Thursday, July 15, 2010

What are the lessons that India should draw from the Eurozone crisis that is unfolding now?

First, fiscal deficits do indeed matter. They matter less when a country has underperformed for so long that it has big catch-up possibilities that fuel growth, and this explains why India has not suffered like some other countries. Yet the taming of fiscal deficits and inflation in 2004-09 led to sharply reduced interest rates that were crucial in making India competitive in its 9% growth phase. The Fiscal Responsibility and Budget Management (FRBM) is a crude tool, yet did indeed help cut the fiscal deficit. The FRBM target of lowering the fiscal deficit to 3% of GDP is sensible in good times, leaving scope for expanding it to 6.5% in a recession without causing a Greek tragedy.

Second, Greece and Portugal have demonstrated that fiscal deficits in countries with structural problems can send the debt/GDP ratio skyrocketing without stoking growth. India has many structural problems despite having advantages too, and so should beware fiscal excesses.

Third, Greece has shown that a monetary union is a bad idea that leads to loss of control over exchange rates. So, India must shoot down proposals for an Asian monetary union.

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