Fiscal stimulus is now a well-known, much talked about but not so well-understood term in economic policy discourse throughout the world; same is the case in India too. The way the term has been employed would suggest that aggressive fiscal policy can provide unalloyed benefits to national economies, particularly when economic activity is decelerating, as is the case currently. The concept has been provided added lustre in recent times as once paragons of fiscal rectitude (surplus budgets and at least balanced budgets) such as the IMF too have unambiguously advocated large deficit programme, if need be, to beat the global recession.

Governments around the world have not been slow to act on the leeway now available to increase public spending. While the attention, quite justifiably, has been focused on the near $800 trillion fiscal stimulus package passed in the US recently (amounting to nearly 6 per cent of the country's GDP), there have been equally remarkable fiscal efforts in other countries also.

Overdrive in Indian fiscal deficit

The large expansion in the Indian fiscal deficit in FY 2008-09 to 6 per cent of GDP from the budgeted estimate of 2.5 per cent is a telling example of the dynamics at work even in emerging market economies. (China had in 2008 announced a package worth nearly $600 billion). To counter what it perceives as a serious slowdown in the economy and maintain its growth around the 7-8 per cent level, the Indian government has budgeted equally large expenditures in FY 2009-10 as well. The deficit for FY 2010 therefore is almost equal to that of FY 2009.

So, why and how is the expansion in the Indian budget deficit significant? And, what could be its implications for the economy and financial markets going forward?

The expansion in the overall deficit is significant just for the fact that it represents more than a doubling of the deficit estimated in the budget - from 2.5 per cent to 6 per cent. It is interesting to note here that we did not have this level of increase in the deficit (as a fraction of GDP) in a single year even during the heydays of deficit budgeting (and monetisation of the deficit) in the 1960s, 1970s and 1980s. Also importantly, the large rise in the overall deficit is a sharp break (on the upside) from the declining trend noticed in the past decade - from around 6 per cent at the turn of the century, the deficit was progressively brought down to levels around 2.5-3 per cent (though with some qualifications, courtesy the oil bonds, fertilizer bonds etc) by 2007-08.

Deficit per se not bad but what is it financing?

To be sure, a government budget deficit per se need not be bad at all. In principle, deficits can serve a useful role by smoothening the path of distortionary taxes over time, particularly over the business cycle. Deficits can be a useful counter-cyclical tool by offsetting the slack in business and consumer spending by enhancing the level of government consumption of goods and services which can then have a multiplier effect in the economy. Longer-term and structural deficits can be justifiable if they finance long-term expenditures (as with an individual who finances the purchase of a home) or if they are expected to pay off in higher national income in the future (as an investment). In a growing economy, even a permanently increasing deficit (if it is not increasing too fast) is sustainable in the long run as long as it is well directed and increases the long run supply potential of the economy.

From this perspective, the Indian deficits do not pass the test. The large rise in the deficit (and the concomitant increased borrowing by the government-up from Rs.100,000 crore to Rs.260,000 crore) in FY 2009 is almost entirely to accommodate a sharp rise in revenue expenditures of around 25 per cent. Overall capital expenditures have been contained at the levels indicated in the budget for FY 2009. In fact, capital expenditures have been near stagnant or declining as a proportion of overall expenditures/ GDP for almost two decades now (this was in response to the fiscal rectitude preached by the IMF, which, in erstwhile years, preferred even essential capital expenditures to be axed).

The favorable multiplier effects of a budget deficit on the economy, to be sure, cannot be denied. But an excessively revenue expenditure driven budget deficit implies that we are simply giving people more and more money to spend without any increase in the underlying productive capacity of the economy. More the money which is handed out for spending in such environment, the less it will be worth in due course (that is, a loss of purchasing power caused by inflation). The revenue expenditure focused Indian budget deficits of the past many years - reiterated so starkly in FY 2009 - and the fairly significant loss of purchasing power for the Indian currency over the past many years (much higher than that implied by a 'stable' inflation rate of 4 to 5 per cent) is a clear case in point.

Direct economic impact of deficits

Another significant and direct economic impact of large budget deficits could be felt in financial markets - particularly on interest rates. Quite simply, a 'crowding out' effect will operate when governments run large deficits. Their draft or claim on overall national savings will be at such high levels that it can 'crowd out' other claimants on the overall national savings. Such other borrowers/ investors (the private sector) will then have to pay higher interest rates to compete effectively with the government for funding.

Of course, a sharp rise in interest rates may be avoided in such an environment if private sector savings rise to match the increased level of deficits or dis-savings on the part of the government, so that overall national savings largely remain unchanged and matchs the level of overall investments in the economy. This assumes rational and forward-looking private sector economic agents - meaning households and the private business sector - who will increase their savings to counter the higher level of dis-savings by the government.

Why should such economic agents increase their savings? Simply because they (being rational) realise that higher government deficits now mean higher taxes (either directly or in the form of inflation) down the road. With increased savings by such agents, there will be no change in the balance between national savings and investment demand. Consequently, there will be no upward pressure on interest rates, goes the argument.

As can be noted, the above theory (called the theory of Ricardian equivalence) is dependent critically on private sector economic agents being rational and forward looking. This is a fairly strong restrictive condition and in practice, has not always been realised.

The Indian experience

In the past decade and more, interest rates on government borrowings and overall interest rates in the economy have declined notably. That has been on the back of rising private sector savings combined with an overall declining trend in the budget deficit (or at least stagnating trend if one factors in off-budget items such as oil and fertilizer bonds) - as pointed out already. The private sector's (household sector plus corporate sector) overall savings rate, for instance, increased from around 25 per cent of GDP in 2000 to 33 per cent of GDP in 2007-08. This served to mitigate the impact of the strain caused by deficit government finances.

As for the immediate future and what is implied for interest rates, one has to wait and see, for the sharp rise in the FY 2009 budget deficit is a clear trend- breaker and could, therefore, lead to different consequences than has been experienced so far. We have to see if the outsized rise in the government's deficit is matched by a commensurate level of increase in the private sector's savings rate. Foreign or external savings can also cushion any strain on interest rates but in the current environment of high risk aversion, this source of funding does not promise much.