• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

S. Venkitaramanan

The spectacle of Germany undergoing contortions in a trap of its own design would be comic if it were not for the tragic fact that it has grave implications for the future of both the EU's Growth and Stability Pact and fiscal activism.

RECENT remarks by European statesmen on the alleged stupidity of the Growth and Stability Pact enforcing fiscal deficit targets in Europe have raised doubts about the feasibility of such targets in other countries also. It is important to revisit the debate in the current context when increased public investment is at the centre-stage of the Tenth Plan.

More fiscal reform is the fashionable slogan today. We have been lectured ad nauseam by international gurus and rating agencies about the dangers of fiscal deficits. The Fiscal Responsibility Act is on the anvil, introducing statutory limits on the fiscal deficits and debt that the Central Government can run. The current revenue-sharing arrangements between the Centre and the States also make it financially painful for the States to exceed certain defined limits of fiscal deficit. Explanations are called for and penalties in the shape of delayed sanctions of aid follow.

The idea of a statutory limit on fiscal deficit gained respectability with the Maastricht Treaty in the 1990s. The Germans, who had a collective national memory of rampant inflation, which led to the breakdown of the German economy and the rise of Hitler's Reich, were mainly instrumental in persuading other members of the European Union to enforce a collective limit of 3 per cent of GDP for fiscal deficit.

The Maastricht limits were criticised by a few observers even at the time of inception itself as being inflexible and unresponsive to macroeconomic cycles. But the keenness on forming the Monetary Union and fear of inflation arising out of unrestrained fiscal deficit and debt got the upper hand.

Especially, the Germans were afraid of innovative budgetary fudges by fiscally weak countries, such as Italy and France, which were proverbially prone to debt.

In surrendering their own proud icon — the Deutsche Mark — the Germans undoubtedly made a great sacrifice. It was inevitable, therefore, that they should reach out for fairly rigid arrangements that would ensure that temptations to breach the Maastricht limits were kept in check. This was the raison d'etre of the Growth and Stability Pact, which was signed a few years ago.

The Growth and Stability Pact bore the clear imprint of its German authorship, in that it not only laid down a target of 3 per cent for fiscal deficit, but also prescribed hefty fines for countries that stepped outside the limits. The fines were to be paid in terms of percentages of the country's GDP. It is ironic that Germany, the author of the fiscal "torture chamber" is among the first defaulters. It is on the cards that Germany will breach the fiscal target this year to the extent of 1-1.5 per cent. It is a humiliating impact of the pact that its prime initiator is among the first to bite the dust. The defence of the German Government spokesmen is that the rise in deficit is a natural consequence of the global slowdown as well as the slowdown in the German economy and consequent fall in revenues and growth in various relief expenditures consequent on the slowdown itself.

The prescriptions of the Pact would, however, demand that the German Government should increase taxes and cut expenditure — just when the economic slowdown demands the precise opposite initiatives. The spectacle of Germany undergoing contortions in a trap of its own design would be comic if it were not for the tragic fact that it has grave implications for the future of both the Stability Pact and the fiscal activism — and, above all, the continuance of the European Union itself.

It is in this context that one has to place the widely reported remarks of the EU President, Mr Romano Prodi, that the Growth and Stability Pact is "stupid". These remarks have been criticised as evidence of political immaturity.

There has been a widespread air of shock and surprise. But Mr Prodi, a former Prime Minister of Italy, is aware of the consequences of rigid fiscal limits that do not take into account the precise phases of the economic cycle. This aspect is too serious to be ignored. Mr Prodi has sounded the alarm and it is now up to the statesmen of the European Union to refashion the Growth and Stability Pact in such a manner that it does not function as a Procrustean bed for the European economies.

That fiscal deficit targets should be adjusted for the phase of the economic cycle is logical. How exactly the deficit targets have to be adjusted to take into account the impact of the cycle is, however, a matter of principle and detail.

It is a question of principle, in the sense that relating the target to the phase of the cycle amounts to accepting the stimulative role that State fiscal action can play in macroeconomic policy. Market fundamentalism may not accept the role of the State in energising economic growth. But the actual experience of all economies confirms the Keynesian insight that public expenditures do have an important role in promoting demand.

For instance, even the most rabid anti-Government expenditure economist in India has been forced to admit that one of the causes of the recent slowdown in India's industry and agriculture has been the decline in public investment. It would be definitely counterproductive to recommend a tightening of public investment in such a macroeconomic situation.

Mr Romano Prodi's famous (or infamous) message has set many economists thinking about how to rectify the situation in Europe. One way out may be to make the targets more flexible. Another may be to distinguish current (our revenue) deposits from investment deficits.

Mr Gordon Brown, the British Chancellor of the Exchequer, has been reported as supporting such a distinction. It is true that investment can take many forms and the scope for ingenuous fudges to make revenue (current) deficits take the shape of investment. However, ways can be found to monitor such fudges. The fiasco in European Union's Growth and Stability Pact should ring alarm bells among our enthusiasts for fiscal reform. If even a well-ordered institution, like the European Union, should find itself in difficulties to enforce fiscal standards, how much more difficult will it be for India to enforce them? Penalties for transgression will inevitably arouse political antagonism and, in the fractured state of our political governance, may lead to governmental instability. It is time, therefore, that enthusiasts for fiscal reform learn their lessons from the European experience.

The least that should be done is to make fiscal deficit targets amenable to the distinction between investment-related and revenue-related deficits. This should, of course, be subject to the caveat that investments so financed are made viable by enforcing proper and adequate user charge recoveries.

Second, there should be a mechanism for making the deficit targets adjustable for the phase of growth or slowdown. This is a task that calls for statistical ingenuity. But it should not be beyond our experts to devise a suitable adjustment measure.

The lessons of the alleged stupidity of the Growth and Stability Pact would seem to be particularly timely, considering that the new Finance Commission is about to start its work. Above all, it should refrain from reiterating what has been acknowledged to be "stupid" in similar contexts elsewhere. While fiscal targeting is certainly desirable, it should not become a mockery of the fundamentals of contra-cyclical public finance.

Hopefully, the new Finance Commission will have a role to play in redefining the contours of fiscal responsibility both at the Centre and the States. It has to come to terms with the reality that public investment — which involves fiscal deficit — has an important role to play in determining the rate of growth of the economy.

The tendency of economic fundamentalists to fight the battles of the deficit and inflation has to be resisted. Inflation is no longer the pressing foe to be defeated. It is deflation that has to be countered. Fiscal reformers have to keep this in mind, lest they participate in another act of economic stupidity.

Send this article to Friends by E-Mail
Comment on this article to BLFeedback@thehindu.co.in

Stories in this Section
Have dollar, open account

Copyright © 2002, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line