In this post, I’m going to address the mystery of the ages aka why economists never seem to agree on anything. They argue not only with each other, but also with themselves a disturbing majority of the time. Why else would American President Harry Truman (famously) say, “Give me a one-handed economist. All my economists say, ‘on the one hand… on the other hand.’”
Hall and Lieberman ("Macroeconomics: Principles and Applications") answer this question with the help of an illustration. I’m going to “indian-ize” the illustration.
India's Modi-led government was able to reign in the Fiscal Deficit (FD) to 3.9% of GDP in FY16 (vs. 4.1% in FY15 and 4.7% in FY14). Low oil prices obviously played an important role. While disinvestment proceeds were lowered than planned, the government chose to boost revenues with excise duty hikes rather than cut Plan spending in order meet the FD target.
Reducing the FD to 3.5% of GDP in FY17, as the government had initially planned, will be hard now given the implementation of the 7th Pay Commission. However, the government remains optimistic about achieving its FD target of 3% by March 2018.
Now, most economists agree that curtailing the Fiscal Deficit is the right policy move. A lower deficit (G-T) where G = government spending and T = net taxes, requires the government to borrow less in the loanable funds market. When the government’s demand for funds is lower, the interest rate tends to be lower, which encourages private Investment spending (I). Strong investment spend is a prerequisite for GDP growth.
Why this is the wrong move
That said, there are others who believe that an acute focus on curtailing the deficit is not a good idea, and infact harmful for growth. They encourage government spending in order to accelerate economic growth.
Both views are correct. One focuses on the Long run (Classical view). The other focuses on the Short run (Keynesian view).
Let me explain.
The first school of thought (curtailing FD is the right move) is based on Classical macroeconomic theory, which provides a good description of the Long run (multiple years). Classicals believe that wages and prices are flexible and that markets always clear, so that demand is = supply.
As a result, they believe the economy is always at “full employment” (i.e. those willing to work at the equilibrium wage always find work). Since the economy is always at “full employment” and producing its “potential output”, an increase in government spending instead of increasing total spending and output, causes an equivalent fall in investment and consumption spend, leaving total output unchanged. Thus, per the Classical school, Fiscal policy is ineffective (does not change total output). All higher government spending does is “crowd out” investment spending.
Since private Investment spend is crucial for long-term growth, based on the classical school of thought, curtailing the deficit is the right move.
Bottom-line: Economists encouraging the curtailing of the Indian FD are taking a long-term view (several years) of the economy.
The second school of thought (focus on cutting FD is the wrong move) draws from Keynesian macroeconomic theory, which is good at describing the economy in the short run (next few quarters, a year). Keynesians believe that an increase in government spending has a “multiplier effect” and increases output/income. There’s some crowding out of investment, but this is only partial. Output rises in response to expansionary fiscal policy (i.e. increased government spending).
This is an apt description of how the economy behaves in the short run i.e. over the next year or the next few quarters. Thus, economists criticizing the curtailing of the Indian FD are focusing on the short-term.
(Note: For the uninitiated, we’ll cover the basic theory behind Classical and Keynesian macroeconomic theory in subsequent posts. So, don’t bother about terms you don’t fully understand at this point)
So, the main bone of contention between economists is the time horizon. When talking about the same time horizon (long run for instance), most are likely to give the same policy prescription.
If two economist with the above-mentioned opposing views are asked if cutting the FD is a good thing long term, they will most likely agree that this would lead to more investment by private firms and faster economic growth. (Per the Classical view)
If these same economists are asked if cutting FD is a good thing short term, they will likely agree that this will mean slower growth over the next few quarters. (Per the Keynesian view)
And this in a nutshell, is the reason why economists disagree so much. They focus on different time horizons. “Once the distinction between the long run and the short run becomes clear, many apparent disagreements among macroeconomists dissolve.” (Macroeconomics: Principles and Applications, Hall & Lieberman)
The right move for India (vis-à-vis the Fiscal Deficit) is a nuanced combination of both schools of thoughts.
The right policy mix involves:
1) Raising tax revenue: This involves expanding the tax base (there are only 5.43 crore tax payers in India currently which is just 4% of the population), rationalizing and lowering tax rates (corporate tax rate is being lowered to 25% over the next few years), checking evasion (the passage of the GST bill is a step in the right direction) etc. Meeting FD goals by raising revenue rather than cutting expenditure would the ideal outcome.
2) Tightening wasteful revenue expenditure/ subsidy spend: The reduction in FD achieved in FY16 was in large part due to the fall in crude prices which allowed the government to reduce its petroleum subsidy burden substantially. However, such a situation may not exist in the future, which is why it is important to expedite reforms in petroleum and other subsidy areas.
3) Enhance capital spending on infrastructure, health and education: It is important for the government to enhance capital spending. India needs to invest heavily in infrastructure (roadways, power, water) for Prime Minister Modi’s “Make in India” campaign to turn from a marketing blitzkrieg to reality. Solid investment is also required in health and education if India is to develop a work force that is readily employable.
While adhering to broad fiscal deficit targets (Classical school), it is important to not get overly obsessive and make sure that government capital spending on the right priority areas does not suffer (Keynesian school). If this means a slightly slower pace of Deficit reduction, so be it.
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