Monday, May 02, 2005

On National Debt

On National Debt

The idea of National Debt has become outdated. Nowadays people look upon it as some sort of benignant tumour, growing all the time, taking all the space but giving no pain; so why worry about it?

Nothing can be more dangerous to the stability of the government than the above view. History has repeatedly shown us countries and empires fail mainly because they become bankrupt. Wars, revolutionaries, epidemics, succession disputes are all only the immediate provocation for a crisis; but ultimately countries fail because they are bankrupt by the time that crisis arrives; because their taxation reaches unreasonable levels; because the people become so disgusted with the government they’d rather see it disappear.

The Government of India is a shining example of Spencer’s Law: Men will go for the rational solution, but only after exploring all other avenues. After experimenting with every possible scheme that goes against the basic tenets of economics, under the sweeping label of ‘socialism’, it has finally found that, to become rich there is no alternative to profit-making. Still, in managing its finances, it is yet to exhaust all the avenues and come to a reasonable understanding.
Let us get our basics straight: the economic laws that hold good for a household hold good for a country. A country has to earn more and spend less to make a profit; a country has to borrow if its expenditure exceeds its income; and a country can become insolvent the same way a family becomes. Anyone who tells you otherwise is either cheating himself or cheating you.

The cute little tricks that the ‘leftist’ economists tried to pull over these basic tenets are as follows: 1. A family cannot ‘create’ or manage its currency whereas a country can; hence a country can determine the level of its wealth through its currency. This ‘law’ fell flat when the currencies so created and artificially managed, like our Rupee and the Soviet Rouble, found their ‘natural’ values in the international markets, however much these governments tried. The pathetic attempts to artificially boost their currencies bled these countries very much. India had to periodically devalue Rupee since 1947. In 1942 a Dollar was worth two and a half Rupees; now it is worth forty-three Rupees. And that too when the dollar itself was sliding down all the time and the Rupee being an inherently strong currency to boot. In short, a government may create its currency, but it is the country’s economy that manages it. No country can become rich by printing currency. 2. There are other ways a country can ‘create’ wealth by redistributing it and by government spending. Some leftists even dare to quote Keynes as the authority who advised this sort of becoming rich through government spending. This method of becoming rich is exactly equal to lifting yourself up in air by pulling your shoelaces. Keynes’ advice was meant for a very special circumstance, namely the Great Depression, when the currency was strong and overvalued, the Government was rich, solvent and conservative but the majority of the people were poorer because they lost their currency. An insolvent Government cannot ‘create’ any wealth by overspending. It rather will cause more inflation and devalue the currency. And this is precisely what Lord Keynes told. So let us not fool ourselves into believing that microeconomics and macroeconomics are altogether different. They are one and the same, only the jargons differ.

Now a brief review of India’s economic history. India always had a balance of trade in its favour, i.e., it always exported more than it imported. This was true even during the height of British imperialism. And again, it always had a surplus budget, i.e., it always earned more but spent less. Again this was true all through the British history except for a few years of the Second World War. Were the British to incur a loss in running India they would have invited Bahadur Shah Zafar to take over. So, when the British handed over India to us, they gave us a solvent government. India had a public debt even then, but it was well within limits. India had a foreign exchange reserve of five billion Pounds in 1947.

Now our socialist experimenters took over. They told us we were a backward economy because we exported raw materials and imported finished goods and we exported agricultural produce but no machinery. Why should a country be backward just because it exported raw materials, they never bothered to answer. They also covered up the fact that we also had a huge labour market and the combination of the raw material and cheap labour would make us a manufacturing country, if only we let the fellows, with the money and the technology, to invest.

No, thanks, we will do it ourselves, we told the world, and set up our public sector, which is public only in making us bear its losses. We frittered away our foreign reserves in buying machinery and technology. We reduced the export of raw materials because it is a sign of backwardness. We nationalized steel, coal and power, with disastrous consequences. We created militant labour unions that were averse to all forms of work. What followed was a communist heaven: no work, full pay. But in Hindu religion, even the longest stay in heaven will end one day, however much be our punya we will eventually exhaust it and return to earth again. This happened after the 1991 foreign exchange crisis. Since then we are limping towards obeying the basics tenets of economics rather than trying to cheat them. But in the process of these socialist experiments we have incurred a huge national debt. Some noise was made about this when India was short of foreign exchange and spent 25% of its earnings to service its debts – a euphemism for the interest we were paying. But now that the foreign reserves are comfortable nobody is worrying about the national debt.

There are many reputed economists who will tell you not to worry. They will tell you that your debt to GDP ratio is still low, your taxes are only about 8% of the GDP and so you must tax more and spend huge amounts in public works for ‘development’. Let us have a look at these gems of wisdom.

Debt to GDP: this is audacious at the very least and atrocious at the most. GDP is roughly the trade turnover of all our people. Public Debt is incurred by the government, often on expenditures that people might disapprove of. The government cannot take away the entire national income as tax, it has to leave a little bit for the people, so that they can subsist and be taxed next year. So the government’s debts must be compared only to what it can collect as tax from the people, not what the people earn in total. It is meaningless to compare the National Debt to GDP. It is like comparing the debts of a profligate son with the business turnover of his patient father who has a big family: however much is his love, he cannot give up any sizeable portion of his earnings to pay off his son’s racing debts. At some point he would disown his son.

Similarly at some point in the raising taxation the people will refuse to pay the taxes. So this Debt to GDP is one of the most malicious tricks of the trade, beware.

In every taxation, people will try to wriggle away and evade as much as possible, an endeavour that our bureaucrats help very much through arcane rules. This will again reduce the tax collectible, and hence the money at government’s disposal. So far there is no authoritative study on how much of the national income can be collected as tax without risking serious riots. But an empirical and witty work of Northcote Parkinson puts this at 36% (of national income, not GDP).

But it is impossible to reach this point in India for the following reasons: the black economy will overwhelm the white economy under heavy taxation; it is easier to bribe the taxman and get away; and India simply does not have such a heavy mechanism that can track all the transactions and tax them. In India’s case, the limit is only 10% of the GDP, given the rudimentary nature of our transactions and the porous tax net. And we are fast approaching this point, as any Finance Minister will tell you that any more new taxes will not fetch much return.

Hence the second point: Taxation as a percentage of GDP is misleading.
Let us get one more thing straight: government is not a mechanism to create wealth, it is a mechanism of the society to govern itself. If we compare the whole society to a business, then the ‘government’ is its administrative expenses. How much should a company spend on administrative costs? Crudely put, you decide to give a free banquet to 10,000 people, costing 10 lakh Rupees, and you engage a fellow to do this. Some part of this money should be spent on this fellow. How much would you allow? Put this way, the answer is obvious: may be ten thousand, may be twenty, but certainly not one lakh Rupees. Put in words, administrative costs should be only one to two percent of the total turnover. Hence the ideal tax to GDP ratio is 1-2 %, not 10%, i.e., the government should take only 1-2% of GDP for all its expenditure, and again of this sum, only 1-2% should be the ‘administrative cost’- salary, etc to its servants.

Now about public spending. The lesser said the better. At present India is like a family that has both some large debts and some small assets. Supposing it decides to sell the assets and get some money; how should this money be spent? Any prudent housewife will advise you to pay off your debts so that your interest burden will come down. If she advises you to buy a plasma TV with this money, to take a trip to the Maldives, or to spend it on the groceries, then it is time you took to sanyas: once the money is thus spent yours will be a family with some large debts and no assets. Yet, here is a government that is selling away its assets in the form of PSU disinvestments, and spending it to cover day-to-day expenditures. In the esoteric language of the Government, capital receipt is being spent on revenue expenditure. Nobody seems to be bothered about it, rather some people want this money to send a satellite to moon, others to fund an outlandish Food for Work scheme.

Of late another interesting twist has been added to this farce. At present due to the vagaries of time India is enjoying an unprecedented foreign reserve. Very learned scholars are debating how to put this money to ‘serve’ the people. Put this surplus in a corpus fund, urges a noble heart, and use the interest for welfare schemes. It is taken for granted that this new found prosperity is going to last forever, without caring to understand the whimsical nature of modern money that it is supported not by any physical asset but only by the credibility of the issuing government (that is what makes Rupee an inherently strong currency: come what may, a billion Indians are accepting only Rupees, therefore anyone wanting to deal with this billion has to keep some Rupees; the day the corner paanwala prefers payment in Dollars or Euros, Rupee is well and truly gone). It occurs to nobody to pay off our huge foreign debts; the nearest suggestion is that we should exchange high-interest loans for low-interest ones. Our ‘huge’ reserves may vanish within a fortnight if we commit a small error in valuing our Rupee, as Indonesia found to its cost a few years ago. The more reasonable option is to take this opportunity to reduce our foreign debts.

Finally a word about our principles of spending. For years we were told that the government could have ‘small deficit’ in its budget to ‘stimulate’ economic growth. Huge deficits were created and debts incurred in following this principle religiously, but the growth was ridiculously small, and unjustly dubbed the ‘Hindu rate of growth’. Now that the private investment is stimulating all the growth ever needed, and the government has a huge debt burden, it is high time this pious advice was forgotten, India’s budget balanced, and the surplus thus created used for reducing our internal debts. It is high time we froze our expenditure for sometime and reduced our debts and interests. This we owe it not to ourselves but to our sons and successors. No son ever likes to take over a debt-ridden family, why should the country be any different ?


Vijaydude said...

insightful and brilliantly written. Thank You!! Just watched the film Thamizhan- the film made the debt sound so easy and trivial. Hope you mail this to the film director.

Anonymous said...

Good post !!

Another item tied to debt is subsidies. With the rise in oil prices, the Government will have to act.

One option is to do away with the subsidies -- but if price of oil rises steeply it can have a chilling effect on the economy. But at the same time, growing Government debt will be a time bomb which would mean a highly unstable economy liable to collapse without warning.

Therefore, the best course of action is to gradually phase out oil subsidies and let oil prices be market driven. Since Indian economy is on a growth path, the phase out should be slow rather than fast.

Anonymous said...

Nice article. Socialism has been the bane of India. I see hope when I see people like youself write such articles.

Anonymous said...

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Nikhil said...

Very Informative. Thank you.

Vivek said...

This Blog was very informative...


Venkat said...

I read several of your articles.
Very good and thought provoking.
Please continue your good work.I sincerely wish even school students rom 11th std onwards(atleast) read these economic articles.