A higher and unsustainable level of fiscal deficit will create financial stability risks and may end up destroying existing jobs.
One of the biggest issues in this election is job creation, or the lack of it, over the last five years. Irrespective of the arguments being presented by both the government and the opposition, it is not hard to argue that the Indian economy is not creating enough jobs. The leaked job survey report showed that the unemployment rate is at a 45-year high.
So, what can the government do to create more jobs? A new paper, Using Fiscal Policy to Alleviate the Job Crisis, published by the Azim Premji University, has made a case for higher government spending to create jobs. It notes: “…fiscal expansion aimed at job creation would also serve to accelerate growth, help the corporate sector repair its balance sheet, and alleviate the non-performing loans in the banking sector.”
However, the idea of running a higher fiscal deficit to create more jobs could actually be counterproductive for a variety of reasons.
First, India is already running one of the largest budget deficits among its peers and still not able to create enough employment. Therefore, it is hard to argue that increasing the deficit by, say another percentage point, will create enough jobs to solve the problem. On the contrary, a higher and unsustainable level of fiscal deficit will create financial stability risks and may end up destroying existing jobs.
Further, higher government borrowing will keep interest rates elevated, affecting investment, growth and job creation. A high fiscal deficit is one of the primary reasons why lower policy rates are not getting transmitted into the economy.
Second, the paper says that a higher deficit will not lead to higher inflation. Such assumptions in policymaking could prove hazardous. For instance, core inflation continues to remain above the 5 percent mark. The headline inflation is low, largely due to softer food prices, which are now expected to stabilize. Therefore, a significant demand push is bound to affect inflation outcomes and not allow the central bank to cut rates.
Aside from higher government borrowing, which tends to keep interest rates elevated, higher inflation will put further pressure on the cost of capital. India needs to bring down the cost of money to be able to push investments and growth. Furthermore, these are still early days for the inflation targeting framework in India. Its success would strengthen financial stability and give a fillip to investment and growth.
Third, a higher budget deficit will affect investor confidence and credit rating. “Instead of setting fiscal policy based on rating agency guidelines, India’s policymakers should take the lead in challenging the framework, robustly arguing India’s long-term record of managing debt, external and internal, while fostering strong growth and moderate inflation,” the paper notes in this context.
While it is correct that rating agencies came under severe criticism, and rightly so, in the aftermath of the financial crisis, India is in no position to change the way global financial markets work. Credit rating is important for institutional investors. India’s rating is at the lowest level in the investment grade, and a downgrade will make it extremely difficult to attract investment. In fact, it will lead to capital flight, resulting in higher volatility in the currency market, stoking inflation and making the corporate balance sheet more vulnerable. Therefore, it is important for the government to maintain fiscal discipline. A risk to financial stability can destroy jobs.Nevertheless, there is a case for government intervention in job creation, but it should be done through efficient spending in areas such as infrastructure and skill development. Increasing the fiscal deficit certainly is not the right response to India's jobs problem.