SIMSR

Eco-Śāstra
1ST MARCH 2009 VOLUME 1.1

Budget or List of Achievements? -By Team Eco-Śāstra

―We have provided a strong stimulus and cannot do more due to constitutional
constraints‖, said Pranab Mukherjee to The Economic Times (ET) after present-
ing the Budget in the parliament on 16th February. Come 24th of the month and
the government came out with the third fiscal stimulus and Pranab Mukherjee
said, ―Due to strong export linkages with these (countries in Europe and Asia)
economies, it is likely that the Indian economy may feel further impact in the
coming months‖. It is hard to believe that this thought would have dawned on
our Finance Minister and the central government in a week’s time. Constitutional propriety was
lost on them in just a matter of few days. Was it the media pressure, which showed discontentment
all around, that led to this decision or was it pre planned to bring it a week later? The chance of
deciding on it so quickly looks bleak, look at the time taken by Barack Obama and his team to
come out with their third relief package! Then the action negates what the Finance minister said
about how the constitutional propitiatory did not permit him to announce a further stimulus for the
economy. This seems to be quite a conundrum to solve. So it is better to see what the Interim
Budget has to offer than deliberate over the timing of the stimulus.
An Interim Budget is nothing more than an arithmetical exercise in order to secure parliamentary
approval for a certain sum of money for the functioning of the government for a few months. How-
ever as ―exceptional circumstances require exceptional measures‖, a lot was being expected out of
this budget. As is always seen, greater the expectation greater the disappointment. Same happened
with this vote on account. There were no tax rate cuts, no package for the recovery of economy.
It was more like a presentation of how well the government had done in the 4 years of their gov-
ernance. However, what actually got highlighted were the huge deficits India is reeling under. Fis-
cal deficit is 6% of GDP. The huge deficit is on account of the farmers’ subsidy, the two stimulus
packages and the 6th pay commission. This is when 60% of recommendations of pay commission
will be implemented in the next fiscal year. 6% is the deficit on ignoring other off budget liabilities
such as the bonds issued to oil and fertilizer companies (1.8%) and state deficits which total to
3.5%. So the actual deficit is 11.3%. This means that FRBM (Fiscal Responsibility and Budget
Management) Act has been breached as it has set the limit of fiscal deficit to 3%. To add to this the
revenue deficit has more than quadrupled in
UPA Government takes a 2008-09 to 4.4% from 1% in 2007-08. The pri-
U-TURN mary deficit has risen to 2.4% as well. The big-
gest repercussion of this huge deficit is that
S&P has reduced the long term sovereign credit
rating of India to negative from stable. This
could lead to higher foreign borrowing costs
and further weakening of rupee.

Word Jumble:
N A D M E D
N I F I N T O L A
Y I C O L P
Y P S P L U
T I C F D E I
SIMSR
Economic Statistical
Eco-Śāstra Supplement

The interim budget continued its impetus on flagship programme which keeps the Bank Rate 6.0%
―aam aadmi‖ mandate before the elections intact. National Rural Employment Guaran- Repo Rate 5.5%
tee Scheme, Sarva Sikshan Abhiyan, mid day meals, Integrated Child development
scheme (ICDS), Jawaharlal Nehru National Urban Renewal Mission (JNNURM), Ra- Reverse Repo 4.0%
jiv Gandhi Rural drinking water mission, Bharat Nirman, Rural infrastructure develop- Rate
ment Fund have all been touched upon in this interim budget.
CRR 5.0%
54 central sector projects have been given ―in principle or final approval‖ worth Rs
67700 crore under public private partnership (PPP). Consumer companies are hoping SLR 24.0%
for a breakthrough impetus in the real budget besides these. They are banking on
PLR 12.75%-
growth in rural demand (by such measures) to act as their savior in recessionary times.
Former finance minister, P Chidambaram feels that if the benefits are passed on to ru- 13.25%
ral India, it will stimulate demand in urban India as well. Savings 3.50%
The interim budget had fallen short of expectations, albeit Pranab Mukherjee has ad- Bank Rate
dressed most of those in the 24th Feb fiscal stimulus. This gives one less point to the Deposit Rate 7.50%-
opposition in the run-up to the elections. 9.60%

Epochal Economist
Strategic Significance of Hayek’s Interest-Rate Brake -By Team Eco-Śāstra
Let us visualize a macro economy sitting comfortably on its production possibilities frontier. That is, the economy is fully
employed, producing an assortment of consumption goods. Investment is financed by saving and profit margins are
equalized throughout the structure of production. In short, the economy is in a macroeconomic equilibrium.
Now let us suppose that newly available technological possibilities enhance the potential payoff of current investment.
Because of technology, a given amount of investment now will result in a larger than before or better than before
assortment of consumption goods in the future. It can be represented by a point on a new PPF—a point located directly to
the east of the initial equilibrium. Graphically speaking, we can say that the preferred point on the new PPF is one that
lies not directly east but to the northeast of the initial equilibrium.
Now, what is the market mechanism through which the economy moves northeast instead of due east? Here, Hayek’s
earliest grappling with this question focused attention on the rate of interest and, more specifically, on the interest rate
brake. The new technology gives rise to increased investment opportunities and hence to increased demands for
investment funds. The supply of loanable funds, however, is not perfectly interest elastic. The interest rate is bid up,
putting a brake on the rate at which the new technology is exploited. In other words, increased incomes earned during the
adjustment period are used in part to increase current consumption. 2
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Saving is increased, too, but not by enough to allow for a full-throttle
exploitation of the new technology.
Our understanding of the role of the interest-rate brake is critical to our
assessment of central bank policy during periods of technological innovation.
Federal Reserve’s role is that of increasing the supply of credit to match each
new increase in the demand for credit. With supply shifting rightward along
with demand, the rate of interest doesn’t change. In effect, the objective of the
Federal Reserve was to override the interest rate brake and send the economy
due east rather than allow it to go northeast. The ―needs of trade‖ imply the
need to take the entire gain from technological advance in the form of
increased future consumption.
The unworkability–the unsustainability–of such a credit policy is easily demonstrated. Accommodating the so-called
―needs of trade,‖ conceived as the needed supply of credit at the pre-existing rate of interest, is inconsistent with the
preferences of income earners, as registered by their pattern of spending and saving. The inconsistency materializes as
an intertemporal disequilibrium, whose eventual resolution takes the form of an economy wide downturn.
Hayek’s own summary assessment is to the point, although in his early work on business cycles, he attributed the
cycles to any system of elastically supplied credit rather than to perverse policies of a central bank:
The immediate consequence of an adjustment of the volume of money to the “requirements” of industry is the
failure of the “interest brake” to operate as promptly as it would in an economy operating without credit. This means,
however, that new adjustments are undertaken on a larger scale than can be completed; a boom in thus made possible,
with the inevitably recurring “crisis.”

Faculty Explains
Lessons from Recession -By Dr. Siva Kumar
The buzzwords of the day are liquidity crunch, slowdown, global economic recession, and stimulus package
# 1,2, and.. n. It is imperative for us to understand that there is globalization (a concept in use as early as 1944, but
popularized by the US Economics professor-cum-HBR editor Theodore Levitt before his demise in 2006) underway.
Globalization presupposes willful integration of developed and developing economies with a view to bringing about
select desirable economic outcomes (other non-outcomes may be considered either secondary or incidental).
In the process of globalization, there is a coupling of the developing economies with the developed economies at
least on two fronts: market access and technical collaboration. It is the former that helped many of the developing
economies, including the BRIC countries, to sustain a decent economic growth. However, globalization is a two-
sided coin-it has its limitations too. The umbrella term for all the shortcomings that could result from globalization is
the contagion effect- growth slowdown, inflation, exchange rates, employment, interest rate, capital flows, and so on.
The developing countries cannot insulate their economies whenever their advanced partners face a trouble or crisis
like the one at present.
Output gap is a term that implies that amplitude from the trend the peak or trough of a business cycle- a
typical cyclical movement involving fluctuations around the trend in real GDP of a country. Such business cycles are
a) persistent b) have deviations from Trend that are choppy, c) have a variability in amplitude, and d) have
variability in frequency.
Documented history reveals that decline in real rate of return triggered the business cycles in the 19th
Century ( Knut Wicksell) whereas in the Mid 20th Century, non-real factors contributed (Keynes -animal spirits &
liquidity Kalecki). Of late, the decline in human productivity, accounting frauds or scandals, synchronized foreign
portfolio movements, and rising oil prices are the main culprits.
Macroeconomic theory classified the business cycles into four types based on the period of the cycle-―Kitchin‖ 3
years cycles, ―Juglar‖ 10 years cycles, ―Kuznets‖ 20 year cycles, and ―Kondtratiev‖ 50 Year cycles. Of late, very
long-term business cycles are becoming rare, thanks to the ―interventions‖ by the governments of the so called
capitalistic economies. Also, the divisions that existed around the Great Depressions between the capitalistic and
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socialistic countries are nearly over, and there is an increasing dominance of the capitalism in varying degree in almost all
countries today.
Inflationary Gap refers to the decrease in autonomous spending needed to bring the economy to a non-
inflationary full employment situation. The vertical distance between the Aggregate Demand curve (C+I line) and the 45 0
Aggregate Supply Line aligning with the full-employment level of income/ output. Whereas recessionary gap refers to the
increase in autonomous spending needed to bring the economy to the full employment level of income (measured like
above).
The financial crunch started in the US which has its origins not merely to a year or two, but almost 8-9 years after
the burst of the so-called dot com bubble. As a State-led policy, the US central bank- The Fed- has enabled conditions in
the domestic banking and financial system to provide cheap and excess credit to all those interested (even if it amounted
to compromising the principles of prudent banking). This was done by repeated cuts in the Fed Fund Rate and also by
lowering the risk weight to advances especially the housing finance, which is considered very safe lending in the banking
circles all over the world. This led to a plethora of homes in US that were financed by banks to private households whose
creditworthiness is far from satisfactory. The upward revision in the interest rates on the outstanding loans coupled with
the layoffs or wage cuts brought to the fore the true picture of solvency of individual borrowers, banks, investment banks,
and the financial institutions. The creditors to the US financial assets (mainly from China, EU, and Japan) also have their
interests intertwined with this worldwide financial and economic imbroglio.
Just to have an understanding of the US financial trends, T-bills indexed at 1.0000 in 1926 reached 17.5554 by
2004, Long-term T-Bonds changed from 1.0000 reached 57.8137, while inflation rate changed from 1.0000 to 10.2950
during the same period. As far inflation rate is concerned, its lowest rise (deflation) was (-) 10.27 in 1932 (The Great De-
pression period) while the highest was + 18.13 in 1946, returns provided by T-bills in US peaked 14.86 in 1981, while
only once during 1926-2004, T-bills provided a very marginal negative returns of -0.06 in 1940.
The panic in India in different spheres of the economy is justified. The country has witnessed a four-decade long
stable investment and economy prior to 1991. Though jobs were not highly rewarding, nevertheless there was no fear of
wage cuts and worse layoffs. With the Indian economy embracing the globalization and getting integrated into the world
economy, particularly high-end services started receiving a major boost and so had been the rewards to the personnel in
this sector. Some economists, including the Indian PM, have advised and cautioned against such irrational executive com-
pensations, which was not only dismissed by the corporate India but was openly ridiculed. Despite this, the Indian gov-
ernment is acting benevolently rising to the occasion and doing all possible help to support the private sector. The Vote
on Account fiscal deficit figures and subsequent tax cuts (Central Excise, Service Tax) is a testimony to this.
As India has a large population and also a vast majority of it comprises of persons with high marginal propensity
to consume (ratio of additional consumption resulting from additional income), there should be no doubt in the minds of
the citizens of this country as well as others that India will positively fight out this problem posed before it by the rest of
the world. However, given the magnitude of the crisis, it may take about 2 years for India to fully neutralize and over-
come the effect, and would march ahead with a long term growth trend of about 8 percent.
Individuals can do nothing (whether you have a penny or you are the richest person of your country or in the
world) as far generating a business cycle or curtailing the period of an ongoing cycle. However, the only way individuals
can insulate themselves particularly during the recession is to act countercyclical. The individual’s saving and spending
behavior needs to be altered in such a manner that they save high proportion of their incomes during recovery/ boom
phases while they should not reduce their essential consumption and avoid taking non-institutional loans during the time
they are out of employment. Also, young employees must not fall prey to high borrowings for owning huge 3/ 4 bedroom
flats/ independent houses in metropolitan cities when during the recovery/ boom when they would normally receive hefty
pay hikes. They must instead start looking for required size of house for next 7-10 years horizon, and can acquire larger
ones leisurely during their career. Same applies to owning four-wheelers. Once individuals in India start adopt this way of
living (slow and steady), there will not be any future shocks when even our economy also would be witnessing more such
business cycles in years to follow.
(Dr. SNV Siva Kumar, Professor in Economics, SIMSR. Disclaimer applies.)
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Śāstra ke Sutra
 Union Budget:
The Union Budget is the annual report of India as a country. It is also a charter of the
government’s economic policies. It contains the government of India's revenue and expenditure
for the end of a particular fiscal year, which runs from April 1 to March 31. The whole process
begins on February 28 when the Finance Minister makes the budget speech.

 Voted funds v/s Charged funds:

All taxes, revenues, grants, loans, repayments, proceeds from loans floated by government, and
advances from the Reserve Bank go into the Consolidated Fund of India. Such monies are voted
funds, that is, they are put to vote in Parliament. All other public money, such as small savings,
goes into the Public Account of India. These are called charged funds and don’t belong to the
government.

 FRBM Act 2003:

The Fiscal Responsibility and Budget Management (FRBM) Act was enacted to bring in fiscal
discipline. The rules impose limits on fiscal and revenue deficit which the central government is
required to stick to. In case of a breach, the government is held accountable under the law and is
required to explain to Parliament the reasons for the breach, corrective steps, as well as the
proposals for funding the additional deficit. The Act also seeks that all government accounts and
financial activities, including the Budget process, are fully transparent and subject to public
scrutiny.

 Fiscal deficit:
Fiscal deficit is an economic phenomenon, where the Government's total expenditure surpasses
the revenue generated. It is the difference between the government's total receipts (excluding
borrowing) and total expenditure. Fiscal deficit gives the signal to the government about the total
borrowing requirements from all sources. Thus, it is the gross addition to the government’s
domestic debt burden. The FRBM Act wants the government to limit its fiscal deficit to 3% of
GDP.

 Primary deficit:
Primary deficit is the difference between the fiscal deficit and the interest payments, and
describes the net new borrowings. In other words, it is the amount by which a government's total
expenditure exceeds its total revenue, excluding interest payments on its debt. A high primary
deficit means the government is borrowing more to simply pay off old, high-cost debt and is
therefore highly undesirable.

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 Revenue deficit:
Revenue deficit occurs when the actual amount of expenditure and actual amount of received
revenue do not tally with the anticipated expenditure and revenue figures. This is the opposite of
a revenue surplus, which occurs when the actual amount exceeds the projected amount. Revenue
deficit measures the gap between the government’s current income through taxes and other
revenues and its spending for the year. A growing economy ends up spending more on the
development and welfare of its citizens as well as on its own consumption such as running huge
offices and staff

 Revenue Budget :
The revenue budget consists of revenue receipts of the government (revenues from tax and other
sources), and its expenditure.
Revenue receipts are divided into tax and non-tax revenue. Tax revenues are made up of taxes
such as income tax, corporate tax, excise, customs and other duties that the government levies.
In non-tax revenue, the government's sources are interest on loans and dividend on investments
like PSUs, fees, and other receipts for services that it renders.

 Capital Budget:
The capital budget is different from the revenue budget as its components are of a long-term
nature. The capital budget consists of capital receipts and payments.
Capital receipts are government loans raised from the public, government borrowings from the
Reserve Bank and treasury bills, loans received from foreign bodies and governments, divestment
of equity holding in public sector enterprises, securities against small savings, state provident
funds, and special deposits.
Capital payments are spending to create an asset such as land or buildings and loans given by the
Centre to states. It includes expenditure on acquisition of assets like land, buildings, machinery,
and equipment, Investments in shares, loans and advances granted by the central government to
state and union territory governments, government companies, corporations and other parties.

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