Specious macroeconomics

Three examples from the major policy pronouncements made by Arun Jaitley in his Budget prove the erroneous thinking behind the exercise.

August 30, 1969: Prime Minister Indira Gandhi being congratulated by a group of Muslim women on the nationalisation of banks. The acceptance of Basel-III "norms", which make bank operations "standardised" across all countries, runs counter to the spirit of bank nationalisation.

THE MACROECONOMIC THINKING THAT Arun Jaitley brings to his first Budget is exactly identical to that of his predecessor. And before this thinking is accepted as being “true” through sheer repetition, it is necessary to point out its erroneousness. The country must not be inveigled into accepting a macroeconomics, and hence policies based upon it, which cannot stand rigorous scrutiny. I shall discuss here three examples of such erroneous macroeconomics, each underlying a major policy announcement of the 2014-15 Budget.

The first states that since India has accepted the Basel-III “norms” for banks, the Indian public sector banks under these “norms” would be required to have a much larger capital base. If they remain government-owned to the same extent as they currently are, then the government will have to raise the bulk of this additional capital. But since fiscal resources are limited, the government cannot obtain funds on the requisite scale from its own budgets. Hence, to increase the capital base of the public sector banks, the government will have to rely on private sector funds to a very significant extent. Nationalised banks, even while remaining in the public sector, should therefore reduce their share of government equity to 51 per cent, which is what Jaitley has pointed towards.

Now, the acceptance of Basel-III “norms”, which make bank operations “standardised” across all countries, runs counter to the spirit of bank nationalisation, which had sought to make Indian banks sui generis and “ non-standardised ” by insisting on their giving loans to peasants and petty producers on a scale unprecedented under capitalism. Basel-III, in contrast, specifies credit risk assessment rules, which could well lead to a truncation of the flow of credit to peasant agriculture. Basel-III “norms” therefore should simply not have been accepted in a country that still has not officially given up its commitment to “development banking”. But the point I wish to make here is not this. Nor does my point relate to the question of whether Basel-III “norms” are necessary: after all, if Indian banks have operated all these years with a lower capital base than what Basel-III specifies, why should this base have to be suddenly raised? My point here relates to something else, namely, the rationale of selling equity to private investors as a means of raising resources for meeting these “norms”.

Selling equity to raise resources

Increasing the capital base of the banks is meant obviously not to effect a pro rata increase in the scale of their portfolio, but to alter its composition, so as to protect them from the ill-effects of “non-performing assets” (NPAs) and bad debt. In fact, in the past itself the Indian government has periodically infused additional capital into nationalised banks precisely for this purpose; the idea now is to have a permanently larger capital base, and to ensure that it is not frittered away through increased NPAs and bad debt, which are supposed to be restrained by the enforcement of the credit risk assessment rules (which, one hopes, will squeeze bank lending for speculative ventures rather than for peasant agriculture). Essential to this whole conception in other words is an increase in the ratio of “non-credit” assets, such as government bonds, or cash in the vault, or deposits with the Reserve Bank of India (RBI), in the total assets of banks. The increase in the capital base of the banks is meant to be held by them in the form of these assets.

Precisely for this reason, however, the government can finance an increase in this capital base through its own borrowing, which would have no ill-effects on the real economy. Such an increase in banks’ capital base does not have to be financed through fiscal resources . Hence the question of the government being fiscally constrained and forced to privatise banks to finance their capital base does not arise.

Avoiding a safe route

Suppose, for instance, that the government simply borrows funds from the RBI to increase the nationalised banks’ capital base. No matter where this capital is held, whether with the RBI or in the vaults of the banks themselves, the entire operation would simply amount to a book transaction : the RBI would hold some IOUs of the government on its asset side and its own IOUs of an equal amount, constituting the enhanced capital base of the banks, would appear on its liability side.

None of this will have an iota of effect on the real economy via expenditure flows. And since there would be no effect on the real economy, to say that this cannot be done because of the Fiscal Responsibility and Budget Management (FRBM) Act, which lays down government borrowing limits, would be absurd: it would mean confusing a mere book transaction for one with real economic significance.

True, when this capital would be required by banks, that is, when they would have to reduce their holding of other assets owing to a large pile-up of NPAs, the funds provided by the government for increasing their capital base would enter the real economy, but not until then. Even then, however, the effect of such funds entering the real economy would not necessarily be inflationary.

What is more, the very increase in the capital base of the banks (or, in the old days the very willingness of the government to provide funds to banks when they were under stress) acts in the direction of imparting stability to the system (preventing “runs” on the banks), thereby ensuring that the increased capital base is used sparingly.

An example from the United States may illustrate this last point. When the financial crisis hit the U.S. recently, the Obama administration supported the financial system, including in the form of guarantees, to the tune of $13 trillion. While this support helped to stabilise the system, the $13 trillion did not come out of the U.S. budget, and only a small fraction of it needed to be actually spent. In other words, the very fact of it “being there” allayed fears and ensured that it did not have to be actually spent.

It follows that capitalising nationalised banks by the government borrowing from the RBI is perfectly safe; and even dipping into this capital which may become necessary in the event of a serious mismatch between banks’ assets and liabilities will be small in magnitude inter alia owing to the very fact of its availability. Hence the argument that equity must be sold to private investors for raising the required additional capital, because budgetary resources are scarce , is totally devoid of any validity. It is made only to provide an excuse for privatising public sector banks.

This point can be clarified in another way. Suppose the increase in the capital base of the banks is actually financed by selling bank equity to the private sector. If it replaces some existing asset in private portfolios through which the “savers” were making loans to the “investors”, its effect would be recessionary (by lowering investment). But it would not be recessionary if such equity is purchased by private wealth-holders by increasing their borrowing from banks, that is, if they borrow from banks for buying the equity of banks .

Now, if private acquisition of bank credit for purchasing bank equity is considered good macroeconomics, then there is absolutely no reason why the government borrowing to purchase the same bank equity should be considered bad macroeconomics, that is why, when discussing how the government should increase the capital base of nationalised banks, the focus should be exclusively on the government’s available budgetary resources .

PSU Disinvestment

The second issue I wish to raise relates to the disinvestment of public sector units. I am not referring here to the much-discussed fact of there being a systematic shortfall in the actual garnering of resources from PSU disinvestment compared to what is visualised in the Budget. My point is that the economic consequences of disinvestment are absolutely no different from those of a fiscal deficit , and if the latter is to be shunned (which I do not believe is always justified), then so should the former. Disinvestment, in macroeconomic terms, is part of the fiscal deficit.

In any economy, the level of overall investment (less net foreign borrowings) determines the level of savings, whence it follows that the excess of investment over savings of the public sector, less net foreign borrowing, generates an excess of private savings over private investment exactly equal to itself; that is, that the fiscal deficit, less net foreign borrowings (of the economy as a whole), finances itself by generating an exactly equivalent amount of excess private savings over private investment.

If there is a fiscal deficit of 100, then (ignoring net foreign borrowing for simplicity) this must generate an excess of private savings over private investment that is exactly equal to 100. Whatever the government borrows during any period is actually put into the hands of the private sector to lend to the government by this very act of borrowing .

The private sector may lend to the government directly by holding government bonds, or it may lend indirectly by, say, holding deposits with banks which then use the money to lend to the government. Put differently, the private sector holds government bonds either directly or indirectly, via financial intermediaries, to finance a fiscal deficit which puts the exactly equivalent amount of resources in private hands by being incurred at all.

All that disinvestment means is that instead of holding government bonds , private wealth-holders hold government sector’s equity instead. This represents only a change in the form of the asset held but does not alter the fact that the resources for buying this asset come into the hands of private wealth-holders by the government’s excess of investment over savings.

How do these resources come into the hands of private wealth-holders by the very fact of government borrowing? In an economy that is demand-constrained, government borrowing, which results in larger government spending, boosts aggregate demand, and hence output and economic surplus, leading to larger private savings.

In an economy which is supply-constrained, larger government expenditure financed by borrowing increases prices relative to money wages (and money incomes of the working people), and therefore boosts the share of the economic surplus in the given output, resulting in larger savings (since the savings ratio out of the surplus is larger than out of wages).

A fiscal deficit in the first case, since it raises demand and output may be acceptable (though even here taxing away the additional profits is preferable); but in the second case, where it causes inflation and a squeeze on the workers, it must be avoided. It has in short an effect on the real economy that differs according to circumstances. But whatever its effect, there is no difference between a fiscal deficit financed by government borrowing and a fiscal deficit financed by government disinvestment of equity .

Disinvestment is a case where the government’s fiscal deficit is financed not by the private holding of government bonds (directly or indirectly) but by the private holding of government equity. Other than this difference in form, disinvestment is exactly equivalent to selling government bonds, with exactly the same effects as a conventionally defined fiscal deficit .

To pretend therefore that government expenditure financed by disinvestment represents sound macroeconomics while government expenditure financed by a fiscal deficit (conventionally defined) does not is an entirely erroneous proposition. The fact that such an erroneous proposition is enshrined in a major government document like the Budget only shows the government’s keenness to privatise public sector assets and its effort to garner public support for such action by popularising a false macroeconomics.

FDI in defence production

My third example relates to a sleight of hand by Jaitley (which even goes beyond P. Chidambaram’s). He justified raising foreign direct investment (FDI) in defence production units to 49 per cent on the grounds that the country was currently importing many of these goods anyway. If, instead of importing, it produced these goods domestically then it would save foreign exchange, achieve greater self-reliance and generate larger domestic employment. For this purpose he increased the FDI cap in the defence production sector to 49 per cent.

Jaitley’s argument is unexceptionable; but it is an argument for import substitution per se and has nothing to do with whether the cap on FDI share of the equity in the producing unit should be 49 per cent or 26 per cent or nil. Indeed, Jaitley’s defence of import substitution is as relevant for the economy as a whole as it is for the defence production sector; it constituted the cornerstone of the Nehruvian development strategy which had prioritised self-reliance through import substitution. If he seriously believed in the argument he was advancing, supposedly for 49 per cent FDI equity in defence production (though the argument was not germane to equity-share), then he should oppose the pursuit of neoliberal policies that have opened the economy to the free flow of goods and capital from abroad, even at the cost of domestic unemployment and “de-industrialisation”.

It may, of course, be argued that since foreign multinational companies (MNCs) possess the technology in these areas, there is no alternative to offering them 49 per cent equity if they are to be at all induced to undertake production on Indian soil. But the whole point of self-reliance is to ensure that the country acquires and possesses the requisite technology. A joint-sector company with 49 per cent foreign equity and foreign control over technology is meant precisely to prevent the acquisition of the requisite technology by the country.

Interestingly, when V.K. Krishna Menon, as Defence Minister, initiated the policy of increasing domestic production of defence equipment, it was backed by a substantial thrust on domestic R&D. The problem with straightforward imports of defence equipment and with domestic production with substantial foreign equity is that both discourage domestic R&D. Jaitley’s is not a move towards self-reliance but a move away from it.

To be sure, we now operate in an intellectual property regime that is vastly different from what we had earlier, and under the current regime the monopoly control over technology by foreign multinationals is far more tight. Nonetheless, we must try to create for ourselves the space for achieving technological self-reliance in defence production, by taking advantage of the competition between rival foreign sellers. Besides, since Jaitley wants self-reliance in defence production, is his government willing to reopen the “unequal treaty” that the TRIPS (Trade-Related Aspects of Intellectual Property Rights) agreement constitutes? If not, then his comments passing off a general case for import substitution as a specific case for 49 per cent equity can only be categorised as “specious”.

In the case of the insurance sector, of course, where Indian public sector companies’ performance in terms of claims settlement, which is what really matters in a country with a substantial low-income population, compares favourably with that of MNCs anywhere in the world, all arguments for 49 per cent FDI constitute “specious” arguments. They only camouflage a desire to appease international finance capital.

The previous government had mastered the art of such “specious macroeconomics”. Jaitley is learning fast and taking up from where Chidambaram left off.