The real meaning of fiscal deficit. and why it should be under control

In the recent budget, the finance minister, Mr Pranab Mukherjee has sought to give the impression to the media and the general public that he has heroically cut the fiscal deficit even as he has handed out lollipops to the middle class in the form of widening of the income tax slabs. We need to understand why the deficit matters instead of getting lost in the numbers.

A huge fiscal deficit means the Government has to bridge the revenue expenditure either by borrowing from the market or by printing money. if the Government borrows, the private sector will be crowded out, ie it will be able to borrow less at the current interest rate. And we all know the Private sector, driven as it is by the profit motive, uses capital more efficiently than the government.

On the other hand, if the government prints money, it will lead to more rupees chasing the same quantity of goods, leading to inflationary pressures.

Sound principles of economic policy making dictate that during the good times, the Government should build budget surpluses that it can run down during recessions. This is exactly what is happening in the US where the deficit as a percentage of the GDP has reached double digits.

In our country, there was a minor slow down after the collapse of Lehman Brothers in September 2008. So there was probably a case for increasing the deficit in the last budget to make up for the reduced global demand. But today, there is little justification.

The developed countries have to be cautious about how they withdraw the fiscal stimulus because the recovery there is still fragile. However, this argument does not apply to India. We must also remember that notwithstanding the Finance Minister's claims of having the deficit well under control, if all the items like the shortfall on the oil account and the deficits of the states are considered, our country's deficit would also be running into double digits. That is why it is a little funny to see so much premature celebration over Mr Mukherjee's deficit cutting efforts.