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Recently, the Indian GDP growth rate for April-July quarter was announced. Since, this was the period when the country was under lockdown to contain the spread of Coronavirus, it was expected that country will witness negative growth rate.  However, the scale of negative growth rate at 23.9 percent (YoY) not only exceeded the prediction of most economists, but it also meant that India witnessed the most severe GDP contraction among the major economies.

Last week, the union government announced that it will keep the borrowing in the current fiscal year to earlier target of 12 lakh crore. The current borrowing level will hardly compensate for the fall in tax and non-tax revenue for the government. Hence, the announcement essentially rules out the possibility of any additional government spending.

Given the severity of crisis and near consensus among economists of different political spectrum for the need of higher spending by the government, the reluctance of the government to engage in expansionary fiscal policy is puzzling.

Generally, those who argue against higher government borrowing, give the following arguments -

-Higher fiscal deficit leads to higher interest rate, and crowds out private investment

-Higher fiscal deficit leads to inflation

-Higher fiscal deficit leads to balance of payment crisis

This article argues that why all three arguments don’t apply to the current situation in India.

Crowding-Out Private Investment

If the government decides to borrow higher amount from the market, it is true that the interest rate government has to pay will increase, and it will also increase the interest rate for private borrowers, i.e. – businesses and individuals. However, it will necessarily lead to crowding out of private investment is not true. Private investment in India has been slowing down in last couple of years, and the lowering of interest rate by RBI hasn’t helped in reversing the trend. In fact the capacity utilisation of Indian companies, as surveyed by RBI, has been around or lower than 70% in last few years. When such productive capacity is lying idle, expecting companies to invest belies business sense. Not to mention that the fall in demand and high level of uncertainty are other barriers for private investment. In such case, the benefit from higher fiscal spending is going to be larger than slight increase in interest rate.

However, the higher fiscal deficit doesn’t have to lead to higher interest rate either. Given the extraordinary circumstances, an exception can be made where the higher fiscal deficit is directly funded by the RBI. In fact, leading economist including former RBI governors have supported the idea of debt monetisation in these unusual times.

Inflation

The argument for higher deficit leading to inflation is simple – consider an economy where certain amount of goods and services are produced. If government increases the fiscal deficit, it will create the addition demand, which will raise the prices. This argument may be valid in regular times, but the current situation is anything but normal.

The lockdown and post lock down period have seen restrictions on large number of economic activities. This means the people deriving their income from such activities are not getting any income. In fact, even the white and blue collar jobs have also seen job losses. These loss of income results in loss of demand. So, if the extra spending of the government compensates for this loss of income generation that has occurred, there won’t be inflation.

There have been some increase in inflation last month, and that is being red flagged to argue against higher government spending. However, this increase in inflation is largely due to the disruption in supply-chain arising out of lockdown and the availability of labour, which saw mass displacement after the announcement of lockdown. To control inflation caused by supply side factors by reducing the demand is counter-productive.

Balance of Payment Crisis

Higher fiscal deficit can lead to balance of payment (BoP) crisis in regular times. However, the likelihood of this in the current situation is low for the same reasons given in previous argument. The higher deficit is required merely to cover the fall in demand cause by the suspension of activities and loss of jobs. In fact, the recent data shows that the fall in domestic demand has been so huge that India’s current account has turned surplus after years. This has happened because the imports have seen drastic decline which is another indicator of the loss in demand. And, higher spending is needed merely to cover for this fall in demand.

To Summarise

Experts have long highlighted the distinction between the hard sciences, like physics and chemistry, and the social sciences, like economics and sociology. One of the primary distinctions is that while the lessons of hard sciences are more or less universal, same is not the case for social sciences, where a lesson can be true in one context, but completely wrong in another context.

This insight applies to the arguments against fiscal deficit as well. While the three negative outcomes of higher fiscal deficit, mentioned above, might occur when the economy is operating around its productive capacity; that is certainly not the case in India at the moment. From fall in employment, to level of new investments last seen around 2000s, all indicators show that Indian economy is operating far below its capacity. And to bring it back to close to the full capacity will require substantial help from the government, which can only happen when the government stops worrying about the fiscal deficit and starts to engage in fiscally expansionary policy.