[This article was published by the Business Standard  on Tuesday, Oct 31, 2017. The article was written in collaboration with Anmol Agarwal, a classmate from LSE. To read the article on Business Standard, click here]


“We should be very careful lest fiscal actions undercut stability,” said Reserve Bank of (RBI) Governor, Urjit Patel, in response to a journalist’s query on fiscal stimulus packages during the monetary policy conference on October 2017. The Prime Minister’s Economic Advisory Council (PMEAC) has also recently expressed its reservations about a mid-term fiscal stimulus package by the government to revive India’s economic growth.


While critics of a fiscal stimulus cite stability — most notably upside risks — as a key reason against a fiscal stimulus, advocates routinely talk about the famed fiscal multiplier and how it would spur a much-needed economic revival.


Fiscal multipliers were first introduced to the world by John Maynard Keynes during the Great Depression of the 20th century. Keynes had argued that a recession could be curtailed by an increase in government expenditure, fuelling savings and capital formation. For instance, a rise in the government expenditure of $100 would raise the real GDP or gross domestic product of a country by more than $100 and bring it back on the path of economic growth.


Keynes and his policies began to be followed by policymakers all over the world until the advent of Milton Friedman, one of the most influential economic thinkers of the 20th century. Friedman challenged ‘naive Keynesianism’ (as he put it) and argued that a fiscal expansion is highly inflationary even as the neoclassical school argued that fiscal deficits brought about by an expansionary fiscal policy would result in rising interest rates, and a subsequent crowding out of private investment.


These ‘non-Keynesian’ effects of government spending were fist empirically documented in the 1990s in a series of researches published by the National Bureau of Economic Research (NBER), a leading economic research organisation in the US. The authors – Francesco Giavazzi of the NBER and Marco Pagano of the University of Naples Frederico II – studiedthe impact of fiscal contractions and expansions in Organisation for Economic Cooperation and Development (OECD) countries, and analysed their impact of private investment, consumption, and economic growth. The OECD is an intergovernmental economic organisation with 35 member countries, most of whom are high income and can be considered as being developed.


Interestingly, they found that spending cuts in Denmark (1983-86) and Ireland (1987-89) actually lead to an increase in aggregate demand and private consumption, stimulating economic growth. On the other hand, the Swedish fiscal expansion — where Swedish Government Debt to GDP jumped from 25 per cent in 1990 to 67.8 per cent by 1994 — counterproductively led to a fall in private consumption and investment. The authors called the events in Denmark and Ireland as ‘expansionary fiscal contractions’, while the events in Sweden as ‘contractionary budget expansions’.


Simply put, the impact of the fiscal multiplier in these cases was negative. These events were not anomalies as further studies have gone on to show several such outcomes from budgetary changes.


In India, there have always been divergent views about the effectiveness of a fiscal stimulus. An important Keynesian argument to illustrate the effectiveness of the multiplier is that a fiscal stimulus should increase income and eventually spur private savings and investment. Does this hold good for Indian? A look at the chart below suggests otherwise. India’s fiscal deficit as percentage of GDP declined continuously from 5.98 per cent in 2001-02 to 2.54  per cent in 2007-08. But, contradictory to the Keynesian view, domestic savings as a percentage of GDP show a continuous rise, peaking at around 38 per cent in 2007-08 when the deficit was the lowest.


Subsequently, there was a sharp decline in savings in 2008-09 due to the onset of the financial crisis in a situation economists commonly refer to as ‘savings paradox’ — where individuals desire to save more due to increasing uncertainty in the economy, but end up saving less due to a decline in their incomes as brought about by a crisis. Focusing on years after the crisis, fiscal deficit rose continuously from 2010-11 until 2014-15, but savings have been on a downward trajectory, clearly suggesting an absence of a Keynes style deficit–income-savings correlation in 


In the Study of State Finances report of 2016-17, the RBI expressed concerns about how increased market borrowings by the states could lead to higher bond yields and costs associated with borrowing. Even a significant part of the central government’s borrowing requirement is taken care of by market borrowings – based on budget estimates net market borrowings for the year 2017-18 stand at Rs 3.48 trillion, or about 64% of the gross fiscal deficit. Since an increased fiscal deficit is likely to be financed with market borrowings, it is likely that bond yields would rise. Theoretically, this can crowd out private investment and have a detrimental effect on the economy, especially at a time when banks are not willing to lend fearing rise in bad debts and many companies have been raising money from the corporate bond market. There have been several studies, which corroborate the relationship between a fiscal stimulus and higher cost of borrowing, including a 2004 study published by Economic & Political Weekly, where an RBI Economist Rajan Goyal, established the relationship for 



After a sharp fall at the onset of the 2008 financial crisis, India’s benchmark 10-year bond yield had an upward trend until 2014-15 (Source: Authors’ Calculations and Bloomberg)

Even those who advocate a fiscal stimulus acknowledge that fiscal multipliers only lead to economic growth when the increased government expenditure is spent productively. A study by the National Institute of Public Finance and Policy, a New Delhi-based economic policy think tank, in 2012 had found that a capital expenditure multiplier was 2.45, while other revenue expenditure multipliers were less than one. However, if one looks at India’s government capital expenditure, the trend is puzzling. In the years when the fiscal deficit was higher, there was a drop in the government’s capital expenditure. This clearly suggests that the quality of expenditure in a fiscal stimulus may not necessarily lead to an economic revival.


A fiscal stimulus will also have a bearing on India’s sovereign rating. It has been stuck at a low level, being upgraded only once in the past 25 years. On 2nd November 2016, the credit rating agency S&P Global Ratings kept the credit rating for unchanged at the lowest investment grade (BBB-), only 1 grade higher than a junk bond rating, with a stable outlook, citing India’s low per capita income and weak public finances as the major reasons. Moody’s and Fitch Ratings followed the suit, expressing scepticism regarding upgrading India’s rating in the near future.


The issue of consistently low ratings baffles Indian economists. India’s chief economic advisor Arvind Subramanian blamed the agencies for their ‘poor standards’, while India’s Economic Affairs Secretary, Shaktikanta Das, had said that rating agencies were out of touch with India’s reality. Even the OECD threw its weight behind India, suggesting that deserves a credit rating upgrade.


performance, growth prospects, debt position and the state of public finances are some of the key criteria used by rating agencies. With the growth rate sagging, India’s only hope of expecting a better rating in the future is for the government to be fiscally prudent. An untimely fiscal stimulus will lead the government missing the 3.2 per cent fiscal deficit target in fiscal year 2018, dent credibility of the government and ruin chances of upgradation in our sovereign rating. The investment climate continues to be weak – gross fixed capital formation as a percentage of GDP has steadily declined from 34.3 per cent in 2011-12 to 29.5 per cent in 2016-17. In such a scenario, missing the fiscal deficit target may dent the confidence of investors, which in turn, could end up threatening capital inflows.


When a patient is sick, the doctor will always suggest medicines but some of the medicines have side effects and taking too much of them may end up causing more harm than good to the patient. It’s time India’s policymakers prescribed the right remedy for the ills that have been plaguing the economy. Fiscal stimulus is not the panacea.

1. Francesco Giavazzi and Marco Pagano (1990), National Bureau of Economic Research, Can Severe Fiscal Contractions be Expansionary? Tales of Two Small European Countries (http://www.nber.org/chapters/c10973.pdf)
2. Francesco Giavazzi and Marco Pagano (1995), National Bureau of Economic Research, Non Keynesian Effects of Fiscal Policy Changes: International Evidence (http://www.nber.org/papers/w5332)
3. Reserve Bank of (2017), State Finances: A Study of Budgets 2016-17 (https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/0SF2016_12051728F3E926CFFB4520A027AC753ACF469A.PDF)
4. Rajan Goyal (2004), Economic and Political Weekly, Does Higher Fiscal Deficit Lead to Rise in Interest Rates