Where did 3% fiscal deficit come from and how did it become so sacrosanct?

TCA Srinivasa Raghavan ponders over this question.

He starts with this interesting Churchill quote which actually applies to quite a few things in economics:

Never in the field of human conflict was so much owed by so many to so few,” said Winston Churchill in 1940 when a few hundred British fighter aircraft were fending off a few thousand German bombers.

In a like manner, where economists are concerned, never in the field of human endeavour has such a small group of intellectual charlatans inflicted so much damage on so many. Many examples of the harm they have done can be given. But here, let’s only examine the notion that the ideal level for a country’s is three per cent of its gross domestic product (GDP).

I have tried, for the last 25 years, with the futility of a fool, to find out why it is three per cent and not 3.5 or 2 or 4.1 or 5 per cent. Where did this three per cent come from? Who thought it up? What’s so special about it? Above all, who made it the prevailing orthodoxy? If someone knows, please let me know through the comments column on this paper’s website. I will be eternally grateful.

Personally, I think it was the (IMF), in the aftermath of the Latin American debt crisis in the 1980s, which invented this level. Before that it was generally agreed that government debt must not be “excessive”. But no number was put on the ratio. If it was, tell me and I will stand corrected.

IMF shares a blame for many a things wrong in world economy. Using their bully pulpit, they have forced all economic policy thinking on simplistic and homogeneous targets. (Despite this, IMF officials are much sought after and continue to drive policies worldwide). Same thing applies for inflation targeting as well. Where did the number come from? What started as an experiment in New Zealand Central Bank is seen as a gold standard for all monetary policy. Here also we have put all kinds of targets without really looking at the nature of the economy. But thankfully, unlike fiscal deficits where 3% is the standard across countries here inflation targets are divided into country-wise – developed country, emerging economy, developing country and so on.


The pressure probably came from American banks, which had been doing a lot of short-term lending to developing countries. They had burnt their fingers, hands and feet in Latin America. They realised then that they needed a benchmark figure that their loan officers could use. (The invention of that figure, by the way, was why the East Asian countries hid their short-term borrowing levels in the late 90s. As long as no one knew, the US and other banks would continue to lend.)

Simultaneously, the people who were manning the incredible financial globalisation that started in 1985 via the institutional investors also needed a number to look at. Thus, by the mid-90s a new notion of good and bad had been born. If a country was at or around three per cent fiscal deficit, it was good; if not, it was bad. This number became what body temperature is to a doctor. Borrowing countries had no choice in the matter. They either adhered to this norm or went with less and more expensive credit.

India, having taken a severe knock in 1991, accepted this number, not least because so many of its economists owed so much to the and its sister, the World Bank. 

Don’t get me wrong. I am not arguing that the fiscal deficit does not matter. I used to do that when financial globalisation had not assumed the scale it has now. But since it is a reality now, the deficit does matter. But why put such a low number on it when it constrains governments so badly?

It is useful to remind the regression-obsessed economists that it was Keynes who legitimised the idea of a budget deficit. Before that the orthodoxy demanded a balanced budget, that is, a zero deficit.

Moreover, Keynes never laid down a number. Nor did his academic followers, like Alvin Hansen, do that. All they said was that when demand is depressed, governments must spur it along even if it means running a deficit, even a very large one.

The whole idea always has been to constrain the government badly. First constraint the govt and then ask govt to do much more for the economy. This is classically happening in India currently.

He says the govt should read LK Jha instead. This is surprising as we hardly read any of these guys anymore. Indian history of economic thought is a banished thought. The whole obsession is to just follow what the western experts have said over the years (despite being wrong):

In 1981, fed up with what Raj Krishna had jokingly described as India’s “Hindu rate of growth”, the highly influential wrote a book (Economic strategy for the 80s) in which he said India needed to give up its obsession with more-or-less balancing the Budget. That recommendation could not be adopted during 1980-84 because of the huge IMF loan, of around $5 billion, India had taken in 1981. But 1984 was an election year and Indira Gandhi needed to spend more. So, India told the IMF that it would not use up the entire loan.

But while Gandhi wanted to spend more on giveaways, Rajiv who became prime minister after her assassination decided to expand the budget deficit – as it was called then – to spur growth. The results were dramatic. India finally broke out of the low-growth syndrome in 1986. But then a terrible drought in 1987 and a contrived political crisis intervened. The deficit continued to expand, but not for financing investments.

In 1991, thanks to poor management by Bimal Jalan, who was finance secretary during an unstable government in 1990, India went bust. Since then India has adopted three per cent as key to fiscal nirvana.But the time has come to give up this obsession. Jaitley should adopt five per cent as the floor level. Otherwise, there is little hope.

Where does 5% come from?

There is a need to rethink and rewrite this standardization of economics around macro targets. The whole pink media goes berserk if the targets are missed by a % or so. Whereas things like water, air, education etc targets are barely mentioned.

(And Bimal Jalan? Did I read that right? He seemed to have only grown despite poor management. And was recently the chair of expenditure commission as well..)



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