Understanding Macro Economy - Is a fiscal deficit good or bad news?

Newspaper headlines these days often paint a grim picture of an unchecked fiscal deficit potentially derailing the economic growth story. Fiscal deficits are seen today as very bad news. Yet, the same newspapers, at a different time, in a different economic scenario, hailed the same fiscal deficit as bold decisions that will help the economy. Is fiscal deficit therefore good news or bad news? When is it good and when is it bad?

In a previous post, we discussed fiscal policies and what a fiscal deficit is . Fiscal deficit, put simply, arises when the total revenues of the Government (from taxes etc) falls short of its expenditure. Indian Governments have resorted to the practice of including divestment proceeds into revenue (which from a strict accounting sense has to be treated as a capital receipt and not a recurring revenue). The logic appears that on the expenditure side, revenue expenses (salaries to Government staff, interest on loans, subsidy programs etc) as well as capital expenditure (infrastructure projects - which are not revenue expenses, but which build assets) are taken into account. India's fiscal deficit - which is currently running at over 5% of GDP, is seen as a major worry, and if unchecked, is seen as something that can derail the India growth story. So, is fiscal deficit all bad news only? Can there be situations where fiscal deficit is actually good news? Can there be situations when markets will cheer a Government policy that moves from a balanced budget to a fiscal deficit situation? Let's take an example of a typical household To understand this simply, lets consider a typical household. If a family whose monthly income is Rs. 75,000, is unable to control monthly expenses below this level, it will need to resort to borrowing to continue paying its bills. Revolving credit on credit cards, personal unsecured loans - the sources are many. The family can continue running a fiscal deficit for some time - but we all know this will be unsustainable. At some point, this family will need to make radical changes in its spending pattern or find new income sources - else, it will soon start defaulting on its loans and will become bankrupt. This is simple and straight forward. Now, lets assume that one of the big monthly outflows in this household is interest payment (no repayment of principal) on an education loan taken for the son's higher education. Does this fiscal deficit situation look somewhat different from the earlier case of pure consumption related deficit? You can say yes, because the interest payment is towards a productive use. Once the higher education is completed, the son is in a better position to get a good job, which can boost the family's income. The interest paid on this loan is aimed at boosting overall family revenues in the long term - and hence the deficit need not result in doomsday for the family - provided the son starts earning incremental income before the accumulated debts become too much for the family to handle. In much the same way, all fiscal deficits of all Governments at all points of time are not bad. There are occasions when running a fiscal deficit is actually good for an economy, in the long run, and can boost the economy's GDP in the long run. Fiscal deficit as a counter-cyclical measure When an economy is experiencing a recession, demand for goods and services is low, unemployment is on the rise and household incomes are either flat or contracting. Corporates are usually reluctant to start fresh projects in such an environment. New projects would mean more jobs, more money flowing into businesses that execute these projects, more income for households, therefore more consumption, and therefore more overall business and growth. But, the environment is not conducive for an entrepreneur to take a risk at this stage. This is also the time when Government finances are in poor shape because taxes are low, while expenses remain the same - so deficits begin to creep in. To help the economy break out of this down cycle quickly, the Government can take a decision to go ahead and launch a series of new infrastructure projects, entirely funded by itself, even though its own financial situation is not good. The resultant deficit is funded by borrowing. But, the infrastructure projects can get momentum going in the economy in the short run through more jobs, more money in the hands of contractors, more downstream orders to suppliers, more consumption from people who are now employed - and thus help boost overall growth. And, if the projects are well planned and well executed, they also lay the foundation for the country's next level of growth. For example, if money went into building more roads and power plants - which are executed well, you now have a lot more productive infrastructure that the private sector can use, when growth picks up. Another measure that many Governments resort to in such times, is to lower the direct and indirect taxes in an effort to spur consumption. Even though this will put a further strain on Government finances, and raise fiscal deficit, if it results in more consumption, the country is better off in the long run as it would have helped the economy recover quicker from a recession. Once the economy is back on track, Government revenues will pick up as taxes will increase with GDP growth - and the Government can then mend its own finances - which went temporarily out of whack in a bid to pump up the economy. Running a fiscal deficit at such times is a welcome and perhaps a necessary step for any Government. The Indian Government reduced excise duties and service tax from 12% to 8% immediately after the 2008 global financial meltdown, for exactly this reason. In recent years, it has restored these taxes back to the 2007 levels, once the effects of the meltdown subsided. When are fiscal deficits bad? Are subsidies good or bad? If essential items like fuel, fertilizers and food are subsidised - and that results in higher fiscal deficits because the Government pays the difference, is that good or bad for an economy? Why do our experts keep fretting over the bloating subsidy bill as a chief worry around our fiscal deficit? Subsidies are not bad for an economy - they can actually be a big long term positive. If the subsidies for the poor segment of a nation reach only that segment which was intended to benefit from it, without any leakages, it will put more disposable income in the hands of this poor section. Apart from serving a social cause, there is a clear economic benefit as well - this segment will start consuming more goods and services, which will increase aggregate demand in the economy and boost growth. If however, a fuel subsidy meant to give cheap diesel and kerosene for the poor, is used by more affluent people to run diesel cars instead of petrol cars, that subsidy is going to do no incremental good for the economy, but only act as a drain on public finances. If fertilizer subsidies are used by rich farmers who can afford market rate inputs, and thus helps them improve their profits even more, that's not going to help the economy - especially, if the incremental profits are invested in land and gold by these more affluent farmers, rather than being put back into circulation. Likewise, if only 10-20% of the subsidies on food actually reach the poor for whom it was targeted, and the rest leaks away through corruption and inefficiency, the deficit that the Government runs to fund these subsidies, provides no returns - social or economic. It is these kinds of poor execution of subsidies that threaten an economy like India. It is in this context that many experts are seeing a ray of hope in the Direct Benefit Transfer program through Aadhar cards - where the cash equivalent of the intended subsidy is directly credited into the bank account of the targeted individuals - with no leakages in between. This incremental cash, it is hoped, will spur consumption and deliver social and economic dividends in the long run. Deficit is neither good nor bad - the cause of the deficit is what matters In short, fiscal deficit is neither good nor bad in itself. As long as a country is running a deficit to finance projects that can deliver progress, growth and prosperity in the long run, these deficits are welcome - just like the interest on an education loan for a son's higher education can potentially deliver higher overall family income in the long run. If deficits are financing frivolous spending, salaries of bloated Government departments and are put to other unproductive uses, such deficits are unhealthy and unsustainable - and certainly something to worry about - just like frivolous consumption by a family beyond its income, is unhealthy and unsustainable. What happens when deficits become high? Sustained high deficits means that each year, the Government will keep borrowing more and more money to pay its bills, and to pay interest on loans it took to pay previous years' bills. As it borrows more aggressively, it will push up interest rates and as it keeps spending beyond its means and printing money to bridge the gap, it will push up inflation - both of which are not healthy for the economy and are bad news for the corporate sector and therefore for stock markets. If this situation continues, the Government will soon find it necessary to borrow just to pay interest on previous loans - forget about any notion of repaying old loans from income. This is a debt trap which hurtles a country towards bankruptcy, where it will then consider the possibility of a sovereign default - of defaulting on its loans.