Fiscal Prudence, Now and Here

Op-ed in the Business Standard, New Delhi

June 24, 2009

Should next month's budget, the first for the new government, start the process of fiscal consolidation or should this consolidation be deferred for some time? One perspective on this question is comparative. We could look at what, say, China and the United States are doing and draw upon their experience to shed light on India's situation.

China has come down firmly on the side of continuing the fiscal stimulus it set in motion last year. In the United States, three views are competing for intellectual legitimacy. The first view, expressed most forcefully by Paul Krugman in his recent Lionel Robbins lectures at the London School of Economics, calls for additional fiscal stimulus. In contrast, the bond-market vigilantes spearheaded by Niall Ferguson, balking at the run-up in deficits and debt, are signaling the need for fiscal consolidation by pushing up interest rates.

The intermediate view, articulated on behalf of the Obama administration by Christina Romer, head of the President's Council of Economic Advisers, is that while there may not be further stimulus there will be no early consolidation either. In an attempt to head off the pressures from these vigilantes, she wrote in last week's Economist warning against premature fiscal consolidation. Let us not repeat history, she said, invoking the actions of President Franklin Roosevelt in 1937, when fiscal and monetary tightening choked off the recovery, pushing the United States back into depression until World War II came to the economy's rescue.

Can a case be made that India, unlike China and the United States, should actually embark on consolidation now, even reversing some of the recent stimulus? What would a comparative analysis of the situation of these three countries suggest?

Take first the public-sector balance sheets in the three countries. China entered the crisis with a mouth-wateringly low level of public debt (about 20 percent of GDP), the United States with an intermediate level (about 40 percent of GDP), and India with a very high level (close to 80 percent of GDP). Thus, on grounds of fiscal ability alone, India should probably be less aggressive in the size of the stimulus and more aggressive in the timing of its withdrawal.

This argument runs into the obvious objection: What about need? Might India not need Keynesian pump-priming more than the other countries?

Let's examine this question carefully. How do the three countries fare in terms of a forward-looking assessment of the need for fiscal stimulus?

First, let's compare India with China. For these countries, the crisis has manifested itself as a large and negative external demand shock. For China, the outlook for a sustained recovery accordingly hinges on the prospects for exports. This is not entirely true for India, because it has a much lower share of exports in GDP. But leave aside this point. How do India's and China's export prospects compare? To begin with, the bulk of what India does export consists of services, which have been much more resilient to the downturn than the manufactured goods in which China specializes. Second, the rupee has depreciated more during the crisis than the renminbi, which has broadly maintained its precrisis levels of competitiveness (it appreciated between September 2008 and April 2009, but has clawed back some or most of that loss in competitiveness since). As long as the rupee does not strengthen unduly going forward, India's competitive position will be stronger in the near term. So, as long as the global economy remains in recession, India's export prospects seem better than China's. (To be sure, this analysis may not hold if the world economy picks up, but then the need for a fiscal stimulus would diminish in the first place.)

How does India compare to the United States? For the United States, this crisis was not due to a negative export shock. There, the problem was a financial crisis, ultimately originating in an overextended household sector that could not service its debts. In fact, prior to the crisis, US household debt was as large as that country's GDP, an astonishingly high ratio. This mountain of debt will need to be leveled in the coming years. As US households focus on repaying debts, future consumption is likely to remain significantly depressed, and savings significantly higher. Balance sheets will not be a comparable constraint on future household consumption demand in India.

Thus, on the two key components of demand, India's outlook is the least bleak: Export prospects are better than China's because India is less export-reliant and because the rupee has gained competitiveness. Consumption prospects are better than that of the United States because Indian households will not have to deleverage like their American counterparts.

What about the other component of demand, namely private investment? Incorporating private investment will not change the picture because private investment is likely to track exports for China and consumption for the United States. So, once again the outlook for India is considerably more favorable than in these other two countries.

All this, of course, is perhaps tedious and roundabout analytics for the fiscal message implicit in the recent flurry of upward revision of the growth forecasts for India. If this optimism is warranted and India reverts to trend growth of say 8-plus percent soon, the time is also ripe for commencing the process of fiscal consolidation, especially since India's public-sector balance sheet remains so fragile.

So, for China the prayer must be: Lord let us have fiscal recklessness now and for some time. For the United States, it is a classic case of Augustinian procrastination: fiscal prudence yes, but not yet. But for India, it may well be a case of prudence, and prudence beginning now.