Take a leaf out of US’ fiscal book

The Government is following the policy of “balanced budget” which means that the expenditures will be reduced to match with the income. The borrowings undertaken to make expenditures in excess of the income will be reduced. This borrowing is called fiscal deficit. This policy was adopted by the United States of America during the 1930s. The American economy was buoyant during the twenties and share markets were on a bull run. It was a bubble though and led to the crash of 1929, known as the “Great Depression.” Thereafter the US Government followed the policy of a balanced budget. The crash led to a reduction in production and tax collections. The Government reduced its expenditures in the same ratio in order to balance its budget, basing it on the theory that it will promote growth. But the economy continued to slide down; and the Government continued to reduce its expenditures to match with the reduced revenues.

Economists proposed two contrary solutions to the Depression. The mainstream economists advised the Government to continue to implement the policy of balanced budget. They said that reducing Government expenditures will lead to lesser Government demand in the market, to lesser overall demand and to a decline in the prices, which will soon generate new private demand and the economy will revive. US Government followed this policy. However, it led to further deepening of the recession which continued till 1939.

In this dismal situation famed economist John Maynard Keynes suggested an exactly opposite policy. He said that consumers were caught in a psychology of fear and were unwilling to increase spending. In normal conditions, the expenditure of one person becomes income of another. For example, the amount spent on the purchase of potatoes by the homemaker is income for the farmer. This virtuous circle of expenditure and income had broken as the recipient was not spending his income. The farmer kept his income safe for security, fearing the economy in the coming year could be worse. Keynes suggested an increase in the Government’s expenditures by borrowing money and allowing the fiscal deficit to increase. That, he said, will generate a virtuous cycle of demand and investment will be jumpstarted. The Government must ‘prime’ the economy by borrowing and making expenditures in, for example, making of highways. That would create confidence among the farmers and they would start investing in new tractors. President Truman listened to Keynes’ advice. He undertook massive investments in the Interstate Highway System. At the same time a huge demand for armaments was created though the expenditures for the Second World War. The mood of the country changed and the US economy came out of the recession.

Faith and emotions are not to be overlooked. The farmer will buy a new tractor if he is confident of selling more potatoes the next year. President Truman was able to build it. The role of increased government expenditures was important because of the confidence that they generated over the demand created.

President Trump follows this confidencebuilding policy. The American people are enthusiastic that protectionism and tax cuts espoused by him will bring good results. Thus, they are spending and investing. Growth is up and unemployment is down. Trump is not making large expenditures in building infrastructure like airports and yet the growth is up.

Now we can assess the suitability of the balanced budget policy taking the American experience as an anchor. The first event was of the bubble bursting in 1920s. I think India is moving in the same direction. The stock market is booming while GDP growth rate is floundering, unemployment is up. It is quite likely that the stock market bubble will burst. Second event in the US’ story was that of the increased borrowing and expenditures by President Truman. Prime Minister Modi has adopted exactly the opposite. The capital investments of the Government have been declining. The investments being made in highways and the bullet train do not appear to be generating a positive emotional ambience. The typical businessperson remains lukewarm about the prospects of revival of growth. The third event in the US’ story is of the economy gaining growth under Mr Trump. He has encouraged manufacturing to come back to the US by increasing import duties even though there is not much of an increase in expenditures. Thus, the growth was created by the confidence created among the businessmen by these two Presidents even though they followed opposite policies with regard to government expenditures. This, I think, is the real lesson for India.

Our capital is fleeing due to the feeling of “tax terrorism” that has been voiced by many industrialists. Trump has reduced income taxes, increased expenditures and generated confidence among businesses and consumers. Mr Modi too has reduced income taxes, increased expenditures but the real challenge before Mr Modi now is to create that confidence that doing business in India will be profitable. Only then will we have growth.

The writer is former professor of Economics at IIM Bangalore.