The other side of fiscal deficits

Sashi Sivramkrishna

The Union budget announced in February 2020 had set the fiscal deficit target for the year 2020-21 at 3.8 percent of GDP.  Apprehensions over the ability of the government to achieve the deficit target were already rife at that time.  The outbreak of the Covid-19 pandemic and the lockdown which ensued in late March have only raised concerns over the deficit even as the government struggles to achieve a balance not only between lives and livelihoods but also between livelihoods and fiscal constraints.  While most economists are sympathetic to the situation of unemployment and the need for fiscal measures, it comes with the usual caveat over the possible burgeoning of the deficit.  Given the predicament that we are in presently, it is critical to deepen our understanding of fiscal deficits so that misplaced fears over a widening deficit are allayed and the government can instead shift focus to issues pertaining to the real economy.

Sectoral Financial Balances

Without an accounting perspective most mainstream macroeconomists fail to grasp the essence of modern money as a financial liability – a promise to pay – which is then a financial asset to someone else.  The most pertinent manifestation of this unknowing is fear over fiscal deficits.  Few economists talk about its “other side” – accumulation of financial assets. This accounting fact is the basis of the sectoral financial balances (SFB) equation, which states that net financial asset accumulation (NFAA) across the three sectors of an economy – the government, the foreign sector and domestic private sector (DPS) – must sum to zero, where net implies external to that sector.  Positive DPS NFAA is then possible if and only if either the government and/or the foreign sectors are accumulating net financial liabilities.  While a fiscal deficit implies that the government is accumulating financial liabilities, a current account surplus (deficit) implies a net outflow (inflow) of capital from (into) the country implying accumulation of financial liabilities (assets) by foreigners.  It is possible that DPS may accumulate net financial liabilities or what is called leveraging, when at least one other sector is accumulating net financial assets; however, this cannot be sustained indefinitely as the private sector must repay its debt over a finite time horizon.  Only economically sovereign governments can issue liabilities, perpetually.

NFAA is an important component of the DPS’s savings portfolio since physical assets like gold, land and property can not only lose value but are also susceptible to theft, encroachment and so on.  While financial assets are safer and more convenient to hold, DPS would usually desire to hold financial assets both within and outside the private sector. The former consists of equity, debt and deposits.  However, these financial liabilities within the private sector are ultimately backed by physical assets, which are prone to capital losses and default arising from risk and uncertainty.  This induces the private sector as a whole to seek financial assets outside the private sector.  The only safe financial assets are the liabilities of the government – the only liabilities not backed by physical assets but by the ability of the state to issue its own currency.  In India, these financial assets, i.e. government liabilities include public provident fund (PPF), government bonds and bills, national savings certificates and so on.  The desire of DPS for NFAA is a key determinant of macroeconomic outcomes and cannot be ignored in understanding India’s present predicament.

The pre-pandemic situation

While the SFB equation does not establish cause and effect, it provides a useful analytical tool to explore possible context-specific macroeconomic scenarios. A study of the evolving trend in sectoral financial balances can allow us to make relevant extrapolations into the future based on present situations.  Drawing upon institution-wise savings and investment data we find DPS NFAA was increasing since 2010-11, remaining at more than 6 percent of GDP since 2015-16; a clear indicator that India’s DPS was steadily deleveraging.  This desire of DPS for NFAA as well as that of the foreign sector to hold domestic assets (through current account deficits) had been accommodated by the government’s large general fiscal deficit (centre, state and off-budget deficits), which was mostly in the range of 7 percent to 9 percent of GDP since 2010.

The SFB equation provides a clue to the possible consequences if drastic austerity measures had been implemented to contain the general fiscal deficit from its 8 percent level in 2018.  A severe slowdown, or more likely a recession would have ensued to contract savings so that NFAA decreased.  However, if DPS were to continue to desire NFAA at about 6 percent, it would raise its propensity to save or cut back investment spending.  Either of these responses would have forced the Indian economy down a vicious spiral.

The decomposition of DPS into household (HH) and private corporate sector (PCS) further provides some critical insights into weaknesses in the Indian economy, pre-pandemic.  First, PCS was unequivocally deleveraging between 2011-12 and 2017-18 by increasing its savings from 9.5 percent to 11.6 percent and cutting back on investment spending from 13.3percent to 12.1percent of GDP.  This amounted to a decrease in leveraging (deleveraging) or de-accumulation of net financial liabilities by more than 3 percent.  Second, the HH sector (which includes non-corporate private sector enterprises) data shows NFAA having marginally decreased from 7.4 percent to 6.6 percent over the same period.  However, this should not be considered as a sign of leveraging since household savings and investment rates show a drastic decline by almost 5 percent each.  The savings rate for HH fell from 23.7 percent to 17.2 percent while investment rate fell from 16.3 percent to 10.6 percent during this period.  This sharp contraction is probably due to a sharp decline in savings and investment in property by households in addition to a decline in investment spending by the non-corporate MSME sector.  Although data availability is limited to 2017-18, it is likely that DPS has probably gone through an even more significant deleveraging cycle since then given the overall decline in GDP growth from 7 percent to 5 percent.

Even prior to the pandemic, India’s situation seemed akin to a “deflating balloon” (exports as a percentage of GDP have also witnessed a steady decline since 2013), driven by a desire for a high NFAA emerging from an overall lack of robust confidence in the private sector.

 The post-pandemic situation

The post-pandemic situation is likely to witness faster and more aggressive deleveraging by DPS.  Private sector investment, which was already showing a dismal trend, will only be further dampened by the simultaneous demand and supply shock inflicted by the pandemic.  Furthermore, given the uncertainty over jobs, salaries and wages, the propensity to save by the DPS is also likely to increase.  While some of these savings will find their way into stock markets, savers will also consider physical assets like gold.  However, the safest asset, in terms of nominal returns, default risks and capital protection, are central government securities. The reported surge in demand for the 7.75 percent Government of India bonds (which was recently suspended) and even for state government bonds (although not equal in safety to central government securities) indicates that the private sector is deleveraging and looking for relatively safer avenues to park their savings.

With the external sector almost in balance, this increased desire for private sector net savings must be accommodated by the government. In other words, a continued and substantial general fiscal deficit is required to satisfy the DPS’s desire for financial security or NFAA.  Any drastic attempt at austerity will drag the economy through the “paradox of thrift” – wherein the higher propensity to save ends up in a lower quantum of savings – into a vicious downward spiral, resulting in a deep recession or even depression.  If a larger fiscal deficit with higher government spending and tax cuts, which accommodates DPS desire for NFAA, manages to revive aggregate demand, it could induce an uptick in private sector investment and consequently, a phase of leveraging.  This best-case scenario, however, can only be expected to play out in the longer-term when the effects of the pandemic have ebbed.