On Some Common Macroeconomic Fallacies

Apr 20th 2000, Prabhat Patnaik

Fallacy 1: The interest rate in the economy is high because the fiscal deficit is high.
The interest rate is the return on a particular asset, namely a debt instrument. It must be determined therefore as part of a stock equilibrium. The fiscal deficit is a flow concept. To say that the interest rate is determined by the size of the fiscal deficit is tantamount to saying that the price of a stock is determined by a flow, which is plain illogical.
But, it may be argued, while the fiscal deficit may not determine the interest rate, it certainly affects the interest rate, since it adds to the supply of the stock of debt instruments in the economy by floating additional government debt. This proposition too is fallacious, for at least two reasons. But before discussing these I should clarify a preliminary point: since debt instruments are also held by banks, whose liabilities can function as money, to talk of a demand for and supply of debt instruments independent of the demand for and supply of money is meaningless; the interest rate therefore is determined, as every school child knows, by the demand for and supply of money.
A fiscal deficit then can raise the interest rate (for a given money supply) through raising the demand for money via any one of the well-known motives for holding money (transactions, speculative, precautionary etc.). It does not constitute ipso facto a corresponding additional demand for money. Looking at it differently, the demand for money which affects the interest rate is the demand for holding money, not the demand for using money. To say that the demand for and supply of debt instrument is just the obverse of the demand for and supply of money, and that therefore the fiscal deficit which adds to the supply of debt instrument constitutes ipso facto an additional demand for money is a fallacy, the first of the two mentioned above. Just as my borrowing Rs.100 from a friend to buy a book does not ipso facto constitute a demand for money, likewise the government's borrowing money to finance investment (i.e. buy investment goods) does not ipso facto constitute a demand for money. It may give rise to a larger demand for money via, for example, increasing income and hence the transactions demand for money; but in this respect there is nothing special about the fiscal deficit. Indeed anything that raises the money income in the economy has this effect of raising the demand for money; emphasising the fiscal deficit has no rationale.
Such emphasis is fallacious for a second reason. In the above para we took money supply as given. But whether it is given, or rising, and if rising then by how much, are all matters of monetary policy. The interest rate is a monetary phenomenon. It cannot, at any time, be where it is without monetary policy keeping it where it is. No amount of fiscal deficit, or anything else for that matter, can have an iota of effect on the interest rate if monetary policy aims otherwise. Therefore if the interest rate is high, then the question to ask is why a "high interest rate" monetary policy is being pursued. The emphasis on the fiscal deficit precludes the asking of any such question (the answer to which would point to the fact that, under the new regime of "liberalisation" where the economy is more open than before to financial flows, retaining "investors' confidence", a euphemism for appeasing international finance capital, becomes necessary).
(Once when I was arguing against a senior economist from the World Bank that high interest rates had nothing per se to do with fiscal deficits but were high because of the pursuit of a monetary policy that kept them high, his response was: "Oh, but you are talking about a repressed financial regime!" This amounts to saying that in a "non-repressed", i.e. "liberal", financial regime, interest rates are high because of fiscal deficits. This argument has four notable features. First, it contains a tautology, since a "repressed" financial regime is by definition one where the interest rates are kept low. His argument in other words amounts to saying: "interest rates are high because in a high -interest rate regime, fiscal deficit keeps them high"! Secondly, the argument contains a non-sequitur. Once the tautology is recognised, dragging in the fiscal deficit introduces a complete non-sequitur. Thirdly, it is ideological. In presenting a non-sequitur he could have put in any term other than the fiscal deficit without altering by one iota the status of the argument in terms of its veracity. For instance, he could as well have said: "interest rates are high because in a high interest rate regime a high level of consumption keeps them so"! The fact that he chose fiscal deficit is indicative of the Bank's ideology. And fourthly, this tautology with an ideologically-motivated non-sequitur does not have one iota of explanatory power.)

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