The Economics supports the Minimum Wage Movement


McDonald’s workers stage protest in Oak Brook, Illinois. Source:

On May Day, the Mayor of Seattle proposed raising the minimum wage in Seattle to $15 an hour. A similar demand has been raised in many parts of the world by workers in the Fast Food industry demanding they be paid at least a $15 an hour minimum wage. In my estimation, in a time when inequality has been emerging as a major policy challenge all over the world, these movements (like Low pay is not okay) are very welcome. Predictably, the naysayers have emerged out of their mansions, slamming down the drink they were nursing with a sense of urgency. And the usual suspects in terms of the arguments against a hike in minimum wage have been out in full strength. So, I think it would be worth my while to spell out the opposition, and argue why the arguments thus presented are fallacious.

The main reason that is cited against raising minimum wage (or were cited against having a minimum wage at all- but thankfully, that battle has been won) are that, while minimum wage would make the people who have jobs better off, it would discourage businesses from hiring more workers, and would in fact encourage them to fire some workers, thereby reducing the total employment in the economy. The economic rationale behind this is as follows:

When making a decision about how many workers to hire, an entrepreneur tries to ascertain whether it will be worth her while to hire the additional worker. Hiring one more worker would do two things: the new worker would contribute to the production process. However, the additional worker would also have to be paid a certain wage. In general, if the value of the additional workers contribution to output is greater than the amount that the worker will be paid, it makes sense to higher the additional worker. I would stop hiring additional workers at the point where the contribution to output equals the wage that is paid to them. Now, in general, it is argued, as a business hires more and more worker, the contribution of the individual worker to the value of the total output falls. This is called the Law of Diminishing Marginal Product (the jargon for the contribution to production of output made by an additional worker is ‘Marginal Product’). So what we then get is a relationship between wages that are paid to the workers, and the number of people businesses would want to hire: given all other things, as the wages that are paid to the workers rises, I hire less workers, since the additional contribution of a worker is higher at a lower number of total workers. Okay, I know that sounds a little loopy, so I’m going to draw a diagram to make that easier.


The Marginal Product of workers fall as more workers are hired. Therefore, as an employer, I would only hire more workers if I could pay them less. On the other hand, as a worker, I would work more as a higher real wage is paid to me. The classical argument says that the imposition of a Minimum Wage would lead to a lower number of workers, N’, being employed, as compared to the number of workers, N, in the absence of minimum wage.

The story, I’m afraid, isn’t complete yet. Bear with me. Now, as far as people making a decision about the participating in the labour market are concerned, if wages are higher, more labour is supplied, and if less wages are being paid, less labour is supplied. So basically, as you can see from the little diagram,  demand and supply for labour interacts in the labour market, so that in equilibrium, the number of people that are employed are N, at a real wage of w/p. Note that the people employed are paid a wage that is equal to their contribution to output.

I’m going to go on a teeny tiny digression to explain what a real wage is. When workers bargain for a wage, they primarily care about how much they can buy with their wages. How much they can buy depends on the amount of wages they get in terms of money, and the prices of the things they are buying. In order to capture this, we complicate matters by defining a real wage: the value of the goods that can be bought with the money wage. We get this by dividing the money wage by the price level. Both workers and entrepreneurs care about the real wage and make their decisions based on it.

So now, we have all the tools to explain the argument against minimum wage. Without a minimum wage, the real wage rate and the level of employment is determined by the demand and supply for labour, as was shown in the diagram. If now, the government mandates that all employers must pay a minimum wage to its workers, a lower amount of labour would be demanded, while a higher amount will be supplied. The employment would fall from the level that was determined by the market, and while the people employed receive a higher minimum wage, fewer people will be hired.

That being said, this is not the way employment is determined (I borrow from Keynes’ General Theory in explaining this).  A small indication of this fact is that we cannot really speak of a supply curve of labour with supply related to real wage in the same way we can speak of labour demand. The supply curve as drawn would mean that as real wage is higher, more labour is supplied, and if real wage falls, less labour is supplied. However, while I may be able to say that with certainty as far as money wage is concerned, I cannot say the same for real wage. This is because if it were the case, every fall in real wage should bring about a contraction of the labour supply, even if the fall of real wage is coming from a rise in the price level. We do not typically find a contraction in the supply of labour with movements in price level (unless it proceeds to an extreme degree). So then, how else is employment determined?

Yes, that is the real question. Now, the thing that a business owner is concerned with, first and foremost, is her profit. Given the technique of production, and the wage rate, the amount of employment that a business decides to create depends on the amount of proceeds that the entrepreneur can expect to receive from the corresponding output. These proceeds depend crucially on whether what they produce will be demanded. And the demand of this commodity, and analogously, demand in the economy as a whole will depend on the level of consumption and investment in the economy. The demand determines how much the entrepreneurs should produce, which in turn determines how many workers should be employed in the economy as a whole.

So basically what I’m trying to say is that while raising the minimum wage certainly affects the costs that an entrepreneur has to incur, but there isn’t a unique relationship between the minimum wage and the level of employment. Therefore, it does not lead to a significant loss of jobs as Classical Theory predicts. If the level of demand were higher, more output would be produced and more people would be employed despite the higher minimum wage. Conversely, if the level of demand were lower, employment cannot be increased by lowering the minimum wage. Moreover, raising the minimum wage will increase the demand, especially for things such as fast food. Keep in mind that I’m making this argument while continuing to assume that workers are paid their marginal product. If this is not the case, that is another reason to ensure that workers are at least paid a basic minimum wage.

To conclude, I think raising the minimum wage would be a splendid idea. It is important to empower workers in the economy to earn at least as much as is necessary to live at a reasonable basic minimum standard of living. Not only will this empower more people to not be dependent on various kinds of state support, it can go a long way in reducing poverty and inequality. As far as the minimum wage hike in Seattle is concerned, here’s an article to put things in better perspective. And anyone interested in this question should most certainly watch this video. Bob Pollin makes a great case for a higher minimum wage.

Update: Here is an article that gives us a list of studies that have found that hiking the minimum wage does not adversely affect employment. 


Giffen Goods and the Real World: On the teaching of Economics

Way back in the day, when I was a still-wet-behind-the-ears undergrad, I lent my book, ‘Principles of Economics’ by Gregory Mankiw to my friend. I have this system of keeping borrowed things until you’re no longer lazy enough to return it with her.  Several books have adorned my bookshelf this way. So I recently, as a still-wet-behind-the-ears “post-grad”, I got it back. And it brought back fond memories. I really enjoyed this book when I first read it. It is very well written, and it is pretty much the primer for ‘basic’ principles taught to undergrads in economics. Flipping through it, I came across something that every Economics student knows about: Giffen goods.

The concept of Giffen goods is taught as a special case in demand and supply analysis. Giffen goods violate the law of demand. The demand for these goods, named after Robert Giffen who noted this possibility, increases with the increases on the price of these goods. The idea is that these goods are so inferior, and less desirable with a rise in income. However, when the price of these goods rise, given the income of the consumer, the amount of goods that can be bought with that income falls; in economic terms, the real income falls. As a result, the ability to afford the other, more desirable goods falls, and therefore, more of this inferior Giffen good is consumed. So, if the price rises, so does the quantity consumed. In general, the law of demand would stipulate that the quantity demanded of a good will fall with an increase in its price. And voila, we have the favourite anomaly of undergrad level microeconomics.

The classic example for the purposes of exposition of the concept of Giffen goods is that of meat and potatoes. In this scenario, potatoes are supposed to be the Giffen good. In Mankiw’s words, “Some historians suggest that potatoes were in fact a Giffen good during the Irish potato famine of the 19th century. Potatoes were such a large part of people’s diet that when the price of potatoes rose, it had a large income effect. People responded to their reduced living standard by cutting back on the luxury of meat and buying more of the staple food of potatoes. Thus it is argued that a higher price of potatoes actually raised the quantity of potatoes demanded.”

However, it is admitted by Mankiw in the very same breath that this may not be true. In fact a mere Wikipedia search will inform the reader that goods have only been established as Giffen goods under very restrictive experimental conditions. Yet, I’m pretty sure everyone who has ever studied Economics would know about the concept. However, the very conditions that have been used to explain the concept are not known as commonly. The Great Famine in Ireland that began in 1845 was one of the worst famines in recorded human history. One million people died as a result, and many other emigrated. As a result, the population of Ireland, that stood at 8 million, declined by about 20-25%. Also of note is that the price of potatoes rose in this episode rose as a result of scarcity arising from potato blight, a disease afflicting potato crop, which made them inedible. However, at the same time, Ireland continued to produce plenty of food grain that was then exported to Great Britain. This food grain, it is estimated, was sufficient to feed the Irish population.

This begs the question: if people in the country were dying of starvation, why were the food grains that were being produced in plenty being exported to another country? At this point, I want to stand up for dramatic effect and say “A-ha! Precisely”, and that’s because, as students of Economics, we weren’t taught to beg this question. The role of the feudal production structures and the long history of British colonization of Ireland is not, in general, discussed with students of economics. Surely, this glaring fact is far more valuable than studying about a triviality that has perhaps no real relevance and very little theoretical significance as well. I’m not saying that studying consumer behaviour is not important; studying economic history is equally important. Maybe if students choose to do a course on Economic history, they’ll get a flavor. But every student who studies economics, whose brain is branded with demand and supply curves to begin with, is more likely than not know very little about economic history. The point very simply is that Economics is taught more often than not in a vacuum, devoid of context to a large extent. And this has been done so for a very long and sustained period of time. So there will be people who would have a degree in economics, maybe even two, and not know anything about the history of colonialism that has had a profound impact on the very things that economists study today: poverty, disparity in development between countries etc. But they will know about Giffen goods. Right.       


Fama, EMH and the Nobel

So I reckon it would be safe to say that this post is a tad bit late. The Sveriges Riksbank Prize for Economics in Memory of Alfred Nobel, colloquially known as the Nobel Prize in Economics was announced about a month back. And frankly, I was stunned. I’m not naïve to think that the Nobel Prize is really, as Robert Shiller (one of the recipients of this year’s prize) put it, “designed to reward those who do not play tricks for attention, and who, in their sincere pursuit of the truth, might otherwise be slighted”. Frankly it has little credibility as is argued very convincingly here. But I was still stunned as to the fact that they’ve completely dropped the pretense of trying to award the “sincere pursuit of truth”. While I’m not very familiar with the work of Robert Shiller or Lars Hansen, I am familiar with the work of Eugene Fama, and its implications. Giving him the Nobel, however flawed a recognition, is just really unacceptable.

Why do I say so? So Eugene Fama’s most celebrated work, called the Efficient Market Hypothesis (EMH), claims that financial markets are such that prices of financial assets fully reflect all information that is available in the market. In this sense they are efficient. So this mean that prices of assets are such that no one investor can systematically make higher than average returns in financial markets. This also means that financial markets left to the dynamics of the market mechanism function in the best possible way.

I’m going to let the crickets chirp in your stunned silence for a bit.

No? Okay, here’s the first problem. Just about five years back we witnessed one of the biggest financial meltdowns in history which had worldwide repercussions, the effects of which we are still feeling to this day. How, in the face of that, can someone hold up this theory as credible is beyond me. It can be argued, and in fact has been argued, that this failure was a result not of problems with the market mechanism, but with policy intervention. Thus if we had just let the markets be, this never would have happened. However, this argument does not hold water, as the fact is that financial crises have occurred again and again and again. And again. Influential work by Reinhart and Rogoff highlights eight centuries of the history the financial system. And this history is littered with incidents of crisis.

But I digress. Clearly this wasn’t enough for the Nobel Committee. So I decided to look at his influential 1970 paper and work around it again. And while I do not claim to have fully understood all its technical aspects, nor do I claim to have read all of the literature surrounding the EMH, a few things scream out as problematic. Briefly, they are as follows:

  1. The efficient market hypothesis in its original form looks at the movement of prices over a very short period of time- one day, four days, nine days. In such a short period of time, the movement of prices is more likely to appear random. This is the case with any quantity that we want to observe statistically. It is why we consider trends in data: does that data display a tendency for movement in a particular direction? Does it exhibit a pattern? There are a variety of statistical tools that can allow us to observe patterns in data. As per Fama’s hypothesis, prices should not depend on the price of the assets in the previous period, or on the previous day. So any time series data set on prices should exhibit random fluctuations in either direction. However, I think, this is the case with any price data-specific events or factors on a particular day may cause a random fluctuation. But this variable can still exhibit a trend.
  2. The reason that observing a trend would be significant is that then there can be systematic increase or decrease in asset prices. This would suggest the possibility of an asset market bubble which have been observed frequently. A bubble is an event in which prices systematically differ from what is believed to be the fundamental determinants of price. That these bubbles are about excessive movements in price, and that they are prone to collapse, point towards inefficiency. To put it in Fama’s terms, it means that prices can be such that all available information in the market is incorporated into the price, and yet the price that is determined is not right.
  3. However, in another more recent paper, he acknowledged that over longer periods of time, other scholars have shown that market efficiency does not hold. In response, he blames the methodology adopted by these scholars. In Fama’s original work, he suggests a way of representing market efficiency is as follows

E(Pj,t+1|It)= [1+E(rj,t+1|It)]Pjt

        where E is the expected value operator; Pjt is the price of security j at time t; Pj,t+1 is its price at t+1; rj,t+1   is the one-period percentage return (Pj,t+1 – Pjt)/ Pjt; and It is a general symbol for whatever set of information is assumed to be “fully reflected” in the price at t.

So in his paper addressing concerns about the EMH over a period of time, he argues that the deficiency arises because of this formulation. However, problems with this formulation does not necessarily imply a problem with the EMH. He then goes on to argue that even if the work that has been done introduces doubts about the EMH, no other alternate model for price determination gives a reasonably testable hypothesis in this regard. But, clearly that is a criticism that can be leveled against the EMH in Fama’s formulation as well for any problem with it is a problem with the particular form market efficiency is assumed to take. But then market efficiency itself reduces to a hypothesis that cannot be tested.

4. Fama ignores a very important aspect of financial markets, that all relevant information is never and can never be fully available. In fact information imperfections characterize financial markets. Moreover, there are incentives at work in these markets that ensure that all relevant information will be revealed, unless an exogenous regulator mandates such disclosure. So then either the EMH reduces to the maxim that that whatever information is available, however imperfect or asymmetric, gets efficiently incorporated into the price (even if the result is eventually disastrous).  Not a very profound conclusion, in my opinion. Or it is the case that the EMH does not hold.

Of course, this criticism is preliminary at best as I myself need to examine some of my claims against data. And I will be doing that in the very near future. Watch this space.

Raghuram Rajan is incredibly hot, and it isn’t just Shobaa De who thinks so

Dr Raghuram Rajan was recently anointed Master of Monetary Policy, the Grand Puba of money supply, the Big Cheese of interest rates, and the King Arthur primed to pull out the sword of regulation from the financial system which is almost always between a rock and a hard place. To say that this elevation came amid much fanfare would be the biggest understatement since when the rupee started its virtual free fall. The arrival of the dapper doctor has been welcomed in so many quarters with a certain messianic quality that this post was right up the alley in satirizing the whole thing.

But then, people started taking this very seriously. Every business newspaper page that was turned and every link related to news related to the economy that was clicked sang paeans about this man. Armed with his fancy degrees and stints as the Chief Economist at the IMF and as the PM’s Chief Economic Advisor, he is being touted as the savior of the economy. And his mere arrival and announcement of reforms (read deregulation) seems to have arrested the slide of the rupee and the fall of the Sensex. True to his IMF credentials, he has promised measures to ease profit making for finance.

However, it is funny that this is the case: it is no longer the accepted conventional wisdom that liberalizing finance across the board is the best way to go. We’ve seen this repeatedly blow up in the faces of policy makers around the world. The reason this is the case that financial markets are the prime examples of market functioning with imperfections. They are characterized by asymmetric information. Simply put this means that I, as a lender do not have full information about the borrower, his or her business acumen, and the profitability of his or her project. Additionally, financial markets are characterized by Incomplete Information: no one knows what the future holds, and hence all returns on investments are uncertain, and may not materialize. These two facts make financial markets especially prone to failure. So, these measures that he is taking may well blow up in everyone’s face. But who needs caution when we have Guvernator Rajan?

Even if it wasn’t the case, it is important to note that he hasn’t actually done most of the things he is promising to do. And we most definitely do not know what will result (incomplete information). Yet, there’s an unnatural exuberance around him. And that’s almost exclusively because of who he is: a foreign educated management Prof, who has been known to advocate the liberalization of financial markets (which incidentally allows finance capital to make ridiculous amounts of profit, often at the expense of the small saver), the former Chief economist of an organization that also advocates similar policies.

But we have many other such people in similar policy making roles with those credentials: the PM, and the Deputy Chairman of the Planning Commission to name a few. What makes the arrival of Raghuram Rajan so special? I think this may be due to the fact that big business does not like the expansion of government expenditure. So fiscal policy, that these people are effectively in charge of, is something that big business wants tightly controlled. And the PM, and Montek Singh Ahluwalia have fallen out of favour precisely because of their inability to do so. Therefore, any hope of economic revival rests on monetary policy.

So the upshot basically is that Raghuram Rajan is unbearably hot. Shobhaa De’s scribble in her very public diary was, while amusing, simply symptomatic of similar wet dreams finance capital has about Raghuram Rajan. It’s like when Obama’s government was given the Nobel Peace Prize right at the beginning of its term. And we all know how that turned out.

Securing Food Security II- Economic ‘Wisdom’ down the drain?

(Slightly technical, but people who haven’t studied Economics should be able to follow. Also, I think I might have made up a word in this post. Brownie points (possibly actual brownies) for spotting it.)

Yes, a mind boggling-ly large number of people in India have very little to eat. Yes, health indicators paint a really bleak picture. These people need food security. But, what about the fiscal deficit? It messes with the economy, stupid! Can’t you see?

A few things can be said in this regard:

The Food Bill is not the cause of, nor is it significantly adding to the seemingly intractable economic woes. The problems that the Indian economy is facing today are slowing growth, a persistent inflation and a declining currency. There has been much fear mongering that the Indian economy is on the brink of a crisis a la 1991. The popular opinion is that fiscal deficit is (ironically) public enemy number 1, as it is not only a barometer of wasteful expansion by of the state machinery, but it is stifling productive private investment (the good old crowding out argument) and raising current account deficit, which is leading to a depreciation of the currency. But there are some problems with this argument:

  1. The maxim that public expenditure crowds out private investment which can result in higher growth in the economy is based on a crucial assumption which in economic jargon is called full employment. This basically means that we are assuming that all the resources in the economy are fully employed in the process of production and therefore, the maximum output that can be produced in the economy is being produced. This output, thus, cannot be increased in the short run. The cheesecake (I am tired of the pie analogy), ladies and gentlemen, cannot be bigger. Therefore, when the government increases its expenditure, it is eating a greater slice of the cheesecake, and leaving crumbs for private firms which bring the productive investment to the table. You know, the real McCoy. This assumption of the economy being at full employment is obviously gobbledegook. There is unemployment in the economy, and unutilized capacity. I mean, the fact that there is disguised unemployment in the agricultural sector is taught to school children like THE universal truth, at the same level as 1+1=2. So when the government increases expenditure, it is making a bigger cheesecake, and enabling the private sector to add more cream cheese and the blueberry topping; it is crowding it in. In fact, this has been documented by many studies for developing nations, and India in particular.
  2. A higher fiscal deficit does not lead automatically to a higher current account deficit. This automaticity is also based on the assumption of (surprise, surprise) full employment, which as I said, is codswallop. Once we remove this automaticity, fiscal deficit can raise current account deficit is if the government is spending on the things that directly increase imports. There’s obviously oil. But let’s face it, whether the government buys it or not, that oil would be bought regardless, and would contribute to the current account deficit. The problem is the ridiculous amount of gold we import and that the economy’s exports are at a laughable level.
  3. The currency is declining not directly because of the fiscal deficit, but because of the foreign capital that is beating the retreat in response to the signals in the US economy, and because of the structurally high current account deficit.
  4. And finally, a higher fiscal deficit is not necessarily inflationary. If we were at full employment, then Milton Friedman’s monetarism rules the world, and any increase in government expenditure will push up prices. However, if that is not the case, then an excess of government expenditure over taxes (the deficit) is no different, in principle, from an excess of private investment over private savings. I don’t see people making the argument that private firms borrowing and incurring investment expenditure is inflationary. So why should that be the case for the government?

All of the above are pretty standard Keynesian arguments, but I think they needed to be repeated. The point, very simply, is that as far as the FSB is concerned, fiscal deficit per se is not a problem. There are other problems, as I have highlighted here. (However, very high levels of deficit are not sustainable for a variety of reasons, such as the one presented here).

Securing Food Security I- The FSB Not Necessarily the Panacea

As is commonly known to everyone who isn’t living under a rock, the Lok Sabha and the Rajya Sabha passed the Food Security Bill recently, taking the bill a couple of steps closer to becoming the law. Under this new legislation, 67% of the Indian population would be eligible to receive 5 kg of wheat, rice or coarse grain per month at Rs 3, 2 and 1 respectively. In addition to this, the bill makes special provisions for the provision of meals to pregnant women, and lactating mothers as well as children between the ages of 6- 14 years.

Economists of all hues and orientation have been debating the merits and demerits of this bill. Some argue that the bill in its present form is not enough, while others argue that this is just condemns the economy to all kinds of fresh hell. I have addressed some of those arguments in the next post, but first, here’s something else.

I think that the Food Bill is not THE solution to the problem of hunger, starvation, and poor health indicators.

As far as I understand, the Food Security Bill seeks to extend the existing Public Distribution System. But I think the problem lies in the very nature of the Public Distribution System itself. Intervention by the State should be such that it benefits the poorest of the poor in a way that reduces their immediate problems of not having enough to eat. But at the same time, State intervention must make the people self sufficient and less dependent on the State largesse itself. No, I am not making the ridiculous argument that giving people food for free will make them lazy. But apart from just giving people food, the intervention should empower people to put food on their own table. My parents worked hard and provided our family with food. Given this, I will be able to do so as well. However, through historical accident, it so happens that the generations of my family have on an average been more fortunate than the destitute people in our country. It has thus been easier for my family, and many others like mine, to provide for itself. Therefore, the State is a hundred percent justified in attempting to ease the suffering of the destitute. But I think it should be done in a way so that they can, by standing on the shoulders of the state, provide form themselves as well.

All of the above sounds great. But is this possible? I think that this could potentially be done by trying to create self sufficient communities on the back of a reformed PDS. The PDS could take the form of decentralized procurement and distribution of food grains where the local forms of government are given greater control. As of now, the Central and State governments play the pivotal role in procuring and distributing wheat, rice, some coarse grains and pulses. In my opinion, this role should be decentralized, and given in the hands of the local administration.

The local administration could then procure the relevant agricultural commodities from local producers. And the relevant commodities need not only be massive amounts of wheat and rice. Different parts of India have different staple diets. In some areas, coarse grains are eaten in a larger quantity vis-à-vis wheat and rice. And it is often the case that the staple of a particular region is closely related to the crops that have been grown historically in that region, and are likely to be better suited to the soil. So not only can this provide a local market to farmers, but can also incentivize the production of crops other than rice and wheat. Where the relevant commodity is not produced locally, higher levels of government can step in and fill the gap.

PDS also faces the problem of massive loss in produce during transportation and because of grossly inadequate storage facilities. Local procurement and distribution can significantly reduce the wastage and cost escalation associated with transporting grains for long distances. As far as storage facilities go, they can be built as required under MNREG scheme. This way, not only will more people be gainfully employed, but the production, procurement, storage and distribution of food will be placed directly in their hands, or the hands of the people who are directly accountable to them. The community then has a large stake in the efficient operation of this scheme.

This obviously does not eliminate the subsidy burden, and I cannot say, at this stage, that this will certainly reduce the food subsidy burden. However, food subsidy per se is not the problem. The fact that a large part of the food subsidy is wasted is the bigger problem.  Yes, it will contribute to the fiscal deficit, but as I have argued here, this particular government expenditure need not sound the death knell for the economy.

So the upshot is, that we have a flawed programme. Extending it will be a bad idea. Not only is it not likely to significantly improve health indicators, but it will make a larger number of people dependent on a State dole. And the crucial point is this: that this is a dole programme. Do not get me wrong; I don’t mean this in the pejorative way dole programmes are considered nowadays. However, the State should facilitate self sufficiency among its people, or at least communities, so that they are not completely dependent on an exogenous factor to provide something as fundamental as food security.

Thoughts On The Brouhaha Over The Budget And The (Not So) Final Word On Fiscal Deficit

Thank God it’s over. The Business section of almost ALL newspapers have been obsessing over the budget for what feels like a lifetime. Reports of last minute lobbying and columns suggesting what the Finance Minister- loved by the markets for his “reformist zeal”- should do, were all over the place spreading their gyaan as to what the Indian economy REALLY needs. Sigh. Thank god that’s over. I could only take so many versions of “rein in the fiscal deficit”.

Now while I have not been through the budget speech-but I’m pretty sure tomorrow’s paper will leave me no choice but to do so- I hear that the Fin Min with the reformist zeal has disappointed. He increased taxes on the super- rich, and made some promises of increasing government expenditure. There have been measures to rake up the revenues so that the some hope for the movement of the revenues and expenditure towards some semblance of an intersection remains.  However, commentators argue that political calculations, with the elections not very far, kept the budget from realizing its potential in terms of finally bringing the economy on the right track, and the government assuming its correct position: as a facilitator and not a major player in the economy.

I used to think that this mania and obsession with the government deficit is really idiotic. I mean, it is the government, and not a corporation. As the government it has certain roles to fulfill; as the government of a developing country in the midst of a global recession that may or may not be over, the government needs to make sure that growth can be brought about. I believe that the alleviation of the appalling state of penury of a massive section of the population depends on it. This entails government expenditure. Private firms can also spend. But they are crucially different from a government in two ways- firstly, they will only spend if they are likely to make a profit, and secondly- they can only spend as much as they earn, or within reasonable limits of what they can hope to earn in the future. Otherwise firms go bankrupt. Governments on the other hands CANNOT GO BANKRUPT. They spend out of consideration other than profit. And, they can raise taxes, print more money, borrow from the market, or from other nations and/or international organizations in the event their revenue is not enough to cover expenditure. This money can then be used to engender growth, thereby creating resources for sustaining this growth and maintaining a reasonable deficit. The deficit in itself is not bad news. Or so I thought.

The reason I see the folly of my ways, or at least my previously held beliefs is because of this thing called foreign capital. The fact remains that under the watchful eye of foreign capital, fiscal deficit becomes a very importance consideration (The same can be argued for domestic capital, but to a lesser extent, especially since there is evidence that suggests that government expenditure actually crowds in, or induces private investment in India).  With Credit Rating Agencies holding the gauntlet of a rating cut on government debt on the government, they are practically holding the government’s economic policy to ransom: make sure the government deficit is controlled, or else. And the fact remains, that investor sentiment, and especially foreign investor sentiment remains most sensitive to levels of fiscal deficit (And the irony is that this segment of the economy and those who benefit the most from this are the least willing to contribute to reducing fiscal deficit by paying higher taxes, or any taxes at all). The global and Indian business media also play a crucial role in forming and influencing this sentiment (more on this later). And spooking foreign investors can definitely mean bad news as flight of foreign capital can lead to a free fall in the currency, collapsing stock markets, and a possible sovereign debt crisis. This can mean a painful contraction of the nature Greece is facing today.

But I’m getting ahead of myself. No, I am not suggesting that we are going to face a sovereign debt crisis. I am merely pointing out where the obsession of a low deficit comes from. Now the bigger question that arises is this: is there any point in whining about this obsession? Or put differently, can we really do without foreign capital, especially institutional and/or portfolio investment? I am not so sure. But I think it is significant to understand the source of this obsession, its resultant very real policy changes and the very real impact that can have on the lives of the people living in the country, and what really is at stake.