Magic 3%

Three per cent Fiscal Deficit! This is a dream announcement any finance minister of India would love to make. 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. 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.

Also Reead: FRBM Law is Irrational. Amend it

Finance Minister Arun Jaitley must be a worried man. He has promised to reach this magic 3 per cent by 2018. He has pegged the fiscal deficit in the last budget at 3.9 per cent. He has to cut it by at least 40 to 50 basis points in this budget, to get to the target of 3 per cent in 2018. But he sees the reality, which the Reserve Bank does not see or refuses to see. Jaitley sees that the economy is short of money and the corporates are not able to absorb credit and push money down into the economy. He must be pained that it happens when India is seen as an Island of growth by the IMF. He has to infuse cash into the system to strengthen the growth impulses. He needs to recapitalise the banks to get them out of the RBI “watch”. He has to sidestep the march towards fiscal consolidation this year — the other name for cutting fiscal deficit to touch the magic figure of 3 per cent. Moving towards fiscal consolidation now when the economy is starved of money will weaken the national growth drives. Jaitley is clearly in a catch-22 situation. If he goes for fiscal consolidation, growth will be hurt. If he does not, his reputation will be. The number ‘3’ must be tormenting Jaitley.

Story in EU

But how did the figure 3 per cent become an ideal fiscal deficit target? Where did the number 3 emerge in the world of fiscal economics. How did it become the bible verse of budget making in India? The story of how the magic number took birth in fiscal world is interesting. 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. This power inherent in a nation state saved the US economy in 2008 when the financial system of the US had all but collapsed.

The EU is not a nation state in which this power is inherent. It is a monetary union in which this power rests on a package of critical commitments by the EU members. Critical 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 band. This is how the figure of ‘3’ made its debut in the fiscal economic discourse.

But how did the Eurozone members 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.

Story in India

However, the FRBM fiscal deficit number, identical to the EU number, has become the celebrated principle of judging the budgets and finance ministers in India. The Indian economic establishment, faced with the criticism that it had adopted the EU rate of 3 per cent, devised a convoluted arithmetical formula to get the same number as in Maastricht treaty. 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 per cent, 5 per cent would “go” to private sector corporates and 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 appropriated 50:50 between them to fund their deficits. That was how the 3 per cent limit for the central government in FRBM was rationalised. Now interrogate them.

The assumption seems to be that the 5 per cent financial savings would “go” to private corporates on the orders of the economic establishment. What if the private sector refuses to take part of it, like they did in the last few years as evident from the decreasing credit to GDP ratio? Should the government then not step in to fill the gap in investment? 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? The experts’ explanation has no answers to these questions. Undeniably the 3 per cent limit in FRBM law has no rational nexus with either the causes or the consequences of deficit financing. The philosophy of deficit funding tries to balance between how much deficit financing is needed for the economy to grow and how much of it will not risk inflation. The Anglo-Saxon nations have taught the world about the need for fiscal deficit, without risking inflation, to trigger and sustain growth. In 1963, when Milton Friedman was invited to India, he advised the government to go for a feasible level of deficit financing for growth without inflation. But his view based on his quantity theory of money, which later won Nobel prize in 1976, was rejected by Indian policy makers who derisively called his quantity theory of money as quantity theology of money. Friedman proved right, finally. The Fourth Plan (1969-74) became the victim of serious forex crisis and inflation. Therefore, avoiding fiscal deficit itself could harm.

3% plagiarized

That the FRBM rate of fiscal deficit and the EU rate are identical is therefore no coincidence. The convoluted explanations to justify the FRBM rate which has no rational nexus with the theory of fiscal deficit actually lets the cat out of the bag. The perception that the Maastricht rate was smuggled into the FRBM law and post facto explanations were invented later to plagiarise it as Indian arithmetic, is unavoidable. Given the pressure on not just India, but on the entire developing world till 2008 to follow the West, that India adopted the EU rate should be no surprise. But it is time it is revisited. A point to flag here. The idea of fiscal prudence is not new to India. Many may be surprised to know that, in India, revenue deficit occurred for the first time in 1979-80.
The issue is not about whether deficit financing is good or bad, but how much of it is good and how much is not. Good economics is not about either this or that, but about how much of both. The need for and quantum of fiscal deficit are a country specific issue and even a context specific one. It needs no seer to say that the adoption of the EU number is not only not rational but harms India. Most EU nations breach the magic number because of its unsuitability for their needs. Mandatorily applying such clerically devised ceiling on fiscal deficit is proving harmful to Indian economy. Await the next part to know the harm the irrational 3 per cent rule causes to India.

(to be continued)

(The author is a well-known commentator on economic and political affairs.)