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Economy Jan 27, 2013

Why growth impacts budgets positively, and not vice-versa

By R Jagannathan

Over the next two months, the media will go into a feeding frenzy over the monetary policy, the budget and the economy.

We will be asked questions about whether the Reserve Bank will cut rates, now that the government has made tentative moves on subsidy reform and wholesale prices inflation is falling. The RBI Governor will be praised for cutting rates on 29 January by businessmen and the markets (that is, if he does cut them), and pilloried for doing so by some right-wing monetarists.

Before 28 February, every economist and market analyst will be asked what the finance minister should do in his budget, and, after 28 February, whether he has delivered the budget we need. Will it revive growth or investment?

The truth is no economist knows the answers any better than the man on the street or the average economically-illiterate media hound. The truth is economic forecasting is no different from astrology: a PhD in Economics will not do any better than you or me in figuring out which way the economy is headed or what will happen to inflation after the budget.

The budget itself will do nothing for the economy beyond allowing punters to make or lose money.

When economists get it right, it is often more due to luck that a brilliant forecasting ability. If you have bad luck, no doctorate will be of any use.

Consider how often (never, in the last two years) the likes of C Rangarajan, Montek Singh Ahluwalia, Kaushik Basu, Duvvuri Subbarao, or even our finance ministers, have got anything right on inflation or growth. If such heavyweights cannot get things right, why bother making forecasts?

The PM's Economic Advisory Council headed by Rangarajan forecast GDP growth for 2012-13 at 7.8-8 percent in February 2012. In August 2012, this was lowered to 6.7 percent, and in October this came down further to 6 percent. In December, the RBI noted that "GDP growth is evolving along the baseline projection of 5.8 percent for 2012-13 set out in the SQR (second quarter review)."

If, in less than a year, a GDP projection can drop by more than a fourth, from near 8 percent in February 2012 to 5.8 percent in December, that would be a Rs 3,43,118 crore drop in GDP in absolute numbers given the budget projection of money GDP at Rs 10,159,884 crore.

But this has not stopped the media from asking for forecasts, and policy-makers from making empty guesses.

Today's DNA newspaper has an interview with Montek Singh Ahluwalia, Planning Commission Deputy Chairman, where he said he hoped for 7 percent growth in 2013-14 - i.e. next year.

Growth impacts budgets positively, and not vice-versa. And growth comes not only from what you do in budgets, but outside them. Reuters

He said: "I would like to see it go back to 7 percent. Internationally, most people think it will be 6.5 percent. But I think we will do better than that. How much better we will see after the budget."

The 7 percent hope apparently comes from a policy paper done by a former Planning Commission member, Pranjul Bhandari, who said that the economy's underlying potential even now is 7-7.2 percent. And Ahluwalia says: "Anything below that is sub-par, anything above that is better than par. And if you use that kind of calculation, I think getting back to 7 percent sounds quite good."

There are two underlying assumptions in Ahluwalia's answers that need debunking. That any economist can really estimate the potential of the Indian economy; and that a mere budget can do anything to raise growth above 7 percent.

There is almost no causality between budgets and growth; but the reverse may be truer. Higher growth may help budgets, but better budgets may not make much difference, unless the basics are right over long periods of time. By basics we mean fairly balanced budget-making.

Budgets have been complete disasters over the last four years, with fiscal and revenue deficit numbers being consistently missed ever since the global financial crisis broke out in 2008.

Lest you think Pranab Mukherjee is the villain, let me be clear: they weren't any better in Chidambaram's time during 2004-08 either. The budgets looked better in UPA-1 not because of what Chidambaram did, but because the global economy was on a roll and revenues buoyant.

The conclusion: growth impacts budgets positively, and not vice-versa. And growth comes not only from what you do in budgets, but outside them. The best a finance minister can do is manage his revenues and expenses sensibly. Balanced budgets will send the right signals to the economy that the government will be responsible, and this is what sets the right tone for long-term growth apart from meaningful and consistent reform.

In 2004-08, despite the economy being on a roll, the finance minister missed all his targets. In 2004, the finance minister promised to bring the revenue deficit (the gap between government's revenues minus expenses, excluding capital receipts and expenses) to zero by 2008-09 - a year later than originally planned. But in 2008-09, he again changed the goalposts. And now, it is a distant dream. Our revenue deficit is projected at 3.4 percent of GDP in 2012-13 - a figure that was to become zero four years before. And we have a new fiscal roadmap that promises this nirvana years down the line.

When you don't get where you want to go, the strategy is "change the map."

However, the broader point is about economic forecasting - and not about the inability of our finance ministers to shoot straight to hit even the broad side of the barn. In a complex global economy, it is near impossible to predict with any precision what a given economic decision will do to inflation or growth or deficits. The best mortals can do, even PhDs in economics, is try their best and keep their fingers crossed.

For example:

It is impossible to say if a rate cut will boost growth or merely reduce savings. It can have different results depending on the expectations of investors and depositors and market players. Companies do not invest unless profits are visible from investment. They don't invest just because rates are lower. FIIs may invest less in debt, if rates are cut. On the other hand, if government can borrow more due to lower rates, it would worsen the situation on the fiscal deficit, and send FIIs scurrying out of the country. Why forecast anything in this situation when you know you can't presume anything?

It is impossible to predict whether the Indian economy will grow faster or slower next year if we cut subsidies by raising diesel prices. Across-the-board increases in fuel prices, which will surely be followed by power and transport costs ratcheting up, will push up the inflation indices and general prices. But we don't know if consumers will see rising prices as reason to cut consumption or increase it, since it would depend on whether they think prices will go higher or lower. Companies will certainly see lower demand, but they will invest if they see growth picking up a year later, and not do so if they think there is no room for optimism.

Nor can we be sure what growth itself will achieve. Growth in the Indian economy was lower in 1999-2004 than in the next five-year period. But 92 million jobs were created in the first period and only 2 million in the second. Did people use higher incomes to opt out of jobs? Or did more people opt for longer schooling to improve their jobs prospects? Or did the government's social sector handouts merely lead to more jobless growth? We don't know anything for sure.

The bottomline is this: economic forecasting is a mugs' game, not a real science. And budgets cannot achieve much by themselves.

The only things we can really predict are the long-term consequences of the actions of policy-makers, not the short-term one.

For example, if governments keep overspending and living beyond their means, we can be sure that some inflation will result. What we cannot forecast is whether inflation will rise next year or the year after. Or whether higher interest rates will bring it down.

When governments overspend over even longer periods of time - like the US and Japan have been doing, and which we have been doing after 2008 - economic repression (debasing money though excessive note printing and inflation) will be the only consequence. It does not matter whether the overspending is justified in the name of the aam aadmi or something else. There is no escape for anyone from the consequences of continuous overspending.

If an individual overspends, he has to cut down expenses to make ends meet. If he borrows to consume, he has to either earn more or cut expenses in future to pay back. He can also borrow even more to pay back old lenders. But ultimately, nemesis will catch up.

Governments are exempt from this law only because of the note-printing presses. But they damage the economy's underlying strengths in the process. This is why all forecasts are going wrong. This is why government economists do not even have the luck of the streetside astrologer in predicting economic numbers.

The lesson: government should reform more and spend less. Growth will follow. And budgets will take care of themselves.

by R Jagannathan

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