“There is a suggestion that fiscal expansion or contraction should be aligned with credit contraction or expansion respectively, in the economy.” This statement, by Union Finance Minister Arun Jaitley, in his Budget speech, hints at a paradigm shift in how to determine >fiscal deficit . Currently, the >Fiscal Responsibility and Budget Management (FRBM) Act insists on a blanket 3 per cent arithmetical limit on fiscal deficit.
Mr. Jaitley seems to recognise the possibility of 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. As the FRBM Act ignores the possible inverse link between monetary and fiscal economies, the Finance Minister has rightly looked for an objective basis for fiscal deficit.
No objective basis
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.
To preface the reality check on the FRBM law, it is necessary to know how the 3 per cent fiscal deficit limit emerged. The story is amusing, even bizarre. The magic number made its debut in the famous Maastricht Treaty to form the European Union (EU) in 1992. The treaty prescribed four criteria which EU members had to comply to be eligible to adopt the Euro as the common currency. One criterion was the 3 per cent fiscal deficit limit — the others being limits on >inflation , long-term interest rates and public debt.
Why did the EU treaty mandate the 3 per cent limit? EU members like Greece and Italy were operating on high fiscal deficits while Germany and France had much lower numbers. In the tussle between prudent and profligate EU members, the limit emerged as a negotiated rate after give and take. There was “no objective economic basis” for it (See: Crises in Europe in the Trans Atlantic Context: Economic and Political Appraisals , Routledge Studies in the Modern World Economy CRC Press 2015). That the 3 per cent limit was not aligned to the economic realities of EU was soon established by its own experience. Ten of the 12 EU members breached the 3 per cent limit over 12 years, from 1999 to 2011 — Greece, every year; Portugal, 10 years; Italy, eight; France, seven; and the strongest one, Germany, five.
The Indian context Now, come to how the 3 per cent limit got its celebrated status in Indian fiscal economics. It was an open secret that the FRBM Act enacted in 2003and implemented from 2004, had adopted the ready-made EU limit of 3 per cent. But some fake reports had first hinted that an expert committee, which never existed, had recommended the limit. Faced with criticism that the EU rate of 3 per cent was carbon copied into the FRBM Act, some convoluted arithmetic was devised retroactively to explain the logic of the magic figure of 3 per cent. The explanation went thus: the time-series household financial savings of India plus external savings was 13 per cent; out of that, 5 per cent would “go” to private sector corporates; of the balance 8 per cent, 2 per cent would “go” to public sector undertakings, “leaving” 6 per cent for Central and State governments to be shared between them (50:50), that is 3 per cent each, to fund their deficits. The expert view rested on two basic assumptions: one, the financial savings would ever remain at 13 per cent, neither rise nor fall; two, obeying the experts, 5 per cent of it would “go” to private corporates. What if the private sector refused to take part of it? That is, if the credit offtake goes down, as it has in the last few years in India? And what if the financial saving rises? Or falls? The experts appear to have no answers. The fake explanation for 3 per cent was intended to hide the copycat fiscal economics written into the FRBM limits.
Looking at FRBM norms Here, now, is a reality check on FRBM norms. Banks create and control most money stock in the economy. This constitutes the monetary economy which is entirely under the control of the Reserve Bank of India. The revenues and expenditure of the government constitute the fiscal economy. If the government spends more than its income, then deficit arises, which it has to finance by borrowing money created by banks. The FRBM Act says it cannot borrow more than 3 per cent of GDP — even if banks do have money, even if the private sector does not take it, and even if the economy needs it for growth. The money may lie idle in banks, and yet the law will not allow the government to borrow! This is perverse economics. The guild of economists the world over — which rarely agrees on most issues — unanimously agrees that as money is critical for economic growth, without adequate money, GDP growth will suffer. The economic debate on the money-growth link dates back to the >Great Depression of the 1930s . While the celebrated Nobel laureate, Milton Friedman, talked about inadequate money supply as the cause of the Great Depression, James Tobin pointed to inadequate demand for money (credit) as the cause. That is even if there is money, a lack of business confidence or high interest may reduce the demand for money. There is no doubt that both — lack of money supply as well as lack of demand for credit — weaken growth. From 2012-13 to now, i.e. 2015-16, the > Indian economy seems to have been experiencing both the Milton and Tobin effects — shrinking money expansion and credit demand shrinking even faster.
Growth, expansion decline Look at how the monetary and fiscal segments have operated in the last few years. 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.
The conclusion is clear. Aligning the monetary and fiscal economies means this. If bank credit growth falls, fiscal deficit may need to go up. If bank credit growth rises, fiscal deficit should reduce. This is particularly true for a growing economy like India. Had the fiscal deficit not been above the FRBM ideal limit of 3 per cent in the last four years, the growth would have suffered even more. It does not need a seer to say that the FRBM law as it stands harms the economy. The Finance Minister has rightly decided to get it reviewed.
(S. Gurumurthy is Visiting Faculty at IIT Bombay and Distinguished Research Professor, Legal Anthropology, SASTRA University.)