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.
[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.
