Follow us on


The poverty of theory

Print edition : Mar 17, 2001 T+T-

Beneath the specific provisions and prognostications of Budget 2001 lies a flawed strategic perspective derived from an erroneous theory.

ANY budgetary exercise is informed by a set of theoretical suppositions which define its strategy; its worth is crucially dependent on the validity of this underlying theory. What is noteworthy about Budget 2001 is that its theory is fundamentally wrong. Beneath its specific provisions and prognostications lies a flawed strategic perspective derived from an erroneous theory.

The essence of this underlying theory is that the economy's sluggishness arises from a high real rate of interest (defined as the excess of the nominal rate of interest over the rate of inflation). A high real interest rate inhibits private investment. I t also affects public investment adversely by contributing to negative public savings through an increase in the interest burden on the government. This high real interest rate in turn arises, it is assumed, because of a large fiscal deficit: as the gove rnment borrows heavily from the market it pushes up the real interest rate. The key to the revival of the economy, on this argument, lies in a reduction of the fiscal deficit, which is what the Finance Minister has set out to do.

The mistake in this theory and the ensuing line of argument is that the high real rate of interest is caused not by the fiscal deficit but entirely and solely by the fact of liberalisation. Once a country allows freer movement of finance into or out of i ts shores, it has willy-nilly got to offer a rate of return to finance what is considered to be at least as good as what prevails elsewhere, for otherwise there would be an outward flight of finance. But if this rate of return is at the same level as in the advanced capitalist countries, then finance, both domestic and foreign, would rather flow to the advanced countries, which, being the home base of capitalism, constitute ceteris paribus, the more attractive destination. Hence a rate of return as attractive as what prevails in this home base must mean, in a Third World country, a rate much higher than what prevails there. Since the real rate of interest is represen tative of the rate of return, it follows that liberalisation in a Third World economy necessarily entails a higher real rate of interest than in the advanced capitalist countries, and a rise in the real rate of interest compared to what prevailed in this same economy in the pre-liberalisation period.

This is exactly what has happened in India. The real rates of interest prevailing in the advanced capitalist economies today are in the neighbourhood of zero (in fact the nominal interest rates as well as the rates of inflation are both exceedingly small ). In contrast, the real rate of interest in India until very recently was about 9 per cent (the increase in the inflation rate would have brought it down a little). This is also much higher than what prevailed in India during the pre-liberalisation peri od, when again the real rate of interest was not much above zero.

Large fiscal deficits are not a new phenomenon in India: they pre-date liberalisation. But the rise in the real rate of interest is a distinct post-liberalisation occurrence, which only confirms that the causation put forward in the theory underlying the Budget is wrong. Indeed all over the Third World, wherever freer financial movements have been introduced, the real rate of interest has increased irrespective of the size of the fiscal deficit. In Thailand, for example, just prior to the financial cris is of 1997 the real rate of interest was about 10 per cent even though the country had a fiscal surplus as large as 3 per cent of GDP.

While fiscal deficits do not cause high real interest rates, the latter ceteris paribus do aggravate fiscal deficits by raising the interest burden on public debt. Or, putting it differently, the high fiscal deficits we observe in liberalised Third World economies are not the cause but the consequence of high real int erest rates. The real cause underlying both these phenomena is the fact of liberalisation which opens these economies to the freer movement of international finance.

Liberalisation aggravates the fiscal crisis of the government in other ways too, notably through a decline in the tax-GDP ratio. Customs duties have to be lowered as part of "trade liberalisation"; since excise duties cannot be raised too much in an econ omy where customs duties are being lowered (for otherwise domestic producers would be discriminated against and there would be rapid de-industrialisation), the government's ability to raise revenues from indirect taxation gets eroded. Likewise the compul sion to attract foreign direct investment (FDI) restricts the scope for raising corporate tax revenue, and hence of direct tax revenue generally. A decline in the tax-GDP ratio as has happened in India during the 1990s is an inevitable sequel.

If all this is ignored and the fiscal deficit is seen as the "villain of the piece", then naturally the effort would be to curtail it by any means, even by cutting back on social expenditures and public investment. But since the high real interest rate w as not caused by the fiscal deficit in the first place, its curtailment would not bring down the real interest rate. Hence no encouragement to private investment would be provided via this channel. On the contrary, since the curtailment of government exp enditure would affect aggregate demand adversely, private investment would actually be discouraged further. It follows that the budgetary strategy, which is claimed to be a growth-inducing one, actually turns out to be the very opposite, namely a contrac tionary one, because of its false theoretical underpinnings.

That is not all. When the curtailment of the fiscal deficit in the hope of promoting growth has the very opposite effect, the desperation to attract FDI to stimulate growth increases, and with it the desperation to introduce further liberalisation measur es, and hence to reduce government expenditure in the social sector and on development even further. Thus, the liberalisation which underlies stagnation and recession in the first place is further promoted in the name of overcoming this very stagnation a nd recession. This is the dangerous dialectics of liberalisation; a country caught in its grip continues to experience growing unemployment and poverty even as more and more concessions are made to multinational corporations (MNCs) and international fina nce in the name of overcoming this very poverty. And every such concession by worsening the situation makes further concessions appear to be absolutely essential to those in the grip of this wrong theory.

AS a further example of wrong theory let us take the case of disinvestment. The usual arguments for disinvestment are altogether fraudulent. One argument sees it as a means of closing the fiscal deficit; but if the objection to a fiscal deficit is that i t creates excess unwarranted demand pressures for any given level of investment in the economy, then this objection is not removed when the fiscal deficit is closed through disinvestment, since the purchasers of the disinvested shares do not skimp on the ir consumption for doing so.

Another argument sees it as a means of improving government finances by retiring public debt which is claimed to have become onerous. But, for disinvestment to improve government finances in this manner, it must fetch a price such that the interest saved on the retired government debt is greater than the expected stream of returns on the disinvested shares. Disinvestment, such as of Balco, is at such throwaway prices that this condition is never satisfied. But the consequence ofdisinvestment then is a w orsening of government finances over time rather than the promised improvement! Lucrative assets being handed over "for a song" worsens government finances over time. But this worsening is then used as an argument for further disinvestment and for a furt her curtailment of government expenditure on the social sector and on development generally.

Budget 2001 is a prisoner of this crisis-producing dialectics of liberalisation, and it justifies this captivity through a false theory which is imbibed entirely from Fund-Bank handouts. In the name of controlling the fiscal deficit supposedly in order t o promote growth, government expenditure is curtailed, which then perpetuates and accentuates the recession. The total Plan expenditure in the current Budget is slated to increase by a mere 8 per cent compared to the Budget estimates of last year and the total Central Plan outlay by a mere 11 per cent. In real terms these proposed increases are insignificant.

The Finance Minister of course made the increases appear more impressive than they actually are by comparing the Budget provisions with last year's revised estimates, which were well below last year's Budget estimates. But since last year's shortfall rel ative to the Budget estimates occurred because of a cavalier overestimation of revenues in the Budget document, and since this same cavalier attitude has been repeated in the current Budget, there is no reason to believe that the Budget estimates of the current year would be adhered to any more scrupulously than last year. Since last year's expenditure compression contributed to the recession, the fact that the current year too does not escape expenditure compression would serve to perpetuate recessiona ry conditions.

This would be buttressed by at least three additional factors: first, the pattern of revenue mobilisation. The increase in excise duty (Cenvat) from 8 to 16 per cent on a whole range of essential commodities, would, apart from its distributive consequenc es, have a demand-compressing effect. Secondly, the de-reservation of 14 items hitherto reserved for the small-scale sector, including items such as leather, footwear and toys, would entail a substitution of small units by MNCs. Since the output of the l atter tends to be more import-intensive, this substitution, apart from its socially regressive consequences, would also be recessionary. Thirdly, the withdrawal of excise duty exemption for small-scale producers of cotton yarn would have adverse conseque nces not only for the producers of such yarn but also for its users, notably the garment manufacturers.

The unreason associated with the obsession with curtailing the fiscal deficit goes much further. It has led to a virtual dismantling of the system of procurement-cum-public distribution of foodgrains that had been in force for the last three and a half d ecades. The government claims that the proposed change amounts merely to a "decentralisation" of the system, but it has three basic features which imply that it is nothing short of a dismantling.

First, until now the Food Corporation of India (FCI) was duty-bound to procure whatever was offered by the peasants at the pre-announced procurement price (strictly speaking it was the minimum support price that was guaranteed but the procurement price o perated for all practical purposes as the support price). Now, the FCI on its own would procure only as much as is necessary for a foodgrain reserve. It is under no obligation to lift anything more.

Secondly, the Central government would not provide any subsidised food to the States. The latter would have to make their own arrangements with the FCI to obtain the requisite physical quantities of foodgrains. Thirdly, the Central government would only give a cash subsidy to cover the population below the poverty line (BPL), but not for the non-BPL population.

Now, with regard to the first two points it may be argued that the States can undertake the job of providing price support and of ensuring the physical availability of foodgrains for the PDS, using the services of the FCI for the purpose. At best, howeve r, this amounts to the Centre passing the burden of the fiscal crisis on to the State governments. Not only are the latter in a much worse position to bear this burden than the Central government (which would necessarily entail a dismantling of the syste m), but among the latter the capacity to bear the burden varies considerably. The consequences of this move therefore would be more severe for the poorer States than for the richer ones.

On the third point, it is claimed that excluding the non-BPL population from the purview of the subsidy is desirable, since subsidies must be targeted towards the really deserving. It is well-known, however, that large numbers of the poor are excluded fr om what is officially counted as the BPL population. (Madhura Swaminathan has noted that in the Dharavi slums with a population of half a million there were only 151 families in 1999 which were counted as BPL!) Providing cash subsidies only for the BPL p opulation therefore amounts to taking off large numbers of the poor from the system of subsidised food. In short, the proposed change in the food procurement-cum-distribution regime would throw both producers and consumers to the mercy of the market wher e they would face price fluctuations far larger in amplitude than was allowed under the existing regime. This, needless to say, would also affect the incentive to invest, and hence the growth rate, in the agricultural sector adversely.

Some people have argued that the dismantling of the system of public procurement-cum-distribution would result in cheap food which would get rid of the huge foodgrain stocks that have got built up in recent years. This, however, is an erroneous view. Whi le dismantling the system may result in making cheaper food available at the present moment, it would also result in food becoming more expensive at a later date: the basic point is that the present system keeps the amplitude of price fluctuations much s maller than what a free market regime would allow, and what actually occurs in the world market. The fact that the level of the food price under the present regime is too high relative to the purchasing power of the poor, resulting in the bizarre situati on of an accumulation of unwanted stocks in a land of starving people, has to be tackled differently, by putting more purchasing power in the hands of the people through employment generation programmes. (The argument put forward by some people that empl oyment generation programmes cannot get rid of foodstocks which only a price reduction can do, is untenable, since it makes contradictory assertions about the effects of a real income increase on food demand).

The real objection to the introduction of a large employment-generation programme is that it would enlarge the fiscal deficit; it is to keep the fiscal deficit in check that the government is willing even to dismantle the public procurement-cum-distribut ion regime. Now, a fiscal deficit which eventually accrues as income to the FCI, a government undertaking, leads to no increase in the net borrowing of the government. It cannot, by any stretch of the imagination, have any adverse consequences for the ec onomy, while the employment-generation it finances would ensure more food for the poor, decumulate unwanted foodstocks, and, if properly conceived, even build up rural infrastructure. But the obsession with the fiscal deficit rules it out. This obsession in turn derives from the fact that international finance is opposed to a fiscal deficit.

To pander to the whims of international finance at the expense of the livelihood of the people, is a triumph of unreason. This Budget invokes a false theory to justify unreason.

Prabhat Patnaik is Professor of Economics, Jawaharlal Nehru University, New Delhi.