On Fiscal Deficits and Real
Interest Rates

Apr 19th 2001, Prabhat Patnaik

The theoretical perception underlying the strategy of the 2001-2 budget can be summed up as follows: the recession that currently afflicts the economy is a result inter alia of the high real rate of interest that prevails, which in turn is caused by the high level of the fiscal deficit. Controlling the fiscal deficit therefore holds the key to economic revival, and this is what the budget sets out to do.
The proposition that the size of the fiscal deficit affects the level of the interest rate, which is advanced by the Bretton Woods institutions, is beginning to gain currency among Indian economists, including many who would not consider themselves to be votaries of "liberalisation". This proposition, it cannot be denied, has an appealing simplicity: a fiscal deficit means fresh demand for loans by the government, and hence an increase in the supply of government securities; this increase, it stands to reason, must lead to a fall in the prices of securities in general, i.e. a rise in the interest rate. This apparently ' obvious'  proposition however is theoretically completely erroneous, which in turn makes the budgetary strategy fundamentally flawed. Let us see why.

The statement that an increase in the supply of government securities must lower security prices in general, requires the assumption that the total demand for securities is given (or, more generally, the demand curve for securities as a function of the interest rate, even if not vertical, is given). But this assumption is incorrect : a fiscal deficit increases not only the supply of securities, but also their demand, i.e. it shifts both the demand and the supply curves outwards. Just as investment generates (in a closed economy) an amount of savings equal to itself at any given level of the interest rate, likewise a fiscal deficit invariably generates (in a closed economy) an amount of private excess savings (i.e. an excess of private savings over private investment) equal to itself, at any given level of the interest rate. In a situation where the real economy is demand-constrained, this happens through an increase in output (or through a decumulation of unwanted stocks); but even if the situation is one of supply constraint, this happens through inflationary forced savings, i.e. through a rise in prices relative to money wages.
One can put the matter differently. An economy must reach both a flow equilibrium where savings and investment are equal, and a stock equilibrium where economic agents are satisfied with the form in which they hold their wealth. The stock equilibrium in other words arises because economic agents have a choice regarding the form in which they hold their wealth, e.g whether they hold a direct claim on capital stock (bonds and equity) or an indirect claim mediated through the banking system (money). To say that a rise in the fiscal deficit raises the interest rate, which logically amounts to saying that the interest rate is determined by the demand for and the supply of savings, i.e. that it is determined exclusively by the flow equilibrium (since both savings and investment are flows), is to deny that economic agents have a choice regarding the form of holding wealth, which is absurd. If this choice is denied, and economic agents are invariably assumed to hold their wealth only directly, in the form of capital stock (or claims upon capital stock), then the possibility of full employment savings not being invested is ruled out by assumption. It follows that anyone who believes that a rise in the fiscal deficit necessarily raises the interest rate, must, to be logically consistent, also believe that the system can never be demand-constrained, i.e. is always at full employment (in the Keynesian sense), which is palpably absurd.

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