India – Not all that bad

India’s fiscal books need reworking, and it faces longer run structural problems. But the usually excellent Ideas for India published a rather hackneyed proposal for “reforms”. Indeed, a sick patient cannot both suffer from obesity and anorexia, as Sarah Chen might have you believe.

Here’s a synopsis of India’s economy:

▪   5% GDP growth rate down from a double-digit peak.

▪   About a 9% trade deficit, up from 5% in 2006.

▪   Headline inflation just over 7% after hitting the double-digit range recently.

Chen thinks India’s balance of payments is at risk, but also worries that government deficits are crowding out spending, increasing inflation, and decreasing inflation:

Although India’s high fiscal deficit constitutes a key vulnerability, there is no immediate financing problem since it is funded primarily by domestic banks and other non-financial institutions like pension/ insurance funds. However, the high deficit does dampen investment activity as it reduces the availability of credit for private firms. Fiscal consolidation is therefore a pre-requisite for an upturn in the credit cycle.   

The widening current account deficit (CAD) also remains a major source of concern. 

Here’s an accounting identity:

private financial savings + public financial savings + foreign financial savings = 0.

This means in a closed economy, if the government is running deficits, the private sector is ipso facto deleveraged. By extension, growing trade deficit can take the edge of government spending. As Matthew Klein notes:

Similarly, one person’s borrowing is another’s lending. The takeaway is that the private sector as a whole can’t switch from borrowing and spending to repaying debt and saving unless some other entities (foreigners and the government) step in.

The contraction of the current account deficit since 2006 has been helpful in this regard, but insufficient. That’s why the federal government had to run very large budget deficits. These deficits helped the private sector in two ways. First, by spending more than it took in through taxes, the government added to the private sector’s total income, making it easier for people to repay debts and save more. 

Here is Chen (effectively) saying the same thing:

A widening CAD could potentially lead to pressures on the country’s BOP and the currency. Although India’s CAD has been offset by capital account surpluses, nearly three-quarters of the deficit for the past four years was estimated to be funded by more volatile sources of capital, including commercial loans, trade credit and portfolio equity and debt inflows (Figure 5). Considering India’s high CAD, the risk of slowdown in capital inflows will exacerbate the funding risks and currency depreciation pressures. 

First, there’s nothing “has been” about current account deficits being “offset” by capital inflow. This is a tautological rule. It will never not be the case. And, as italicized, it is clear that government deficits are not necessarily crowding out private credit. This isn’t economics, it’s accounting. And no one should be surprised that it’s the case. She continues:

India’s rising CAD raises serious questions about its sustainability, particularly against the backdrop of volatile global conditions and volatile capital flows. 

This again ignores the necessary relationship between capital and current accounts. Global capital conditions are a) not all that volatile, but b) will be “offset” by changes in trade balance. In fact, it’s not even a bad thing that India runs a capital surplus. As the Americans know, it’s a great way to import capital and hence finance much-needed development. But it’s also something simpler. More consumption: something India desperately needs.

And someone has to wonder what this means:

The government has announced a fiscal consolidation path to reduce the fiscal deficit to 3% of GDP by FY 2016-2017 but the details of how it will achieve this are unclear. India’s fiscal deficit remains one of the highest in the region and this limits its ability to use counter-cyclical policy to attenuate the growth slowdown. 

So when international demand crashed collapsing India’s export market, the government stimulated the economy – a “counter-cyclical policy to attenuate the growth slowdown” – and, because it did this, it’s limited in its ability to do it again? Kind of like how I used to skip school when I had a bad headache but, because I skipped school, I was limited in my ability to skip school next time I had a headache. India was apparently too slow in withdrawing its stimulus:

While the approach of stimulating domestic demand via fiscal expansion in 2008 put India’s economy back on track after the global financial crisis, the inertia in withdrawing stimulus had subsequently led to a spike in inflation that prompted monetary policy tightening10, and dampened aggregate demand.

But if India had crushed public deficits too quickly, aggregate demand would remain “dampened”, this time because of fiscal and not monetary policy. It’s a tradeoff between fiscal and monetary policy. The NREGA program is blessed with many problems, but to the extent targeted redistribution is what India wants, fiscal policy can be more effective.

Note none of this is to suggest India should continue to run large fiscal deficits or that inflation isn’t a problem. It’s just when economists note a bunch of truisms as if its something out of the ordinary, it is important to ignore the noise, which is what most of her article is.

P.S. For what it’s worth, India is the only “BRICS” nation in the top 10 of the new Business Profitability Index by Daniel Altman. Me and Altman will both bet on stable net capital flow into India over the next few years. That means a current account deficit. Gasp!