financial crisis in 2008, the UPA government deferred the target date, justifiably. But with the passage of FRBM law, the rate of fiscal deficit has come to play determinative role on budgets. If a budget moves on the road map to get to 3 per cent fiscal deficit, the finance minister is glorified. If not, he gets demonised.
I have been saying for long that fiscal expansion or contraction should be aligned with credit contraction or expansion respectively, in the economy. There is an inverse correlation between fiscal deficit (fiscal expansion) and bank credit (monetary expansion). That is, 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. I have been pointing out for some time that the current strategy of “loose monetary “ policy with tight fiscal policy (taxation/spend policy) is not going anywhere and will lead to perpetual stagnation by keeping asset prices high while limiting the means of middle class to buy them.
Not many people even know how this limit of 3% came into existence? Is there any mathematical reason or logic behind it? Nope! It was just accepted as as number to align with EU target, which too was not an arithmetical deduction but a negotiated one between various countries of EU. It made its advent in fiscal economics when European nations signed the famous treaty at Maastricht in the Netherlands to form the European Union (EU) as an economic and monetary union in 1992. The treaty named after the university city Maastricht was preparatory for the EU to evolve as a single currency — the Euro — zone from January 2002. A national currency is the product of a politically sovereign state in exercise of what is known as its “seignorage power”. Put in layman’s language, seignorage power is the authority to print nation’s currency or borrow from central bank. In monetary economics, this means creating money if the economy needs it.
It is critical for survival of Euro as currency because if the individual nations do not comply with the package, the Euro will not survive as a common currency. The package agreed stipulated that a member’s inflation should not exceed 1.5 per cent over the average of three member states with the lowest inflation; its public debt should not exceed 60 per cent of GDP, and importantly, its fiscal deficit should not exceed 3 per cent of its GDP. For Eurozone’s survival as one monetary unit, individual nations cannot have inflation, debt, interest or fiscal deficit beyond the agreed limit. This is how the magic figure of ‘3’ made its way in the fiscal greatness parameter discourse.
I have been saying for long that fiscal expansion or contraction should be aligned with credit contraction or expansion respectively, in the economy. There is an inverse correlation between fiscal deficit (fiscal expansion) and bank credit (monetary expansion). That is, 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. I have been pointing out for some time that the current strategy of “loose monetary “ policy with tight fiscal policy (taxation/spend policy) is not going anywhere and will lead to perpetual stagnation by keeping asset prices high while limiting the means of middle class to buy them.
Not many people even know how this limit of 3% came into existence? Is there any mathematical reason or logic behind it? Nope! It was just accepted as as number to align with EU target, which too was not an arithmetical deduction but a negotiated one between various countries of EU. It made its advent in fiscal economics when European nations signed the famous treaty at Maastricht in the Netherlands to form the European Union (EU) as an economic and monetary union in 1992. The treaty named after the university city Maastricht was preparatory for the EU to evolve as a single currency — the Euro — zone from January 2002. A national currency is the product of a politically sovereign state in exercise of what is known as its “seignorage power”. Put in layman’s language, seignorage power is the authority to print nation’s currency or borrow from central bank. In monetary economics, this means creating money if the economy needs it.
It is critical for survival of Euro as currency because if the individual nations do not comply with the package, the Euro will not survive as a common currency. The package agreed stipulated that a member’s inflation should not exceed 1.5 per cent over the average of three member states with the lowest inflation; its public debt should not exceed 60 per cent of GDP, and importantly, its fiscal deficit should not exceed 3 per cent of its GDP. For Eurozone’s survival as one monetary unit, individual nations cannot have inflation, debt, interest or fiscal deficit beyond the agreed limit. This is how the magic figure of ‘3’ made its way in the fiscal greatness parameter discourse.
But how did the Eurozone honour the deficit figure 3 per cent of GDP? Of the 12 members, 10 breached the 3 per cent limit during the twelve years, 1999 to 2011 — Greece, every year; Portugal,10 years; Italy, eight; France, seven; and the strongest one, Germany, five. Also the ceiling 60 per cent of debt to GDP, inherently linked to fiscal deficit, too was violated by most including France, Spain, Belgium, Austria, Italy, and Germany. The Maastricht treaty, including the 3 per cent rule, is observed more in breach.
How did this farce made it's way to India?
Our economic gurus of UPA devised a formula to deflect criticism of copying EU. It was first reported that the magic figure was recommended by a committee of the finance ministry, but no such recommendation seems available on record. Later, somewhere in 2006, long after FRBM law had adopted the 3 per cent limit, Dr S Rangarajan and Dr Subbarao explained the logic of the magic 3 per cent thus: out of the average financial savings of India, which was 13%, 5% would “go” to private sector cos and of the balance 8%, 2% would go to public sector undertakings — “leaving” 6% for central and state govts to be appropriated 50:50 between them to fund their deficits. That was how the 3% limit for the central govt in FRBM was rationalised. What if the pvt sector refuses to utilise 5% of the allocation or doesn't have the capacity to use As evident from the decreasing credit to GDP ratio? What if the pvt sector needs more? Is the basis for fiscal deficit not linked to the extent of credit demand by private corporates rather than by the amount of savings notionally allocable to them?
See what S Gurumurthy has to say about this madness of fiscal responsibility and needs..
"The logic of correlation between credit expansion and fiscal deficit has five sequential limbs.
| One, money is the blood of economic growth. |
| Two, most money that fuels the economy is created by banks, not by government. |
| Three, banks and financial institutions fund business and others, and it is that credit money which drives the economy. |
| Four, 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. |
| Five, 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. |
The fifth limb ensures that growth does not decelerate for want of enough money circulating in the economy. Otherwise, it will. The FRBM law has ignored the fourth and fifth limbs of the logic and fixed the 3 per cent fiscal deficit as inviolable. The time has come to uncover how far its intents match with the reality and how rational its fixation with the 3 per cent limit is. The working of the FRBM law, particularly in the last few years, needs a reality check."
It seems that for their own very selfish reasons a Group of economist now being promoted by Bloomberg Group called “Modern Theorists” (?) have started calling for higher fiscal deficit limit.
Eventually loose monetary policy + loose fiscal policy will convert the present stagnation to stag-inflation (stagflation).
Eventually loose monetary policy + loose fiscal policy will convert the present stagnation to stag-inflation (stagflation).
" Money supply growth had averaged 17.8 per cent between 2006-7 to 2010-11. It began declining later. It declined from an average growth of 16.5 per cent in the two years ending 2010-11 to an average growth of 13.5 per cent in the three years ending 2013-14. In 2014-15 its growth had come down to 11.5 per cent — a fall in growth of 45 per cent 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 per cent in 2009-10 to less than 8 per cent 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 per cent in 2014-15 and to 4.4 per cent in the nine months of 2015-16, from 11 per cent 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 per cent in 2009-10 to 8.8 per cent, which is less than nominal GDP growth. Three things are obvious. Money supply growth has reduced. Credit expansion has fallen. And even fiscal deficit and credit growth put together have declined, all pointing to the growing economy being starved of the needed money needed, in which the FRBM Act has also lent its hand. "
We should have reasonably loose fiscal policy but tight/controlled monetary policy. The artificial limit of 3% GDP for fiscal deficit has to be replaced by dynamic limit based on :-
1. Rate of GDP Growth
2. Velocity of money , CRR/SLR Ratio, Monetary policy etc
3. Amount of Budget invested in productive assets
4. Reasons of inflation whether it is cost push or due to excess moeny in the system
For India I think that Prime Interest Rate hovering around 10% should be around 8% while Fiscal deficit limit should be 5% with massive Govt Investment in Infrastructure and seed money for high tech industries.
Quotes from S Gurumuthy's article in The Hindu
http://www.thehindu.com/opinion/lead/frbm-acts-3-limit-on-fiscal-deficit-hinting-at-paradigm-shift/article8320964.ece
http://www.thehindu.com/opinion/lead/frbm-acts-3-limit-on-fiscal-deficit-hinting-at-paradigm-shift/article8320964.ece
