The high risks in high deficits

The argument to abandon the restraint the FRBM Act places on government is unwise because inflation is just one danger of large fiscal deficit

Consumer prices in June 2006 were 6.5 percent higher than in June 2005. Last year in June price rise over the previous year was less than 4 percent. Under fire in Parliament, with the BJP and Left parties walking out of the Rajya Sabha on Tuesday over the issue, the government has tried to combat the sharp increase in inflation by a combination of supply side measures and higher interest rates. Undoubtedly, the impact of these steps is more direct and visible, while that of fiscal policy is not. But when the government is trying to restrict private expenditure by raising interest rates, is there not a case for it to restrict public expenditure too?

Ironically, in these taxing times with acute pressure on prices to rise, arguments are being made to abandon even the legitimate restraint that Parliament places on government through the Fiscal Responsibility and Budgetary Management FRBM Act.

Considering that inflation is only one of the dangers of large fiscal deficits 8212; others include external indebtedness, inflation, large interest payments and debt default 8212; this is a very unwise argument.

One option is that the government finances additional expenditures by simply printing money. India has tried it in the past, suffered high inflation and then wisely put an end to this option. What it can do, instead, is to borrow money from the public and from commercial banks.

But if the government8217;s deficit exceeds the amount the domestic private sector lends to it, the country as a whole now spends more than it produces. It imports more than it exports. The additional spending has to be financed by capital inflows like FDI, FII or foreign debt. For any given domestic savings rate in an economy, if the government borrows from the public, then either domestic investors get to borrow less and investment goes down, or the sum of borrowing by the government plus private investors must be met by capital inflows from abroad, or foreign savings. Foreign capital inflows like FDI and FII happen when the economy is doing well. Foreign equity inflows are deterred when India runs large deficits. So large deficits go with large offshore borrowing.

The Indian government ran large deficits in the 1980s and ended up hugely indebted to foreign lenders by 1991. Now again, if we raise deficits and if foreign investment is inadequate to meet our deficits, foreign debt could build up.

Moreover, the government often gets preferential treatment as a borrower both from public sector banks and from those with a lower risk appetite. Private borrowers have to compete for a smaller share of savings as the government pre-empts savings. It thus 8220;crowds out8221; the private sector by hiking interest rates and reducing private investment.

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Further, high fiscal deficits mean high public interest liabilities. The more the government borrows today, the greater are its committed interest liabilities in the future. This reduces the flexibility it has with spending. Last year interest payments took away two-thirds of taxes collected. If the state of public services is poor today, then the blame partly lies on the fiscal profligacy of the previous governments. If the state of infrastructure is poor, the problem is not unrelated to the size of past deficits. If we run higher deficits today we are tying down the hands of future governments who will use all their tax collections to pay for our expenditure today.

As the government continues to run deficits and borrows more, it will eventually borrow only to repay its debt. It starts running a 8220;Ponzi scheme8221;, borrowing from B to pay A and from C to pay B and so on. As the size of the debt increases this could lead to a situation in which the government thinks it is better to default on its debt. The current level of the public debt is very high by world standards. As it rises further, there would be fears about the government defaulting on its debt obligations. Not only will millions of households lose their savings in post-offices, National Saving Scheme, PPF, GPF and RBI bonds, the banking system 8212; which holds about 85 percent of government debt 8212; will lose heavily.

It is very easy today for the government to spend crores of rupees on welfare schemes financed by deficits. The voter is unable to comprehend that he is paying for them through higher prices. Yet it should be remembered that the inflation tolerance of the Indian consumer is low, and at the end of the day high deficits may prove to be very costly.