MacroScan (Printable Version) - On Fiscal Deficits and Real Interest Rates

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.

I

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.

                                                         II

The Prime Minister's Economic Advisory Council (PMEAC) in its recent report has put forward an argument which is slightly different from the one presented above, though belonging to the same genre. This argument states: "The consequences of a high fiscal deficit depend upon the way the deficit is financed." If the deficit is financed by monetisation, and if this monetisation is "excessive", then this leads to domestic inflationary pressure, whose "impact is the highest on the poor." On the other hand if the deficit is financed by "borrowing in domestic financial markets" then "the result is that real interest rates become very high" which chokes off private investment.

The PMEAC's argument is different from the one presented above because it does not assert that an increase in real interest rates is the inevitable consequence of a rise in the fiscal deficit; the consequence according to it depends on how the deficit is financed. But this proposition, namely that the consequences of a fiscal deficit are determined by how it is financed, flies in the face of elementary economics, as can be seen from simple IS-LM analysis.

Consider the first case mentioned by the PMEAC, the case of monetisation. Even if the deficit is financed by monetisation which adds to bank reserves, this need not cause an inflationary squeeze on the poor as long as the real economy is demand-constrained to start with, and the deficit is not large enough to cause it to become supply-constrained [1] . (Moreover when bank reserves are being added to, it is not even clear why the deficit should be "financed largely by monetisation" as the PMEAC report assumes rather arbitrarily). On the other hand suppose the entire deficit is completely monetised. If the value of the Keynesian multiplier (at unchanged interest rates) is higher than the value of the money multiplier times the income velocity of circulation of money (also at unchanged interest rates), there would be an excess demand for money that would push up the interest rates, even though the fiscal deficit had been entirely monetised! In other words the proposition that when the fiscal deficit is monetised it affects not the interest rates but only prices relative to money wages is doubly wrong: there is no necessary reason why it should at all affect prices, and there is no necessary reason why it should not at all affect the interest rates.

Now consider the second case, where there is no monetisation. Even if the deficit is financed entirely by "borrowing in the domestic financial market", it need not raise the interest rate at all if banks had excess reserves to start with. On the other hand if the fiscal deficit so financed occurs in a real economy which is supply-constrained to start with, then it raises prices in terms of the wage-unit, thereby imposing an inflationary squeeze on the poor. Thus the PMEAC's second case which is supposed to show that a fiscal deficit financed by market borrowing as opposed to monetisation causes a rise in interest rates rather than in prices in terms of the wage-unit is also doubly wrong: there is no necessary reason why it should at all affect the interest rates, and there is no necessary reason why it should not at all affect prices.

There are two quite distinct errors underlying the argument of the PMEAC report. First, as simple IS-LM analysis would show, it is not how the fiscal deficit is financed that matters but the state of ex-ante excess demand in the goods and the money markets with which we start and how these are affected by the fiscal deficit. Second, again as simple IS-LM analysis would show, a rise in the fiscal deficit would raise prices in wage units (whether or not it raises interest rates) only if the economy is supply-constrained to start with, and would raise interest rates (whether or not it raises prices in wage-units) only if bank credit is supply-constrained to start with. This latter situation in turn cannot arise if banks have excess reserves (for a given stock of reserve money), or, alternatively, if the stock of reserve money itself can adjust to the demand for it. Thus the argument of the PMEAC report must necessarily be assuming (though this is nowhere explicitly stated) both that the real economy is supply-constrained and that bank credit is supply-constrained. Both these assumptions are palpably wrong in the context of the Indian economy today. Let us see how.

                                                                 III

Let us take bank credit first. In any situation where banks hold a larger amount of government securities than required under the SLR obligation, they can always off- load a portion of these securities to the RBI, if not directly then at any rate at the margin by not picking up fresh government debt (which ipso facto would then devolve upon the RBI in its role as the underwriter of this debt). It follows that whenever banks hold excess government securities, since these can be traded for reserve money but are not, the credit market must be a buyers' market, i.e. there must be a shortage of demand for credit from worthwhile borrowers. Credit cannot be supply-constrained in such a situation.

This is precisely the case in India today. Indeed the Economic Survey 2000-01 states this quite clearly: "The position changed with the inflows under IMDs in November 2000, which led to a sharp increase in the RBI's net foreign currency assets. The resultant generation of liquidity facilitated a sharp reduction in RBI's net domestic assets by enabling the RBI to off-load from its portfolio a significant portion of Central government dated securities to the market" (p.55). If credit had been supply-constrained in the economy, then the "market" which includes the banking system would never have moved into government securities.

One remark of the PMEAC may be construed as a counter-argument to what has just been said, but that remark itself constitutes yet another logical contradiction in the PMEAC's argument. The PMEAC report says: "In recent years the government has been borrowing at around 11 percent when inflation averaged around 5 percent. This implies real interest rates of 6 percent for government borrowing, which means that private sector financing has to be at real interest rates of 8 percent or so for the best corporates and correspondingly higher for others. With such high real interest rates, private investment is bound to be choked off, which is exactly what has happened." This argument would appear to contradict my argument that "excess holding" of government securities by banks can occur only when credit is demand-constrained, since it believes that this "excess holding" is because of the attractiveness of government securities.

This argument of the PMEAC however is logically faulty for two reasons: first, a 6 percent real rate of interest on government securities can correspondingly increase the interest rate on private securities only under certain circumstances. An obvious one is if the supply of government securities is infinitely elastic at this rate. If the supply is only a finite amount, then after this amount has been picked up, banks having additional resources will start picking up private securities at 6 percent or even lower real rates (as long as they cover "marginal cost"). A 8 percent floor real rate for private securities can operate only if banks' resources are limited relative to the supply of government securities. But if that were the case then the Reserve Bank (whose Governor is a member of the PMEAC) should be deemed to have committed a great disservice to the nation by offloading "from its portfolio a significant portion of Central government dated securities to the market." The RBI cannot gratuitously increase the stock of government securities in the market and then complain that there are too many government securities in the market! Attributing sense to the RBI must therefore lead to the conclusion that it offloaded securities because banks had extra resources owing to insufficient demand for credit from worthwhile borrowers. In other words, banks' holding of excess government securities suggests that credit is not supply-constrained.

Secondly, the interest rate comparison in the PMEAC report is wrong, as the following example will show. Suppose for simplicity that banks have only three assets, cash, government securities, and loans to commercial enterprises, and suppose they are required to maintain 10 percent of their assets as cash and 25 percent as government securities. Suppose also, to start with, that they hold Rs.10 of cash reserves, Rs.29 of government securities, and Rs.61 of credit, i.e. they are maintaining the cash-reserve ratio but have "excess holding" of government securities. Then by selling Re.1 of government securities to the RBI, they can, collectively, expand their assets to Rs.11 of cash, Rs.28 of government securities, and Rs.71 of credit, provided there is plentiful demand for credit. If the number of banks is small and profit prospects significant,they would indeed be expected to co-operate to realise these prospects. Hence if r denotes the real interest rate on government securities and r' the rate on credit, then banks in the above example would get rid of excess holding of securities if 10 times r' exceeds r. More generally, if the cash-reserve ratio is denoted by c, banks would never hold excess government securities as long as r'/c exceeds r. The real comparison to make in other words is not between r' and r, as the PMEAC does, but between r'/c and r, where the former must win. It follows then that "excess holding" of government securities will never be resorted to if adequate credit demand is forthcoming.

The fact that the banking system in India has been holding excess government securities implies then that credit has not been supply-constrained, in which case one of the assumptions underlying the PMEAC argument collapses. The other assumption, namely that the real economy is supply-constrained, is even more palpably wrong. When the country has 45 million tonnes of foodgrain stocks, when industrial growth is slowing down, when the existence of a demand constraint over vast sectors of Indian industry is recognised even by the Economic Survey, it is indeed sad to see that the group of highly distinguished economists which constitutes the PMEAC has put forward an argument which assumes Keynesian full employment!

Since our system is demand-constrained both in credit and commodity markets, the basic assumptions of the PMEAC report break down. Thus, no matter which of its alternative versions we consider, the proposition that the real interest rate is high because of the high levels of fiscal deficits is erroneous: the theory it invokes for itself is in each case untenable; and the conditions under which it might hold empirically, if inserted within a tenable theory, are far removed from those that are actually obtaining.

                                                         IV

But if the high real rates of interest prevailing in the economy have nothing to do with the level of the fiscal deficit, then what does account for them? We have to bring in the stock-decisions here, i.e. the factors underlying the stock-equilibrium. [2] We also have to take cognisance of the fact that the 1990s have seen an opening up of the economy to freer capital flows, including in particular financial flows, from and to the rest of the world.

In a world in which finance is free to move, if the identities of the countries did not matter at all, the rates of return would be equalised across all countries. In fact this was the proposition that underlay the Mundell-Fleming model. But identities of countries do matter: finance whether originating in the first or the third world would, if the rates of return were identical, rather move to the first world, which constitutes the home base of capitalism, than stay on in the third world where the elements of risk and uncertainty are much greater from its point of view. Consequently, in a world with free mobility of finance, the tendency would be for the rate of return to finance to be higher in absolute terms in the third world countries than in the first world in order to prevent its flight, which means that the real rate of interest, as a representative rate of return, would generally tend to be higher in the former than in the latter. Since the real rate of interest was exceedingly low, even close to zero in several third world countries, including India, in the period before "liberalisation", this also necessarily entails an increase in the average real rate of interest in the post-"liberalisation" as compared to the pre-"liberalisation" years. To be sure, since the real rate is the difference between two magnitudes, in particular periods, with sudden changes for instance in the inflation rate, it may move up or down sharply. The point however is that "liberalisation", in particular the opening up of the economy to freer movements of globalised finance (even when the currency is not fully convertible), pushes the country into a real interest regime that is higher compared to what prevails in the metropolis, and higher compared to its own past.

This is exactly what has happened in India where the real interest rate in the 1990s have been higher on average than in the metropolis and higher on average than in the past. And the same story can be read in the case of virtually every third world country.

Now, it is quite possible that if a third world country increases its fiscal deficit, then international finance, which does not like any form of State activism except that which promotes its own interest, would consider this a dangerous development, and start moving out of the country; and in such a case it may have to be enticed to stay through the offer of an even higher real rate of interest. The size of the fiscal deficit in other words may have a bearing on the real rate of interest, not because of any sound economic reasons but solely owing to the caprices of international finance capital. But to argue for a reduction in the size of the fiscal deficit on these grounds, as a means of appeasing international finance capital, is both unsound and obnoxious.

It is unsound because, no matter what the size of the fiscal deficit, a certain minimum real rate of interest which itself is quite high would necessarily have to prevail in a third world economy open to financial flows. It is significant for example that Thailand which on the eve of its financial crisis in 1997 had a fiscal surplus equal to 3 percent of its GDP had nonetheless a 10 percent real rate of interest.

The argument is obnoxious because it tailors economic policy not to the needs of the people but to the caprices of international finance. Just as the fact that international finance may not like a particular Prime Minister, or a particular political Party in power, should not be an argument for jettisoning that person or Party if they enjoy popular support, likewise the fact that it dislikes fiscal deficits should not be an argument for eschewing the latter if there is no sound economic case against them. On the contrary the prejudice of international finance in all such cases has to be dealt with by circumscribing its freedom of movement rather than by circumscribing the country's freedom to pursue economic policies of its choice.

It follows from what has been argued above that the high fiscal deficit is not the cause but the result of the high real rate of interest, which ceteris paribus increases the interest payment burden of the State. Since the high real rate is itself a necessary accompaniment of "liberalisation", the fiscal deficit in turn can be traced to the process of "liberalisation" itself. To be sure India had a fiscal crisis before the policy of "liberalisation" began, but this fiscal crisis has got accentuated by the process of "liberalisation", and the fact that the fiscal deficit continues to be high despite significant expenditure compression is a reflection of this accentuation.

There are in fact two distinct ways in which "liberalisation" has contributed to this accentuation. One, as already mentioned, is the rise in interest rates that must occur as a consequence of freer financial flows. The other is the reduction in tax-GDP ratio which inevitably occurs in a "liberalised" economy. Since trade "liberalisation" involves reducing customs duties, and since an economy that is reducing customs duties can scarcely increase excise duties (as that would entail gratuitous de-industrialisation) the capacity of such an economy to raise revenues through indirect taxes gets impaired. Likewise since attracting foreign capital involves taxing it as lightly as other wooing economies, and inter se equity implies that the taxing of domestic capital can not be too far out of line with that of foreign capital, and also that personal income taxation cannot be too far out of line with corporate income taxation, the capacity to garner revenues through direct taxes gets impaired. A reduction in the tax-GDP ratio, such as has occurred in India in the 1990s, is the inevitable sequel. This fact and the rise in the State's interest payments obligation, both fall-outs of "liberalisation", underlie the accentuation of the pre-existing fiscal crisis, which results in some mix of expenditure compression and an even larger profile of State debt (which makes things even worse over time). Expenditure compression in turn whittles down anti-poverty programmes (which despite all "leakages" have some impact by way of reducing poverty, especially in rural areas), reduces social expenditure as well as investment in infrastructure, and unleashes recession and stagnation in major commodity-producing sectors.

The fallacy in the thinking of several well-meaning economists who want both "liberalisation" and greater social expenditure lies precisely in their failure to see this fact, namely that expenditure compression, including on social sectors, is an inevitable fall-out of "liberalisation". The fallacy in the government's position lies in mistaking the consequence for the cause, in identifying what is the consequence of "liberalisation" as the cause for its lack of success. One particular example of this inverted reasoning is to see the high interest rates as the consequence of the fiscal deficit, while in fact they are a cause of it.

This reasoning however leads to further expenditure compression, a further compounding of the crisis engulfing the infrastructure and social sectors, and a further perpetuation of recessionary conditions. Curtailing the fiscal deficit brings little relief by way of a reduction in interest rates, and hence scarcely any stimulus to aggregate demand via this avenue; on the other hand the cuts in expenditures, especially investment and social expenditures, which are undertaken for achieving this curtailment in the fiscal deficit, have a demand depressing effect. The obsession with cutting the fiscal deficit in a demand-constrained system represents quintessential economic unwisdom.

                                                                   V

The most bizarre example of this unwisdom relates to the foodgrain economy: in a country of starving millions over 45 million tonnes of foodgrain stocks are held which the government does not know what to do with, and is even exporting abroad at prices charged to the BPL population, i.e. prices less than those charged in the domestic market. The high carrying costs of these stocks (including interest costs) are the principal reason behind the inflated the food subsidy bill. The government's misguided effort to curb food subsidy by increasing PDS prices, such as the one undertaken in last year's budget, has the apparently paradoxical effect of not doing so: the higher prices simply lead to lower offtake which keeps the foodgrain stocks larger than before and hence their carrying cost increases. As a result the total food subsidy remains as large as before while its composition changes with a higher share going for holding costs and a lower share to the consumer.

Some have even suggested a dismantling of the entire PDS, on the grounds that this would bring down the foodgrains price. But while that may be true today, and may even get rid of the existing unwanted stocks, the suggestion is extraordinarily short-sighted: when market prices rise at some future date, the poor would be without any protection in the absence of the PDS. The whole point of the system of procurement-cum-public distribution that has prevailed in the country for the last three and a half decades has been to keep down the amplitude of price fluctuations both for producers and for consumers, which would have otherwise been extremely large in the free market, and which is actually extremely large in the world market. The system has been remarkably successful in meeting this objective. If the level of the food price is high in the PDS, and there is an inadequate lifting of stocks, then the solution lies in putting grater purchasing power in the hands of the poor, so that they can lift larger stocks, rather than in dismantling the system altogether. In other words a simple solution exists to the problem of surplus foodstocks, namely to expand the food-for-work programme. This would get rid of the stocks by enabling the poor to consume more food; and if properly conceived could even result in the creation of rural infrastructure and community assets.

This however is not on the government's agenda, since it would raise the size of the fiscal deficit. This particular objection to an enlarged employment programme is doubly erroneous: first, in a demand-constrained system, a rise in State expenditure on the poor, even if financed by a fiscal deficit, should be welcome anyway. (If international finance disapproves of it and expresses this disapproval through capital outflows, then that constitutes an argument for controlling its unrestricted movement rather than for restricting such expenditure). Secondly, a substantial part of this expenditure which would flow back to the FCI (or to other State-owned units) does not even constitute fiscal deficit, since it leads to no increase in the net indebtedness of the State. Yet, so great is the current obsession with restricting the fiscal deficit that the government is willing to dismantle the PDS rather than undertake a larger employment-generation programme.

This effectively is what the current budget has announced, notwithstanding all claims to the contrary. What appears at first sight as a mere transfer of the responsibility for procuring and distributing foodgrains from the central government to the state governments, actually amounts to a blow against the entire system for at least two reasons. First, any replication of the problem of unsold stocks, which currently plagues the system as it is run by the Centre, at the level of the states, would place the latter in a far worse position to take corrective measures. This is because the Centre has passed the burden of the fiscal crisis down to the level of the state governments to a point where it is even more acute for them than for the Centre. Secondly, states which are far removed from the centres of procurement will have to pay much more for food even if they continue a system of public distribution, since the Central government will no longer provide them with food, and since the cash subsidy it will give would only cover the BPL population. Under these circumstances the maintenance of a system where both producers and consumers are offered a degree of insulation from extreme price fluctuations will become well-nigh impossible. The virtual dismantling of the PDS, instead of supplementing it with a food-for-work programme, is perhaps the most disastrous fall-out of the obsession with the fiscal deficit, which, as Joan Robinson would have put it, is part of the "humbug of finance".

[1] Of course even in a demand-constrained system an increase in aggregate demand, while generating larger employment and output, might cause some increase in the price in terms of the wage-unit, owing to (possibly) increasing marginal costs. But this surely is not what the PMEAC is referring to, for otherwise even getting out of a slump would be dubbed "anti-poor". Its notion of "inflation" clearly refers to a state of affairs where it is only price adjustments that occur.

[2] In fact in view of our argument above that credit has not been supply-constrained, the level of the interest rate can be explained solely in terms of stock decisions.



Themes > Analysis	19.04.2001


On Fiscal Deficits and Real Interest Rates

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. I 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. II The Prime Minister's Economic Advisory Council (PMEAC) in its recent report has put forward an argument which is slightly different from the one presented above, though belonging to the same genre. This argument states: "The consequences of a high fiscal deficit depend upon the way the deficit is financed." If the deficit is financed by monetisation, and if this monetisation is "excessive", then this leads to domestic inflationary pressure, whose "impact is the highest on the poor." On the other hand if the deficit is financed by "borrowing in domestic financial markets" then "the result is that real interest rates become very high" which chokes off private investment. The PMEAC's argument is different from the one presented above because it does not assert that an increase in real interest rates is the inevitable consequence of a rise in the fiscal deficit; the consequence according to it depends on how the deficit is financed. But this proposition, namely that the consequences of a fiscal deficit are determined by how it is financed, flies in the face of elementary economics, as can be seen from simple IS-LM analysis. Consider the first case mentioned by the PMEAC, the case of monetisation. Even if the deficit is financed by monetisation which adds to bank reserves, this need not cause an inflationary squeeze on the poor as long as the real economy is demand-constrained to start with, and the deficit is not large enough to cause it to become supply-constrained [1] . (Moreover when bank reserves are being added to, it is not even clear why the deficit should be "financed largely by monetisation" as the PMEAC report assumes rather arbitrarily). On the other hand suppose the entire deficit is completely monetised. If the value of the Keynesian multiplier (at unchanged interest rates) is higher than the value of the money multiplier times the income velocity of circulation of money (also at unchanged interest rates), there would be an excess demand for money that would push up the interest rates, even though the fiscal deficit had been entirely monetised! In other words the proposition that when the fiscal deficit is monetised it affects not the interest rates but only prices relative to money wages is doubly wrong: there is no necessary reason why it should at all affect prices, and there is no necessary reason why it should not at all affect the interest rates. Now consider the second case, where there is no monetisation. Even if the deficit is financed entirely by "borrowing in the domestic financial market", it need not raise the interest rate at all if banks had excess reserves to start with. On the other hand if the fiscal deficit so financed occurs in a real economy which is supply-constrained to start with, then it raises prices in terms of the wage-unit, thereby imposing an inflationary squeeze on the poor. Thus the PMEAC's second case which is supposed to show that a fiscal deficit financed by market borrowing as opposed to monetisation causes a rise in interest rates rather than in prices in terms of the wage-unit is also doubly wrong: there is no necessary reason why it should at all affect the interest rates, and there is no necessary reason why it should not at all affect prices. There are two quite distinct errors underlying the argument of the PMEAC report. First, as simple IS-LM analysis would show, it is not how the fiscal deficit is financed that matters but the state of ex-ante excess demand in the goods and the money markets with which we start and how these are affected by the fiscal deficit. Second, again as simple IS-LM analysis would show, a rise in the fiscal deficit would raise prices in wage units (whether or not it raises interest rates) only if the economy is supply-constrained to start with, and would raise interest rates (whether or not it raises prices in wage-units) only if bank credit is supply-constrained to start with. This latter situation in turn cannot arise if banks have excess reserves (for a given stock of reserve money), or, alternatively, if the stock of reserve money itself can adjust to the demand for it. Thus the argument of the PMEAC report must necessarily be assuming (though this is nowhere explicitly stated) both that the real economy is supply-constrained and that bank credit is supply-constrained. Both these assumptions are palpably wrong in the context of the Indian economy today. Let us see how. III Let us take bank credit first. In any situation where banks hold a larger amount of government securities than required under the SLR obligation, they can always off- load a portion of these securities to the RBI, if not directly then at any rate at the margin by not picking up fresh government debt (which ipso facto would then devolve upon the RBI in its role as the underwriter of this debt). It follows that whenever banks hold excess government securities, since these can be traded for reserve money but are not, the credit market must be a buyers' market, i.e. there must be a shortage of demand for credit from worthwhile borrowers. Credit cannot be supply-constrained in such a situation. This is precisely the case in India today. Indeed the Economic Survey 2000-01 states this quite clearly: "The position changed with the inflows under IMDs in November 2000, which led to a sharp increase in the RBI's net foreign currency assets. The resultant generation of liquidity facilitated a sharp reduction in RBI's net domestic assets by enabling the RBI to off-load from its portfolio a significant portion of Central government dated securities to the market" (p.55). If credit had been supply-constrained in the economy, then the "market" which includes the banking system would never have moved into government securities. One remark of the PMEAC may be construed as a counter-argument to what has just been said, but that remark itself constitutes yet another logical contradiction in the PMEAC's argument. The PMEAC report says: "In recent years the government has been borrowing at around 11 percent when inflation averaged around 5 percent. This implies real interest rates of 6 percent for government borrowing, which means that private sector financing has to be at real interest rates of 8 percent or so for the best corporates and correspondingly higher for others. With such high real interest rates, private investment is bound to be choked off, which is exactly what has happened." This argument would appear to contradict my argument that "excess holding" of government securities by banks can occur only when credit is demand-constrained, since it believes that this "excess holding" is because of the attractiveness of government securities. This argument of the PMEAC however is logically faulty for two reasons: first, a 6 percent real rate of interest on government securities can correspondingly increase the interest rate on private securities only under certain circumstances. An obvious one is if the supply of government securities is infinitely elastic at this rate. If the supply is only a finite amount, then after this amount has been picked up, banks having additional resources will start picking up private securities at 6 percent or even lower real rates (as long as they cover "marginal cost"). A 8 percent floor real rate for private securities can operate only if banks' resources are limited relative to the supply of government securities. But if that were the case then the Reserve Bank (whose Governor is a member of the PMEAC) should be deemed to have committed a great disservice to the nation by offloading "from its portfolio a significant portion of Central government dated securities to the market." The RBI cannot gratuitously increase the stock of government securities in the market and then complain that there are too many government securities in the market! Attributing sense to the RBI must therefore lead to the conclusion that it offloaded securities because banks had extra resources owing to insufficient demand for credit from worthwhile borrowers. In other words, banks' holding of excess government securities suggests that credit is not supply-constrained. Secondly, the interest rate comparison in the PMEAC report is wrong, as the following example will show. Suppose for simplicity that banks have only three assets, cash, government securities, and loans to commercial enterprises, and suppose they are required to maintain 10 percent of their assets as cash and 25 percent as government securities. Suppose also, to start with, that they hold Rs.10 of cash reserves, Rs.29 of government securities, and Rs.61 of credit, i.e. they are maintaining the cash-reserve ratio but have "excess holding" of government securities. Then by selling Re.1 of government securities to the RBI, they can, collectively, expand their assets to Rs.11 of cash, Rs.28 of government securities, and Rs.71 of credit, provided there is plentiful demand for credit. If the number of banks is small and profit prospects significant,they would indeed be expected to co-operate to realise these prospects. Hence if r denotes the real interest rate on government securities and r' the rate on credit, then banks in the above example would get rid of excess holding of securities if 10 times r' exceeds r. More generally, if the cash-reserve ratio is denoted by c, banks would never hold excess government securities as long as r'/c exceeds r. The real comparison to make in other words is not between r' and r, as the PMEAC does, but between r'/c and r, where the former must win. It follows then that "excess holding" of government securities will never be resorted to if adequate credit demand is forthcoming. The fact that the banking system in India has been holding excess government securities implies then that credit has not been supply-constrained, in which case one of the assumptions underlying the PMEAC argument collapses. The other assumption, namely that the real economy is supply-constrained, is even more palpably wrong. When the country has 45 million tonnes of foodgrain stocks, when industrial growth is slowing down, when the existence of a demand constraint over vast sectors of Indian industry is recognised even by the Economic Survey, it is indeed sad to see that the group of highly distinguished economists which constitutes the PMEAC has put forward an argument which assumes Keynesian full employment! Since our system is demand-constrained both in credit and commodity markets, the basic assumptions of the PMEAC report break down. Thus, no matter which of its alternative versions we consider, the proposition that the real interest rate is high because of the high levels of fiscal deficits is erroneous: the theory it invokes for itself is in each case untenable; and the conditions under which it might hold empirically, if inserted within a tenable theory, are far removed from those that are actually obtaining. IV But if the high real rates of interest prevailing in the economy have nothing to do with the level of the fiscal deficit, then what does account for them? We have to bring in the stock-decisions here, i.e. the factors underlying the stock-equilibrium. [2] We also have to take cognisance of the fact that the 1990s have seen an opening up of the economy to freer capital flows, including in particular financial flows, from and to the rest of the world. In a world in which finance is free to move, if the identities of the countries did not matter at all, the rates of return would be equalised across all countries. In fact this was the proposition that underlay the Mundell-Fleming model. But identities of countries do matter: finance whether originating in the first or the third world would, if the rates of return were identical, rather move to the first world, which constitutes the home base of capitalism, than stay on in the third world where the elements of risk and uncertainty are much greater from its point of view. Consequently, in a world with free mobility of finance, the tendency would be for the rate of return to finance to be higher in absolute terms in the third world countries than in the first world in order to prevent its flight, which means that the real rate of interest, as a representative rate of return, would generally tend to be higher in the former than in the latter. Since the real rate of interest was exceedingly low, even close to zero in several third world countries, including India, in the period before "liberalisation", this also necessarily entails an increase in the average real rate of interest in the post-"liberalisation" as compared to the pre-"liberalisation" years. To be sure, since the real rate is the difference between two magnitudes, in particular periods, with sudden changes for instance in the inflation rate, it may move up or down sharply. The point however is that "liberalisation", in particular the opening up of the economy to freer movements of globalised finance (even when the currency is not fully convertible), pushes the country into a real interest regime that is higher compared to what prevails in the metropolis, and higher compared to its own past. This is exactly what has happened in India where the real interest rate in the 1990s have been higher on average than in the metropolis and higher on average than in the past. And the same story can be read in the case of virtually every third world country. Now, it is quite possible that if a third world country increases its fiscal deficit, then international finance, which does not like any form of State activism except that which promotes its own interest, would consider this a dangerous development, and start moving out of the country; and in such a case it may have to be enticed to stay through the offer of an even higher real rate of interest. The size of the fiscal deficit in other words may have a bearing on the real rate of interest, not because of any sound economic reasons but solely owing to the caprices of international finance capital. But to argue for a reduction in the size of the fiscal deficit on these grounds, as a means of appeasing international finance capital, is both unsound and obnoxious. It is unsound because, no matter what the size of the fiscal deficit, a certain minimum real rate of interest which itself is quite high would necessarily have to prevail in a third world economy open to financial flows. It is significant for example that Thailand which on the eve of its financial crisis in 1997 had a fiscal surplus equal to 3 percent of its GDP had nonetheless a 10 percent real rate of interest. The argument is obnoxious because it tailors economic policy not to the needs of the people but to the caprices of international finance. Just as the fact that international finance may not like a particular Prime Minister, or a particular political Party in power, should not be an argument for jettisoning that person or Party if they enjoy popular support, likewise the fact that it dislikes fiscal deficits should not be an argument for eschewing the latter if there is no sound economic case against them. On the contrary the prejudice of international finance in all such cases has to be dealt with by circumscribing its freedom of movement rather than by circumscribing the country's freedom to pursue economic policies of its choice. It follows from what has been argued above that the high fiscal deficit is not the cause but the result of the high real rate of interest, which ceteris paribus increases the interest payment burden of the State. Since the high real rate is itself a necessary accompaniment of "liberalisation", the fiscal deficit in turn can be traced to the process of "liberalisation" itself. To be sure India had a fiscal crisis before the policy of "liberalisation" began, but this fiscal crisis has got accentuated by the process of "liberalisation", and the fact that the fiscal deficit continues to be high despite significant expenditure compression is a reflection of this accentuation. There are in fact two distinct ways in which "liberalisation" has contributed to this accentuation. One, as already mentioned, is the rise in interest rates that must occur as a consequence of freer financial flows. The other is the reduction in tax-GDP ratio which inevitably occurs in a "liberalised" economy. Since trade "liberalisation" involves reducing customs duties, and since an economy that is reducing customs duties can scarcely increase excise duties (as that would entail gratuitous de-industrialisation) the capacity of such an economy to raise revenues through indirect taxes gets impaired. Likewise since attracting foreign capital involves taxing it as lightly as other wooing economies, and inter se equity implies that the taxing of domestic capital can not be too far out of line with that of foreign capital, and also that personal income taxation cannot be too far out of line with corporate income taxation, the capacity to garner revenues through direct taxes gets impaired. A reduction in the tax-GDP ratio, such as has occurred in India in the 1990s, is the inevitable sequel. This fact and the rise in the State's interest payments obligation, both fall-outs of "liberalisation", underlie the accentuation of the pre-existing fiscal crisis, which results in some mix of expenditure compression and an even larger profile of State debt (which makes things even worse over time). Expenditure compression in turn whittles down anti-poverty programmes (which despite all "leakages" have some impact by way of reducing poverty, especially in rural areas), reduces social expenditure as well as investment in infrastructure, and unleashes recession and stagnation in major commodity-producing sectors. The fallacy in the thinking of several well-meaning economists who want both "liberalisation" and greater social expenditure lies precisely in their failure to see this fact, namely that expenditure compression, including on social sectors, is an inevitable fall-out of "liberalisation". The fallacy in the government's position lies in mistaking the consequence for the cause, in identifying what is the consequence of "liberalisation" as the cause for its lack of success. One particular example of this inverted reasoning is to see the high interest rates as the consequence of the fiscal deficit, while in fact they are a cause of it. This reasoning however leads to further expenditure compression, a further compounding of the crisis engulfing the infrastructure and social sectors, and a further perpetuation of recessionary conditions. Curtailing the fiscal deficit brings little relief by way of a reduction in interest rates, and hence scarcely any stimulus to aggregate demand via this avenue; on the other hand the cuts in expenditures, especially investment and social expenditures, which are undertaken for achieving this curtailment in the fiscal deficit, have a demand depressing effect. The obsession with cutting the fiscal deficit in a demand-constrained system represents quintessential economic unwisdom. V The most bizarre example of this unwisdom relates to the foodgrain economy: in a country of starving millions over 45 million tonnes of foodgrain stocks are held which the government does not know what to do with, and is even exporting abroad at prices charged to the BPL population, i.e. prices less than those charged in the domestic market. The high carrying costs of these stocks (including interest costs) are the principal reason behind the inflated the food subsidy bill. The government's misguided effort to curb food subsidy by increasing PDS prices, such as the one undertaken in last year's budget, has the apparently paradoxical effect of not doing so: the higher prices simply lead to lower offtake which keeps the foodgrain stocks larger than before and hence their carrying cost increases. As a result the total food subsidy remains as large as before while its composition changes with a higher share going for holding costs and a lower share to the consumer. Some have even suggested a dismantling of the entire PDS, on the grounds that this would bring down the foodgrains price. But while that may be true today, and may even get rid of the existing unwanted stocks, the suggestion is extraordinarily short-sighted: when market prices rise at some future date, the poor would be without any protection in the absence of the PDS. The whole point of the system of procurement-cum-public distribution that has prevailed in the country for the last three and a half decades has been to keep down the amplitude of price fluctuations both for producers and for consumers, which would have otherwise been extremely large in the free market, and which is actually extremely large in the world market. The system has been remarkably successful in meeting this objective. If the level of the food price is high in the PDS, and there is an inadequate lifting of stocks, then the solution lies in putting grater purchasing power in the hands of the poor, so that they can lift larger stocks, rather than in dismantling the system altogether. In other words a simple solution exists to the problem of surplus foodstocks, namely to expand the food-for-work programme. This would get rid of the stocks by enabling the poor to consume more food; and if properly conceived could even result in the creation of rural infrastructure and community assets. This however is not on the government's agenda, since it would raise the size of the fiscal deficit. This particular objection to an enlarged employment programme is doubly erroneous: first, in a demand-constrained system, a rise in State expenditure on the poor, even if financed by a fiscal deficit, should be welcome anyway. (If international finance disapproves of it and expresses this disapproval through capital outflows, then that constitutes an argument for controlling its unrestricted movement rather than for restricting such expenditure). Secondly, a substantial part of this expenditure which would flow back to the FCI (or to other State-owned units) does not even constitute fiscal deficit, since it leads to no increase in the net indebtedness of the State. Yet, so great is the current obsession with restricting the fiscal deficit that the government is willing to dismantle the PDS rather than undertake a larger employment-generation programme. This effectively is what the current budget has announced, notwithstanding all claims to the contrary. What appears at first sight as a mere transfer of the responsibility for procuring and distributing foodgrains from the central government to the state governments, actually amounts to a blow against the entire system for at least two reasons. First, any replication of the problem of unsold stocks, which currently plagues the system as it is run by the Centre, at the level of the states, would place the latter in a far worse position to take corrective measures. This is because the Centre has passed the burden of the fiscal crisis down to the level of the state governments to a point where it is even more acute for them than for the Centre. Secondly, states which are far removed from the centres of procurement will have to pay much more for food even if they continue a system of public distribution, since the Central government will no longer provide them with food, and since the cash subsidy it will give would only cover the BPL population. Under these circumstances the maintenance of a system where both producers and consumers are offered a degree of insulation from extreme price fluctuations will become well-nigh impossible. The virtual dismantling of the PDS, instead of supplementing it with a food-for-work programme, is perhaps the most disastrous fall-out of the obsession with the fiscal deficit, which, as Joan Robinson would have put it, is part of the "humbug of finance". [1] Of course even in a demand-constrained system an increase in aggregate demand, while generating larger employment and output, might cause some increase in the price in terms of the wage-unit, owing to (possibly) increasing marginal costs. But this surely is not what the PMEAC is referring to, for otherwise even getting out of a slump would be dubbed "anti-poor". Its notion of "inflation" clearly refers to a state of affairs where it is only price adjustments that occur. [2] In fact in view of our argument above that credit has not been supply-constrained, the level of the interest rate can be explained solely in terms of stock decisions.



© MACROSCAN 2001