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.
