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.)
