Fiscal hawks, flying blind?

Print edition : May 12, 2017

Former Revenue Secretary N.K. Singh presenting the report of the Fiscal Responsibility and Budget Management Review Committee to Finance Minister Arun Jaitley in New Delhi on January 23. Chief Economic Adviser Arvind Subramanian, who gave a dissent note, is at extreme left. Photo: PTI

THE report of the Fiscal Responsibility and Budget Management (FRBM) Review Committee has finally been made public, around three months after it was submitted. The voluminous report ( Responsible Growth: A fiscal policy framework for 21st century India, Ministry of Finance, Government of India, January 2017 ), which runs into four volumes, with the first volume coming to 186 pages, is not exactly light reading, but its recommendations will obviously have a huge impact on the government’s fiscal policy in the coming years, so it cannot be ignored.

What makes it more interesting is the somewhat public spat between one of the members, Chief Economic Adviser Arvind Subramanian, and the rest of the committee headed by N.K. Singh, as expressed in Subramaniam’s Note of Dissent and the rest of the committee’s rejoinder. Since this brought to light various logical discrepancies, it is clearly worth considering in more detail.

But, first, what exactly does the report say? The opening sentences make it clear that the approach will be one of an emphasis on fiscal discipline: “The maxim that ‘you cannot spend your way to prosperity’ is now widely accepted. Fiscal policies must therefore be embedded in caution than exuberance. In restraint than profligacy” (sic).

This strict approach is then justified by a bit of casual empiricism based on India’s experience: “India’s own recent experience illustrates this starkly. The years in which India adhered to the first FRBM framework were also the years characterised by strong growth, low inflation and no glaring external and internal imbalances. In contrast, the years in which it went off the FRBM framework—post the global financial crisis in 2008—and did not adhere to the envisaged path of fiscal consolidation, were also the years characterised by the most macroeconomic instability, pushing the economy to the brink during the ‘taper tantrum’ crisis of 2013.”

This rather slapdash analysis makes a mistake that students of economics are warned against in their first semester: that of confusing correlation with causation. It is well known that periods of strong income growth are more likely to show better fiscal indicators, for the obvious reason of larger public revenues. And implicitly ascribing the capital flight across emerging markets in mid 2013 during the “taper tantrum” to domestic fiscal irresponsibility is bizarre.

Nevertheless, this underlying approach is what drives the committee’s main recommendations. The report suggests shifting the anchor for determining fiscal responsibility from the fiscal deficit to the public debt to gross domestic product (GDP) ratio. This is not in itself particularly unusual: many countries with fiscal prudence legislation do indeed use a debt target rather than a fiscal deficit target. However, theoretical arguments for looking at this ratio have generally focussed on the need to avoid an explosive trajectory, in which the debt-GDP ratio grows rapidly and thereby creates problems of servicing and repayment over time. The fixing of a particular ratio as sacrosanct is much harder to justify.

The committee states the “prudent medium term ceiling” for general government debt to GDP to be 60 per cent, with a ceiling of 40 per cent for the Centre and 20 per cent for the States. No clear rationale is provided for this level or for the division of this debt across the Centre and the States. It is true that this was the level the European Union adopted in its Growth and Stability Pact, and this, much like the E.U.’s 3 per cent of GDP fiscal target, then generated copycat legislation and similar policy approaches in many other countries. But there is little historical or current evidence to suggest that the 60 per cent limit has any validity. Among the advanced economies, many countries such as Japan (235 per cent), the United States (108 per cent) and Singapore (111 per cent) have higher ratios without any concern about a debt problem. Even in the E.U., the average for the eurozone is 91 per cent, and several of the stronger and larger economies have even higher ratios, such as Belgium (107 per cent), Italy (133 per cent) and France (96 per cent).

The relevant issue is obviously whether the public debt is sustainable. This is typically defined as the ability to meet debt obligations without requiring debt relief or accumulating arrears. In cases where the debt is denominated in the national currency, this is clearly not an issue, and that is why high levels of public debt in Japan or Canada merit little comment. In cases where the debt is not denominated in national currency—for example, in the eurozone countries or in developing countries with dollar-denominated debt—the relevant indicator is obviously the foreign debt that must be repaid in foreign exchange rather than the total debt. Leaving aside such debt, any level of public debt relative to GDP can be both sustainable and perfectly compatible with a non-explosive trajectory.

It is interesting that among the research quoted, the FRBM report relies heavily on the work of Kenneth Rogoff and Carmen Reinhart, even though their famous result that public debt ratios above 90 per cent consistently reduce economic growth has now been completely discredited. A much celebrated paper by Thomas Herndon, Michael Ash and Robert Pollin (“Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff”, Cambridge Journal of Economics, December 2013) found that Ragoff and Carmen Reinhart’s empirical result was affected by selective exclusion of available data, coding errors (including embarrassing simple spreadsheet errors) and inappropriate weighting of summary statistics. This led to serious miscalculations that inaccurately represented the relationship between public debt and GDP growth, to the point that more careful use of the same data showed that the relationship between public debt and GDP growth varies significantly by period and country and cannot be expressed in these simple terms. Indeed, Subramanian also questioned this result of Carmen Reinhart and Rogoff in his Note of Dissent.

So there is no clear and universally applicable “desirable” level of the public debt to GDP ratio, and certainly nothing special or even particularly stabilising about the 60 per cent target. Indeed, most countries that adopted this as a rule no longer seem to bother with it very much, even when the statute remains in their books. Nevertheless, the FRBM Review Committee takes this ratio as its holy grail, based on little justification other than some use of this magic number in other countries and stray references to other emerging markets that currently have even lower ratios, such as Indonesia and Turkey (neither of which, incidentally, presents a positive example of economic stability). The division of this debt between the Centre and States similarly is not really justified at all and is probably based on the fact that this happens to be the approximate distribution of the public debt at present.

The fiscal deficit is then seen as the key operational target to achieve this debt ceiling. The committee proposes the following path for the fiscal deficit to GDP ratio: 3 per cent in 2017-18 to 2019-20, 2.8 per cent in 2020-21, 2.6 per cent in 2021-22, and 2.5 per cent in 2022-23. Deviations from this cannot exceed 0.5 per cent in any given year. The revenue deficit is supposed to decline steadily by 0.25 percentage points each year: 2.05 per cent in 2017-18, 1.8 per cent in 2018-19, and so on, until it reaches 0.8 per cent in 2022-23. No deficit financing is allowed: the FRBM Report says the Central government cannot borrow from the Reserve Bank of India except to meet a temporary excess of cash disbursement over cash receipts in any financial year.

Escape clauses

This is a strict path indeed and therefore necessarily requires escape clauses. But these too are rather stringent, covering only the following: a) overriding consideration of national security, acts of war; calamities of national proportion and collapse of agriculture severely affecting farm output and incomes; b) far-reaching structural reforms in the economy with unanticipated fiscal implications; and c) sharp decline in real output growth of at least 3 percentage points below the average for the previous four quarters.

It is strange, and even somewhat amusing, that the committee should set such strict targets well into the future. After all, the experience with the existing FRBM Act should have made it clear that such targets are mostly honoured only in the breach, and usually dealt with by governments through creative accounting, including the use of off-budget expenditures and simply delaying payments to many public entities. Indeed, the very use of these methods of getting around such targets points to the futility and meaninglessness of the targets themselves, since not adhering to them in actual practice has not had any of the predicted negative effects of high inflation, sharply reduced growth or economic instability.

Subramanian's stand

Nevertheless, the major argument within the committee appears not to have been about this flawed economic logic per se but about which specific target to use. In his Note of Dissent, Subramanian has argued that the simultaneous use of what are effectively three targets (the public debt to GDP ratio, the fiscal deficit to GDP ratio, and the revenue deficit to GDP ratio) would “force policymakers to aim at too many, potentially inconsistent objectives and policy frameworks, running the risk of overall fiscal policy being difficult to communicate for the government and comprehend for market participants, and the risk of the government not achieving any of its goals” (page 163).

He correctly finds each of these individual medium-term targets to be arbitrary and questionable, simply asserted without adequate justification. For him the oddest of all is the prescribed trajectory of the fiscal deficit path, which calls for a deep cut to 3 per cent of the GDP in the first year (2017-18), then a pause for three years, then more moderate reductions. “No real rationale is provided for such a serpentine path, and it is difficult to find one.” In addition, he notes that all fiscal rules require some flexibility and points out that the escape clauses are too stringent and too symmetric, leaving the government no flexibility to counter ordinary recessions and allowing “too much room to expand during growth booms”.

After this stinging indictment, Subramanian offers his alternative: a focus on the primary balance (non-debt receipts minus non-interest expenditures) so as to put the public debt to GDP ratio on a steadily declining trajectory. So he proposes a “steady glide path” to bring the primary deficit to GDP ratio down to zero within five years or even less, which he argues would have the added benefits of sharper reductions in both fiscal deficit-GDP and debt-GDP ratios over time.

The rest of the committee seem to be rather miffed at this. In their rejoinder, they argue that zero primary deficits or even primary surpluses are neither necessary nor sufficient for public debt to GDP ratios to decline over time, if, for example, the interest rate is higher than the GDP growth rate and the stock of debt is large. They note that there is nothing to indicate the correct level at which this primary deficit should eventually be anchored. They finally argue that there is no basis for determining the distribution of this primary deficit between the Centre and States.

This exchange is fascinating because in this debate the criticisms of both sides against the other are quite valid! In fact, the committee’s arguments against Subramanian hold equally against their own preferred targets, the fiscal deficit and the revenue deficit. And of course, neither side of the debate is able to convincingly answer the question of why the public debt must be at a particular level in relation to GDP or must continuously decline as a share of GDP over time, regardless of all other economic circumstances. There is neither theoretical nor empirical justification for either position.

This is particularly so in the current global economic context in which many advanced countries are grappling with “secular stagnation” where monetary policy has little or no expansionary effect, and many emerging markets face extremely volatile external circumstances that call for continuously responsive fiscal strategies. So it could be perceived that this entire exercise has been at best an enormous waste of effort because it has contributed little to an understanding of the appropriate fiscal policy in the current context. At worst, the introduction of rigid rules for uncertain and ill-defined gains will unnecessarily constrain fiscal policies at a time when external circumstances and internal developmental goals both call for more flexibility.