I

down fiscal deficits, and finance public expenditure through progressive taxation, preferably on wealth.

This proposition, because of which the Left has traditionally been opposed to “deficit financing”, and which is independent of whether such financing is inflationary or not (the opposition would be even greater when such financing is inflationary in terms of the wage-unit), has nothing to do with the principle of “sound finance”, which insisted in the days of yore that governments should balance their budgets, and which, in its new (FRBM) incarnation, insists that the fiscal deficit should remain confined, come hell or high weather, to a certain small pre-specified ratio of the GDP.

The difference between the two positions, the equalitarian and the “sound finance” ones, can be summed up as follows: equalitarian critics of fiscal deficits would nonetheless prefer, in a demand-constrained system, a deficit-financed increase in public expenditure to no increase in public expenditure (though they would consider a tax-financed increase even better, especially a tax on wealth); the votaries of “sound finance” will always vote against deficits.

This difference can be highlighted through an example: if t denotes the tax-GDP ratio (assumed constant) and d the fiscal deficit-GDP ratio that “sound finance” considers permissible, then the output of the economy is given by:

If for some reason any of the autonomous expenditure components, I or X, or autonomous consumption declines, then a fiscal policy based on “sound finance” exacerbates this decline (as it happened in India during the Great Depression of the interwar period). The equalitarian opponents of fiscal deficits would, however, in this case, advocate the maintenance or indeed an increase in government expenditure, financed ideally by a tax on wealth or on savings (or even on the incomes of the rich) but if that is not possible, then by an increase in the fiscal deficit.

There is a theoretical reason for this difference between the two positions, namely, that the votaries of “sound finance” never theoretically cognise the possibility of a demand-constrained system. This is not just a matter of empirical judgment; it is a matter of theory, which is why even when the empirical reality cries out for larger government spending through a fiscal deficit if need be, they invariably resist it, with adverse consequences for the people. We shall give some examples in the next section.

The theoretical inability of the votaries of “sound finance” to cognise a demandconstrained system in turn is rooted in a deeper theoretical problem, namely, their assumption that wealth can be held only in the form of capital goods or direct claims upon such goods. This at great variance with the realities of a modern economy, where money constitutes an obvious form of wealth-holding as an alternative to capital goods. As a result, the proponents of “sound finance”, buffeted between a reality they cannot ignore and their basic assumptions that are at variance with it, usually end up being theoretically inconsistent. For instance, in India even though we have passed the FRBM Act, no proper theoretical justification has even been provided for it, other than homilies about the state not “living beyond its means”. Such homilies typically draw an analogy between the state and a household, which is illegitimate.

The only place, where a theoretical justification for curbing the fiscal deficit from a “sound finance” perspective was provided, was in a report of the economic advisory council to the prime minister under the NDA regime. This stated that a fiscal deficit, if monetised, caused inflation, and, if non-monetised, caused a rise in interest rates and hence the crowding out of private investment – an argument that is so untenable [Patnaik 2001] that it was surprising to see some of India’s most distinguished economists appending their signatures to the document. Apart from all other objections, one point illustrates this untenability. In the standard IS-LM framework, if the impact of a non-monetised fiscal deficit is to be solely on the interest rate, then the original equilibrium must have been on the vertical part of the LM curve,

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i e, the equilibrium income in terms of the wage-unit must have been what it is because that is what the existing stock of money supply (in terms of the wage-unit) can sustain at the maximum value of the income velocity of circulation. On the other hand, if inflation in terms of the wage-unit is to occur because of the monetisation of the fiscal deficit, then that is possible only because the economy is at full employment, i e, is supply-constrained. The argument of the council in other words, presumes that the money-supply-constrained level of output is also the full employment level of output, which can only happen by coincidence.

Such theoretically flawed propositions, however, can extract heavy toll by way of people’s welfare. Two illustrations will suffice here. The first concerns foodgrain stocks, which were steadily rising in the period up to 2002, and had reached a peak of 63 million tonnes by mid-2002, implying 41 million tonnes of surplus stocks.1 Now, if the government had started an employment generation programme, and if such a programme had been financed by a fiscal deficit, it would have been immensely and unambiguously beneficial for the country and the people. First, by putting purchasing power into people’s hands, it would have improved their living and nutritional standards. (This would have been particularly beneficial since there is plenty of evidence to show that the stock pile-up was a result of consumption compression of the rural population owing to the government-expenditure deflation of the preceding years [Patnaik 2004].) It would have also caused no inflation whatsoever, as foodstocks had piled up to an unprecedented extent, unutilised industrial capacity existed in ample measure in the relevant spheres, and the foreign exchange position was more than comfortable. (The comfortable foreign exchange position, together with the fact that the foreign exchange demand of such a programme would have been small, would also have precluded the possibility of any separate balance of payments problem.) Second, the foodstock pile-up was itself proving to be burdensome, and its use for employment generation was a far more worthwhile manner of depleting it than any other. Third, to the extent that the employment programme would have created some capital assets, it would have added to rural infrastructure and productive capacity. Fourth, since the foodstocks were with the FCI, which is a governmentowned organisation, such a programme, even if financed by a fiscal deficit, would have caused very little increase in the net indebtedness of the government (it would have done so only with respect to that part of the requirements of the programme which would have been supplied by the private sector). In other words, this apparently fiscal deficit-financed programme would not really have entailed any increase in the deficit of the government sector taken in its totality. What the government would have borrowed with its right hand (through its budgetary transactions) would have largely come back to its left hand (the FCI). Yet the government did not do this. Instead, it chose to get rid of the stocks by dumping them on the world market at prices that were reportedly below what were charged to the domestic BPL population. In addition, a majority of these stocks were purchased as animal feed by richer countries (for Japanese pigs and European cattle to be precise). The theoretical basis of the absurdity of a government denying larger foodgrain consumption to its own half-starved population but subsidising these grains for the consumption of pigs and cattle of rich countries, lies in the principle of “sound finance”, of which the FRBM Act is the quintessential contemporary expression.

The second illustration relates to a current issue, discussed in a paper by Isaac and Ramakumar in a forthcoming issue of this journal. The state governments who are curtailing their expenditures owing to a lack of funds are holding, paradoxically, enormous amounts of surplus funds, partly as cash and partly as central government treasury bills that yield 5 per cent interest, even though the states themselves have acquired these funds inter alia by paying

9.5 per cent on small savings, and over 7 per cent on market borrowings. This bizarre situation of the states being strapped for funds while holding massive surplus funds, and of having to borrow dear to lend cheap, is a contribution of the fiscal responsibility legislation, even though the finance minister has been at pains to deflect attention from this fact by putting the blame on “poor governance” by state governments. (If the finance minister really thought this to be the case, then he should make an effort to explain why so many states in the country have in such short time been afflicted by this disease of “poor governance”.) The fact is that the states have been forced to adopt their own fiscal responsibility legislation by the Twelfth Finance Commission which made it a “conditionality” for debt-relief (even though the basic cause of the debt problem of the states was, to start with, the exorbitant interest rates charged by the centre on the loans it made to the states during the 1990s, rates that were often in excess of the rate of growth of the nominal NSDP of the states, a sure recipe for crisis). The absurd denouement of such legislation can be seen as follows.

Suppose the revenue receipts of a state amount to Rs 100. If the state is allowed 3 per cent fiscal deficit, then its total expenditure, both revenue and capital, can only be Rs 103. If the state has gross capital receipts of say Rs 6, it still cannot raise its expenditure to Rs 106, for that would still violate the Fiscal Responsibility Act. Since, it cannot raise expenditure, it perforce holds Rs 3 as cash or in central government paper as a transitional arrangement until capital receipts have been reduced. The question may be asked: why does the state not reduce its capital receipts immediately or why does it at all raise capital receipts worth Rs 6 when it knows that it can spend only Rs 103? This is because the state has an obligation to borrow the small savings raised within its domain which, because of the attractive interest rate offered garner substantial amounts. Another element of inflexibility is introduced by foreign-financed projects where the state government is committed to undertaking certain expenditures in a timebound manner. The upshot is that while the states’ indebtedness to small savers and foreign financiers goes up, their spending is restricted and unspent cash balances pile up, which they are not allowed to use even for redeeming their earlier debt!

The absurdity, however, does not end there. The states are to maintain not only a particular fiscal deficit target, but in addition, they are also supposed to maintain a revenue deficit target. Even if they hold no surplus cash, and tailor their capital receipts to only Rs 3, which is the “permissible” fiscal deficit, they would still not be able to spend more than Rs 100 (assuming a zero-revenue deficit target) on a whole range of social sectors where expenditure is classified as revenue expenditure, a point made recently by the Planning Commission itself in its draft approach paper to the Eleventh Plan! The public health sector in most states, and also the centre has run down to an alarming

Economic and Political Weekly November 4, 2006 extent, as has public education. Yet the states can do nothing about it.

It may be asked, why are union government insists on such bizarre legislation, when there are no compelling theoretical or practical reasons for it? Further, why indeed has such legislation been passed in a large number of countries, while just a few years ago (even during the Reagan era) the advocacy of such legislation was confined to a marginal fringe of economists such as Buchanan? The answer to these questions have to be sought in the realm of political economy in the emergence of the phenomenon of globalised finance.

Finance capital has always been opposed to expenditure activism on the part of the state, and hence disapproves of state intervention by fiscal means for boosting employment and the level of activity in the economy. From the City of London’s opposition to Lloyd George’s proposal in 1929 to increase public spending via an employment generation programme financed through borrowing, to the opposition by assorted financial interests to the Keynes and Blanqui plans for overcoming the Great Depression through a policy of concerted expansion by a number of capitalist states, and to the more recent opposition by European financial interests to president Mitterand’s “Keynesian” reflation, we have a consistent story of how finance capital reacts to state activism of this sort. We also use how it consistently advocates money wage cuts (a la Herbert Hoover), as distinct from state expenditure increases, as the panacea for any unemployment that it may recognise as existing. Keynes’ opposition to rentier interests, and to finance capital that quintessentially represents such interests, expressed in his call for “the euthanasia of the rentier”, arose from this.

This hostility of finance capital to state expenditure activism, and its preference for an expenditure-deflation by the state, as a means of countering the Keynesian legacy, acquires a spontaneous effectiveness when the state is a nation state and the finance capital confronting it is globalised finance capital. In a world where finance capital is essentially nation-based and dependent on the support of the nation state, the balance of domestic class forces can in certain conjunctures bring about a dissonance between state policy and the predilections of finance (as happened in the aftermath of the second world war).

However, if finance is globalised, then the predilections of globalised finance command priority, for otherwise it can flow out of the country, causing havoc, which is why Keynes had been particular that “finance above all must be national”. Unless the economy restricts the movement of finance into and out of it through capital controls, the possibility of a dissonance between state policy and the predilections of finance disappears.

In India, even though we still do not have capital account convertibility, and still retain restrictions on the ability of domestic agents to take finance out of the country, the free movement of finance into and out of the country by foreign agents imposes sufficient pressure on the government to respect the predilections of finance capital for curbing expenditure activism by the state. The FRBM Act is an instrument of it. We have such an act, not because it is wise or based on sound theory, but because we want to retain “investors’ confidence”, which is a euphemism for bowing to the caprices of a bunch of international speculators. We have to put up with the absurdities of “sound finance”, the absurdities of an FRBM Act based on “sound finance”, not because “sound finance” is sound, but because international speculators demand it. Further, the irrationality of neoliberalism consists in the fact that instead of insulating the economy from the baneful consequences of the caprices of international speculators, by strengthening capital controls and then pursuing a fiscal policy in the interests of the people, it does the very opposite, namely, sacrifice the interests of the people in respecting the caprices of speculators. This irrationalism is now being sought to be carried further through the proposal to introduce capital account convertibility.

The basic question, however, still remains: why should finance be at all interested in curbing the expenditure activism of the state? One can cite at least three reasons: the first and the most obvious one is the fear of inflation, which always hurts rentier interests. In a world of globalised finance this is buttressed by a fear of exchange rate depreciation as a fallout of inflation, a fear that often tends to be self-fulfilling (which makes the initial fear of depreciation even more pronounced and independent of any inflationary prospects).

The second reason consists in the fact that FRBM type acts and others like it curb expenditure activism, forcing the state, if it wishes to undertake a certain amount of expenditure, to take recourse to

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“disinvestments” of public sector equity. (Such disinvestments, convenient but entirely illegitimate from a theoretical point of view, are considered a permissible way of reducing the fiscal deficit.) Since such “disinvestments” invariably occur at throwaway prices and since finance capital is invariably a beneficiary of such “disinvestments”, it has a vested interest in promoting legislation akin to FRBM legislation. Again, the view that financing public expenditure by selling government debt is somehow theoretically unsound (which is what the FRBM Act states) whereas doing so by selling government equity (which is what “disinvestment” does) is sound, is completely untenable. Despite this, enough economists and more than enough economic journalists can always be found on the side of finance claiming the contrary!

The third argument is a more basic one [Kalecki 1971]. The very fact that the public sector exists a public sector, that the state has to intervene to overcome the deficiencies of capitalism undermines the social legitimacy of capitalism. It naturally raises the question: if the public sector can do what the capitalists claim that they alone have the proficiency to do and if a system run by the capitalists is subject to such serious flaws that it needs systematic rectification by the state, then do we need such a system? However, if state intervention undermines the social legitimacy of capitalism, then one can imagine how much more serious must be the damage it does to the social legitimacy of finance capital, whose role, to use Keynes’ words, is that of “functionless investors”. If capital, in general, views state activism of this sort with hostility, then the hostility of finance must be several times greater.

The fact that the need to appease international finance constitutes a major motive underlying the FRBM Act is evident from the target it specifies. There is no theoretical reason cited for having a fiscal deficittarget of 3 per cent. The only sanctity behind this figure is that it appears in the Maastricht Treaty of the European Union (EU). This slavish copying, however, is not without its own peculiar rationale, once we enter the reified world of globalised finance: if a development country like India is serious about retaining “investors’ confidence”, then it cannot possibly afford the luxury of having a fiscal deficit target which is higher than what “true-blue” capitalist countries of the EU have. Hence, once 3 per cent has been ordained for the EU, then, no matter whether it makes sense for India or not, India must also have a target of 3 per cent.

In this process however, inconsistencies arise within our policy domain. For instance, a debt-income ratio in excess of 30 per cent is what now qualifies a state to be considered “debt-stressed” by the ministry of finance. States, in short, can have a debtincome ratio up to 30 per cent. Now, this ratio can be sustained over time if ΔD/ΔY = D/Y. Since the average rate of growth of nominal income in the states, ΔY/Y, is, by the government’s own admission, not less than 13 per cent, a 30 per cent debtincome ratio can be sustainable even with a 3.9 per cent fiscal deficit. There is, in short, an apparent connection between the debt-income ratio target of 30 per cent and the fiscal deficit target of 3 per cent.

This argument points to a deeper problem. From the point of view of the sustainability of the debt burden, the target fiscal deficit ratio cannot be independent of the rate of inflation in the economy (not to mention the rate of growth); it will be higher for a higher rate inflation (as indeed for a higher rate of growth), but certainly not a constant as the FRBM Act specifies. Of course it may be argued that in a period of high inflation the fiscal deficit target should be cut anyway, so that a fixed target invariant to inflation has the possible virtue of being inflation-stabilising. However, this argument does not take into account the fact that the main type of inflation that afflicts a liberalised economy is cost-push rather than excess-demand-caused (precisely because of the expenditure deflation imposed upon the state). In the presence of cost-push inflation, such as is being caused at present by the hike in petro-prices, curtailing the fiscal deficit is no panacea: it only adds the further burden of unemployment to the burden of inflation. The idea of having a pre-determined fiscal deficit target, quite apart from being theoretically unsound, and practically damaging, is not even logically consistent in a world with changing rates of growth and inflation.

IV

Many are afflicted by the fear that unless a pre-specified fiscal deficit target is institutionalised, there will be a veritable explosion of public debt; that is, if the government systematically pursues a policy of overcoming demand constraint in the economy, then this will necessarily give rise to an unsustainable level of public debt. This, however, is not the case. Even in the absence of a pre-specified target, if the government pursues, through the use of fiscal deficits, what most would consider a desirable macroeconomic policy, the debt-output and fiscal deficit-output ratios will nonetheless stabilise at certain constant values. The question of what the fiscal deficit should be if not a fixed ratio of GDP, which comes up in any critique of “sound finance”, has a very clear answer for both, a single period and over time.

Of course, this question can become meaningful only if we assume that there are certain limits upon the tax-GDP ratio. Otherwise, since government expenditure financed by a tax on wealth is ceteris paribus preferable to a fiscal deficit, on account of its keeping down wealth inequalities, the fiscal deficit should be replaced by such a tax. To talk about an “optimum” level of the fiscal deficit presupposes therefore, that there is no escape from a fiscal deficit, i e, that there are certain constraints upon the garnering of tax revenue. In what follows, we shall assume that the only tax in the economy is levied on profits at a constant rate (an assumption that can be substituted by a range of others without damaging the results).

Likewise, if the economy is exposed to the vortex of globalised finance, then the question of the “optimum” level of the fiscal deficit ceases to be meaningful, since no fiscal deficit other than what caters to the caprices of globalised finance can be feasible. We assume therefore that the economy is armed with sufficient capital controls to have the requisite freedom for choosing its level of the fiscal deficit. Indeed, to highlight the proposition that even without believing in “sound finance” we can still subscribe to the idea of an “optimum” level of the fiscal deficit, we deliberately assume a closed economy.

There are a host of specific factors that would determine the desirable level of the fiscal deficit ratio in any period, owing to which, this ratio will change from one period to the next. Underlying these specific factors, however, there will be certain basic considerations. To concentrate on these, let us deliberately assume away all shortterm considerations necessitating periodto-period fluctuations in the deficit-GDP ratio. We answer the question of the “optimum” level of the fiscal deficit, in short, through a model of a closed economy where there are constraints upon the tax-GDP ratio.

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Let us assume for simplicity that all wages and a proportion c of capitalists’ post-tax income are consumed, the latter consisting of post-tax profits and interest earnings on public debt. For any period t, denoting private investment by Ip (t), and ignoring capital decay (so that the grossnet distinction ceases to matter), we have the following equations:

Y(t) = C(t) + I p (t) + G(t) ...(1)

G(t) = I g(t) + E (t) ...(2)

where E refers to government consumption.

Ip(t)/K(t) = ip(t) = f (u (t)), f ’ > 0 ...(3)

where u (t) = Y (t)/β K (t) ...(4),

β being the (technological) output-capital ratio.

C(t) = W (t) + c. [(Y (t) – W (t))(1 – τ)

+ r.D(t)] ...(5)

where τ is the rate of profit tax and D (t) refers to the magnitude of public debt at the beginning of period t.

W(t)/Y(t) = h(u(t)), h ‘ < 0 ...(6)

which means the share of pre-tax profits is an increasing function of the level of capacity utilisation. We assume that the economy has an “inflationary barrier”,2 so that

W(t)/Y(t) ≥ ω ...(7)

and that the government’s objective in any period is to maximise the level of activity. Clearly then, equation (7) holds as an equality and equations, (1) and (3)-(7) determine, for any given r, D, and K, the levels of Y, C, Ip , G, u and W. The level of fiscal deficit, given by [G(t) + r.D(t) – τ.Y(t) (1 – ω)], is nothing else but the optimum level of fiscal deficit for the period t.

So far nothing has been said about the composition of G; and the optimum level of the fiscal deficit in any period is independent of it. Let us now postulate that

E(t) = e. Y(t) ...(8)

and discuss the trajectory of output and public debt over time.

From equation (6), let us denote by u* the level of capacity utilisation h-1(ω). The government fixes the economy at u* in every period, so that the rate of growth of capital stock and the rate of growth of output are the same. Denoting the rate of growth of capital stock by g, we have g(t) = Ip (t)/K (t) + Ig (t)/K(t)

= [1-ω-c.(1-ω)(1-τ) – c.r.d(t) – e].β.u*

...(A) where d refers to the ratio of the stock of public debt at the beginning of the period to the output of the period. Equation (A) is simply the growth identity with the term in square brackets being the savings ratio of the economy, and β.u* the output-capital ratio.

The growth of debt over time is given by

g(t)/(1+g(t)).β.u* – [f(u*)/β.u* – e

+ τ(1-ω)]/(1+g(t)) + d(t).(1+r)/(1+g(t)) = d(t+1) ...(B)

f(u*) > r …(C)

i e, the minimum rate of growth when the government maintains u* still exceeds the interest rate r, the debt-output ratio given by equation (B) will converge to some stationary level d*, corresponding to which the economy would experience steadystate growth g* given by equation (A). In other words,

g* = [1-ω-c(1-ω)(1-τ)-c.r.d*-e].βu* …(D)

and the optimal ratio of the fiscal deficit to output along this path is given by d*.g*.

It follows then that if we started from the other end, i e, instead of choosing some arbitrary ratio of the fiscal deficit which we insist on maintaining, come what may, we actually have a policy regime which achieves the maximum level of activity subject to an inflationary barrier, which in other words prevents the economy from settling down to a demand-constrained state, we can still maintain a steady fiscal deficit ratio over time. The idea that overcoming the demand constraint through government expenditure financed by a fiscal deficit necessarily leads to an unsustainable burden of public debt, is plain wrong. True, international finance would not like such a policy. However, this is an argument for insulating the economy from its caprices, through capital controls, whose necessity even the IMF these days grudgingly accepts. To adopt expenditure deflation which hurts the people, just to keep international capital happy, is scarcely forgivable.

Finally, suppose for a moment we accept the argument in favour of the FRBM Act, and of “sound finance” generally, that a monetised fiscal deficit necessarily leads to inflation and must be avoided. Then surely the same argument must hold for financial inflows from abroad which are held as reserves and which also boost money supply. How is it that the proponents of the FRBM Act have never expressed similar concern over the boost to money supply arising from the latter source, and demanded, as with the government sector, a similar curb on the inflow of finance from abroad? If their concern is to avoid inflation, then they should be asking for similar curbs on foreign financial inflows which add to the RBI’s assets (and hence liabilities) exactly the same way that government securities do. Further, if massive accretions to the RBI’s foreign exchange reserves have not had any perceptible influence by way of accelerating inflation, then why do they get so exercised over accretions to the RBI’s stock of government securities which have dwindled dramatically of late? The inconsistency implicit in the positions of the advocates of “sound finance” only underscores the nexus between the doctrine of “sound finance” and the interests of international finance capital.

EPW

Email: prabhatptnk@yahoo.co.in

Notes

References