The fiscal myth: 

The fiscal myth:

Overview

• Slow growth in the last few quarters, with growth in GDP dropping to 5.7% has led to speculation that the government might resort to increased spending to boost economy.
• While there has been no official announcement of a fiscal stimulus yet, government is looking at ways to revive the economy.
• Many have justified the idea saying that in the absence of help from Reserve Bank of India, the government is right to take things into its own hands.

What is the argument behind government spending?

• The argument that government spending can revive the economy and put it on a high-growth path is based on weak economic logic.
• Support for aggressive fiscal stimulus measures comes from the belief that it can put more money in the hands of citizens, thus spurring them to spend and boost demand in the economy.
• This is the famous Keynesian “multiplier effect” that economists talk about as a tool to counter economic downturns.
• Apart from the fact that citizens do not necessarily have to spend the money they receive from the government, the logic of fiscal spending is found wanting on various other levels.

Logic of fiscal spending

• Contrary to Keynesian orthodoxy, insufficient demand is often not the primary reason behind an economic slowdown.
• Instead, it is only the side effect of production shocks, like the chaos induced by the implementation of the goods and services tax (GST), that cause the income levels of people to drop and, in turn, affects their ability to spend.
• Fiscal stimulus does nothing to address the root of the problem, which is disruption in production rather than insufficient demand.
• Fiscal spending is a zero-sum game, wherein resources are misallocated from their original use towards other ends.
• Taxes that the government collects to spend on the economy, for instance, come out of the pockets of citizens who would otherwise spend it according to their own tastes. Such taxes also weigh negatively on an economy that is already reeling under the impact of other disruptions to production.
• When government borrows from the credit markets to fund its spending habits, it distorts the spending and saving decisions of citizens.
• Even when additional fiscal spending is funded, for instance through deficit spending funded by the central bank, the misallocation of resources is unavoidable.
• While fiscal spending is praised for its ability to employ idle resources, it also impedes the movement of such resources towards more productive employment.
• In fact, fiscal spending can artificially prolong a recovery by delaying economic adjustment.

Way forward

To foster recovery, government must undertake pro-market reforms that can help the economy to quickly recover from the shocks of demonetization and GST.