We all know how the license/permit raj was a hindrance to India's development. Perhaps it is not fully recognised how it was a product of faulty economics based on Professor Lionel Robbins view that economics is about allocating the given productive resources. What was forgotten is that the level of productive resources depends on the incentive system and under a proper incentive system, the productive potential can increase allowing both private and public sectors to achieve higher production. We are all grateful that the license /permit raj was abandoned and our economy grew faster than before.
Unfortunately, we jumped to another form of license/permit raj where there were limits imposed on public investment through the FRBM Act. The implicit assumption was that with finite investible resources, if the public sector invests more, the private sector will have less to invest. The actual results have been some creative accounting of the most deplorable kind by the public sector, little progress on price stabilisation and slowdown in growth momentum.
In designing the FRBM Act, the lessons of Keynesian economics were forgotten. In an economy with underutilised resources, investment can create its own savings and both public and private investment can increase provided the financial sector is doing its duty of increasing finance for viable projects at a reasonable real rate of interest and there is a surveillance mechanism to ensure that borrowers are utilising resources as proposed in their loan proposals. Surveillance is needed at a micro-level but macro-limits on expenditures are no guarantees of quality assurance. As seemed to have been done in countries like China, agencies should be created for providing finance for viable projects in private and public sectors and up to a point, investment will create its own savings.
The Act was intended to provide for the responsibility of the central government to ensure inter-generational equity in fiscal management and long-term macro-economic stability. This was faulty economics. Fiscal deficits and domestic public debt management mean reallocation of resources within the generation and not between generations. And macro-economic stability depends on total effective demand (including both public and private sector) in relation to productive potential and not deficits of the government alone. When private investment is buoyant, public investment may be modest to keep within the potential output and when private investment is muted, public investment may be buoyant. This requires a counter-cyclical fiscal strategy rather than a predetermined glide-path for fiscal deficits irrespective of the state of private investment which ended up with the target of fiscal deficit of 3% of GDP for which no rationale was provided except a copy-catting of the Maastricht guidelines which had a completely different background. It is interesting to see that during 15 years after the implementation of the FRBM Act in 2004, the rate of inflation as defined by the consumer price index was 7.3% per annum - only marginally lower than in the preceding 15 year from 1990-2004 (7.7%). The authors of the Act defined limits to fiscal deficits going up to March 31, 2021 which went well beyond their mandate as per the Constitution. They were aware of the need for some flexibility in the fiscal deficit targets but provided for a miniscule deviation of 0.5% of GDP under very special circumstances such as, “Due to ground or grounds of national security, act of war, national calamity, collapse of agriculture severely affecting farm output and incomes, structural reforms in the economy with unanticipated fiscal implications, decline in real output growth of a quarter by at least three per cent. points below its average of the previous four quarters.”
In the current situation, fiscal deficit needs to be increased to fill up the gap created by the collapse of private sector demand and that may require the fiscal deficit of the central government alone to increase to at least 10% of GDP during this fiscal year. It is not a question of providing a range for fiscal deficits while remaining in the fiscal silo as seems to be under consideration now but considering the fiscal policy, monetary policy and prices and income policy as an integrated whole by the Economic Committee of the Cabinet. Unless the FRBM Act is jettisoned, the finance ministry cannot do it under the laws of the land. Since the FRBM Act was very much influenced by the thinking on fiscal policy in the West, it is worth noting how there is some basic rethinking going on in this area in the West. In an influential paper, Jason Furman and Larry Summers argue, “In a world of unused capacity and very low interest rates and costs of capital, concerns about crowding out of desirable private investment that were warranted a generation ago have much less force today. We argue that debt-to-GDP ratios are a misleading metric of fiscal sustainability that do not reflect the fact that both the present value of GDP has risen and debt service costs have fallen as interest rates have fallen.”
On a broader framework, we need at least an 8% annual growth during 2021-2035 to achieve our employment objectives and that will require some 40% of GDP in investment with public investment rising substantially in the current period when the private investment is short of animal spirits. This will be impossible unless the FRBM Act is given a burial. Also, as was done in China, macro-economic management has to be integrated in its monetary, fiscal and prices and incomes policies and not work in silos. The Cabinet Committee for Economic Management has to take over the task of macro-economic management with whatever advice needed from other agencies. If the current government fails to take the necessary corrective legislative and executive action, we may well face a lost decade in terms of creation of decent jobs - particularly for the educated youth.