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Eichel and Sinha face similar problems

S. Venkitaramanan

THE Finance Minister, Mr Yashwant Sinha, is not alone in his dilemma about reining in the fiscal deficit, especially during an economic downturn. Mr Sinha faces the dismal prospect of a decrease in Government revenue, both on corporate and personal incom e tax as also from indirect imposts, such as Customs and excise. Expenditure continues to rise.

While he has made brave promises about attaining his fiscal deficit targets -- as also the revenue deficit targets -- it remains to be seen how he will achieve these goals, given the economic decline. Any additional taxation he might be tempted to propos e to rectify the fiscal picture will be counterproductive, as it will result in further depressing the markets and investment sentiments, which are already at a low ebb.

Mr Sinha's dilemma is not unique. He is in good company. Mr Hans Eichel, the German Finance Minister, is in the same boat. Recently, Mr Eichel made a statement protesting against the rigid requirements of tough fiscal deficit targets imposed on Germany a s also on other European Union countries by the Maastricht Treaty.

He has pleaded for a more enlightened approach, which would look at expenditure targets in place of fiscal deficit targets. Unorthodox as this stance can sound, it has the merit of being honest. Mr Eichel says, ``You can plan spending in a budget, but yo u cannot plan your income''. He is referring to the difficulties of capturing income streams in a declining economy. This is also the problem Mr Sinha faces.

It is ironical that the German Finance Minister is asking for a reconsideration of Maastricht targets. The irony is all the greater as Germany was the leader among the European nations to seek strict fiscal deficit targets.

In fact, observers recall that in the wake of the suspicions that Italy and France fudged their deficit numbers in order to get entry into EMU, the German Finance Minister at that time, Mr Theo Waigel, had pushed through a stability and growth pact, whic h not only reiterated the fiscal deficit targets set by Maastricht, but also imposed financial penalties on countries which did not attain these targets. Penalties were to be paid by countries failing to reach the designated goals. At that time, Mr Waige l was absolutely confident that he would not be a candidate for such fines.

When Lord Keynes suggested massive public outlays in the years following the Great Depression, he did not have to contend with targets of fiscal deficit/GDP. He was, above all, pragmatic in his vision of what Governments should do to revive the aggregate demand. This is what Mr Hans Eichel of Germany is focussing on. And this is what Mr Yashwant Sinha should ask his economists to work on.

Pre-eminent among the considerations that went into the Maastricht Treaty and the stability and growth pact was the philosophy that maintaining fiscal balance was crucial to inflation control. Germany was paranoiac about inflation management. At that tim e, the French Treasury did argue for some relaxation in the Treaty to meet cyclical declines, which could call for increase in public investments. These objections were overruled and the stability and growth pact was signed.

Even the Finance Minister of UK, Chancellor Gordon Brown, had at that time raised a pertinent issue about the need to treat spending on public investments differently from current spending. This is, in essence, similar to the argument voiced in this colu mn repeatedly that Government spending on investments should be treated more as contra-cyclical actions and not condemned for contributing to fiscal deficit. This argument fell on deaf ears. Germany is today feeling the need for using public investments because of the decline in growth and massive increase in unemployment.

While it is true that Mr Eichel did make a diplomatic withdrawal later from his initial objections to the harsh requirements of fiscal stability, this was consequent on pressures from Brussels. The problem before the Finance Minister of Germany remains u nsolved. Managing fiscal consolidation in a cyclical downturn -- which calls for stimulative investments by the Government or even tax cuts -- is, indeed, contradictory to the concept of maintaining fiscal deficit at a specific percentage to GDP.

Macroeconomists should consider some variant of this yardstick, adjusting it to the factor of cyclical decline in GDP and the downtrend in the economy. That is to say, when the economy is in recession -- as India is today -- the firm goals of a specific percentage of fiscal deficit to GDP should be capable of adjustment.

This suggestion will, of course, be received with scorn by fiscal purists. But the German experience suggests that the current mantra of sticking to firm and unadjusted targets for the cyclical factor is a recipe for economic disaster. As Mr Eichel point s out, ``pro-cyclical policies, that is, increasing Government expenditure in a downturn, will only prolong the downturn''.

Mr Sinha himself has made various suggestions in the Budget Speech for increasing investments in the economy. But all this will come to naught in the face of his sticking to the declared goal of fiscal deficit management. Mr Gordon Brown's suggestion of a sustainable deficit target based on public investments as distinct from the revenue account deficit seems to be well worth exploring. Revival of the economy should be a goal.

The German Finance Minister's reactions would suggest that the angry response of many of the emerging economies to IMF recommendations to restrict expenditure in the Asian economic crisis was not unfounded. The IMF had at the time denied the logic of pro test by the recipients of its aid. But Mr Hors Kohler, the IMF Managing Director, may find Mr Hans Eichel's views more relevant and substantial, especially in view of his prior experience in Germany.

Economic theoreticians need to revisit the linkages between fiscal deficit and inflation. There may be different levels of fiscal deficit that can be sustained, especially when the economy is on a cyclical decline, given the slack in manufacture.

While it is true that unbridled monetisation may trigger an uninflationary spiral, there should be sophisticated methods of handling bond financing by public authorities to fund investments in a non-inflationary manner, especially in a situation where fo od-stocks are adequate and the foreign exchange situation can sustain additional imports. To repeat ad nauseam the call for fiscal deficit reduction even when the economy is in need of stimulus in the form of public investments, appears to be whistling i n the wind.

The dilemma is, indeed, difficult, but the Finance Minister needs to ask his economic advisers to ponder the concerns raised by Mr Eichel. The RBI and the Economic Advisory Council will have to find a way out as to how to resolve the dilemma that Mr Eich el has given expression to and which is akin to Mr Sinha's own problem. The dilemma is more acute in India, as the symptoms of deep decline are already in evidence in the economy. They can be cured only by a bold investment policy. Unless the cyclical de cline is factored into the fiscal deficit targets, the mantra of fiscal deficit reduction may work havoc on the real economy.

Mr Sinha has to remember that he cannot sell a policy of deficit reduction to his colleagues in the Cabinet on the basis of theoretical abstractions. What counts is a successful policy for the revival of the economy and jobs to the millions of unemployed . Any nostrum that stands in the way of such a policy deserves to be re-examined radically. From distant Berlin, Mr Eichel has raised his concerns. I hope Mr Sinha will see the Indian case as an extension of what Germany is going through.

One of the critics of the growth and stability pact had observed that it is virtually a torture chamber. By dogmatically sticking to definite targets of fiscal deficit/GDP reduction, Mr Sinha may consign the economy to an Indian version of a torture cham ber. Desperate situations call for desperate remedies, even if they call for the abandonment of pet orthodoxies. It is true that fiscal deficit management has come to be a hallmark of macroeconomic performance. But the targets have definitely to be adjus ted, keeping in mind the structural characteristics -- the economic cycle in particular.

Innovative macroeconomic thinking is the need of the hour. Given an integrated policy of inflation management, which is possible, and the objective conditions of the Indian economy today, such as abundant food-stocks and forex reserves, a relaxation in f iscal deficit targets to adjust for the cyclical decline may well be justified.