Tuesday, August 07, 2012

The macroeconomics and public finance of inflation in India - 2

(Update : I was writing the original series as just one long post. But then, it got too long, so I have decided to split it up into multiple posts. If you haven't, you should read the earlier posts in the series first.)

Fiscal deficit

A fiscal deficit is simply the excess of government spending over its revenues. Spending minus taxes. G-T, national income accounts wise. G-T is +ve when the government runs a deficit, -ve when it runs a surplus. Begin with the identity that Y (income) = C (consumption) + I (investment) + G (goverment spending) + NX (exports minus imports) (1). Private sector savings (S) are private sector disposable income not consumed. S = Y-T-C  (2).

Combining (1) and (2) gives S = I + G - T + NX. Or, (S-I) = (G-T) + NX. This rather simplistic identity goes by the name of the sectoral financial balances approach, with Wynne Godley being its foremost exponent. The macroeconomic world has been split up into three seemingly autonomous sectors - government, private and foreign. It is scarcely believable, but playing around with this identity seems to give some heterodox theorists additional analytical edge and real-world relevance over mainstream macro-theory. Witness, for example, Martin Wolf. How in the world does a definition add insight?

Well, here it is. S-I is the net private sector surplus. G-T is the fiscal deficit. NX is the net foreign sector surplus. At a given level of NX, a private sector surplus is necessarily matched by a fiscal deficit. Read that carefully, again. A private sector surplus is matched by a government deficit. Ceteris paribus, an increase in government deficits increases the private sector surplus. A decrease in government deficits crashes the private surplus. The government (and net exports) creates financial wealth for the private sector. Most importantly, if your NX is -ve, i.e., you have a current account deficit, you cannot possibly have a private sector surplus unless the government runs a deficit. Read that again too. A government deficit is almost a foregone conclusion if you want to invest sustainably (through domestic savings) in the face of current account deficit.

Now let's back out a bit. This can't possibly be true. Private sector wealth should not be positively related to government deficits. All our received wisdom says otherwise. And yet, there it, a mathematical equation, the last thing in the world which can be jaundiced by ideology. So what's going on? Obviously, ceteris is not paribus.

The equation is true at all levels of Y, I, C etc. It says nothing about the evolution of those quantities over time. Arguments against government spending and deficits must have some implicit behavioural assumptions that affect the course of these quantities over time. G-T creates S-I, sure. But does it boost S (good) or crash I (bad) ? Does it hold NX constant, or does something happen to crash NX while G was increasing? The equation does not say. Ultimately, what that equation reveals depends on other equations implicit in your mental model. But just as in the Friedman quote on inflation, even if not particularly edifying when taken literally, the sectoral financial balances approach gives us pause. It makes us understand that one plausible role of the state is that of a financial intermediary, that deficits may be helping the private sector achieve its desired levels of savings and investment.

So again, what does all this arcane theory of government finances have to do with India's current woes?

For one, let's get out of the mode of 'twin deficits'. Even the RBI governor mentions this in his speech, but while it's an ok phenomenon to invoke when analysing currency price movements, it does not add much value to a discourse on overall macroeconomic stability and performance. A country with a current account deficit will almost always have a twin deficit.

Second, recall that the fiscal deficit is typically split up into two parts - the primary deficit, and interest payments. The primary deficit is the main measure of the sustainability of a government's revenue balance - e.g. do our taxes cover for the salary payments of our armed forces? Interest payments are on the outstanding government debt. They are nominally fixed. They will spike only if g-sec investors believe that the government is running a ponzi scheme, and thus each roll-over of government debt will imply a worsening fiscal situation. Otherwise, any inflation only helps to bring the fiscal balance under control, by reducing the real value of government debt payments.

Now, India's total public debt (state + central) is 68% of GDP. The average maturity of that debt is 10 years. The benchmark 10 year g-sec yields 8% p.a. 8% of 68% is 5.4%. (All figures from here). The interest payments of the Indian state are thus 5.4% of GDP. India's total fiscal deficit is 5.9%. India's primary deficit is thus 5.9% - 5.4% = 0.5%. Round that up to 1%, and read that slowly again. India's fiscal deficit is being driven by its interest payments. Of course, there's also a primary deficit, so that reducing the interest payments themselves unilaterally by simply not rolling over the debt is not immediately feasible. But go back to the concept of the state as a financial intermediary. The Indian state is taking on debt mostly to pay interest on debt. That sounds like a Ponzi scheme! So what exactly is the government doing here?

The government is creating a pool of credit-risk-free financial assets at all maturities of the term structure. The government is creating the way in which you and I are able to park our funds in 2 year, 5 years, 10 year fixed deposits. It is creating the source of income for closed end mutual funds. It is running a Ponzi scheme, albeit one that is perfectly sustainable as long as the expected growth of the economy is in excess of the interest rate on government securities. This is state as a financial intermediary, as what Perry Mehrling calls a social mutual fund.

Now you may wonder - how in the world did a bunch of poorly incentivized bureaucrats and people like Palanappian Chidambaram come up with such a fantastic, commercially viable role of the state. I don't want to push the point, but the answer perhaps lies in Hayekian spontaneous order. We don't have to be well meaning and in possession of a master blue-print to organically stumble upon beneficial arrangements, and beneficial arrangements need not be restricted to 'the market'. Perhaps we copied the advanced states. Perhaps some regulator just gave in to some market pressure for kick-back and asked for a new and improved term structure of government debt. Who knows.

The point to remember is - fret about the fiscal deficits yes, but recognise the fact that most of them arise not from profligate 'spending', but from the state playing a financial intermediary. Arguments challenging the viability of latter will take a very different form than those that challenge the viability of the former. For one, the key variable to look at is not inflation, but interest on benchmark 10-year government debt. And that particular metric has stayed put at around 8%.

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