On Some Common Macroeconomic Fallacies Prabhat Patnaik

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.)

Fallacy 2: A Large Fiscal Deficit is Necessarily Harmful

There are three possible adverse consequences of a fiscal deficit (I am excluding such consequences as “lowering investors’ confidence”, since they arise only in a particular regime, of “liberalisation”, which itself has no sanctity). First, it may generate excess demand pressures in the economy, giving rise to inflation and/or a current account deficit on the balance of payments. Secondly, a fiscal deficit generates wealth inequalities in society. An excess of expenditure over income of the government must be matched by an excess of income over expenditure of the non-government sectors (i.e. of the private sector and the “rest of the World”). We have already mentioned the problem of enlarged foreign debt (which arises from a larger current account deficit on the BOP); so let us leave the “rest of the world” out. Financing government expenditure through larger domestic borrowing implies (relative to either not having this expenditure at all or financing it through taxes) larger private wealth. Since the propensity to save is larger among the rich, this necessarily means larger wealth in their hands; wealth inequalities therefore increase. What is particularly bizarre is when fiscal deficit causes inflation: here inflation squeezes out forced savings from the poor and working people, but these savings add to the wealth of the rich (Keynes had rejected such “deficit financing” in How to Pay for the War). Thirdly, deficit-financed expenditure (relative again to either tax-financed expenditure or to no such expenditure) sets up a debt-service obligation upon the government, which may aggravate fiscal strain in the future.

In a demand-constrained system the first of these adverse consequences would be inoperative (such a system may still experience a current account deficit following a fiscal deficit, since imports increase with output, but this is not specifically related to the fiscal deficit; any other way of enlarging output by a similar magnitude would have generated an equal current deficit). The other two adverse consequences of course would still remain. But this means that in a demand-constrained system, while it may be better to finance enlarged government expenditure through taxes (provided they do not nullify expansion) rather than through a deficit, it may still be preferable to have a deficit rather than not expand expenditure at all. A large fiscal deficit need not be shunned in a demand-constrained system.

But the matter appears in an altogether different light when we use the term fiscal deficit in the conventional sense in which it is used in India. Here fiscal deficit refers not to the deficit of the government sector as a whole but only to the excess of expenditure over income in the government budget. Since a large part of government activity is not covered in the budget, it is perfectly possible that the fiscal deficit as revealed in the budget is matched by a corresponding surplus not in private hands (we leave out the external sector for the moment), but in the hands of the non-budget sector of the government itself. If this happens, then the concern over private wealth inequalities and possible future fiscal strain (owing to debt-service payments) need not be serious. If the economy in addition happens to be demand-constrained, then a fiscal deficit need have no adverse consequences at all. Indeed in such a situation curtailing government expenditure in the name of keeping down the fiscal deficit would be a foolish policy to pursue, because it would perpetuate the demand constraint which could have been removed “costlessly” (i.e. with no adverse consequences). The foolishness would be truly astounding if, even in the presence of idle capacity located within the government sector itself, not only is fiscal deficit, which would have generated demand for using up this capacity, kept down, but “shortage of rupee resources” is simultaneously invoked as an argument to invite foreign investment to set up plants with the import of the very equipment whose production capacity is lying idle within the government sector.

In India, regrettably, fallacy 2 has become the cornerstone of official macroeconomic thinking; what is more, government policy even pursues the “astoundingly foolish” course just mentioned. Let me give two examples to illustrate my point.

At present there are over 32 million tonnes of foodgrain stocks of which at least 13 million tonnes are surplus stocks. These surplus stocks should be used to alleviate poverty and hunger through an employment-generation programme, which, if properly conceived and executed, can have the additional advantage of giving rise to rural capital formation. Even if this programme is financed entirely through deficit financing, this would have no adverse consequences: the money spent would accrue to the FCI (ignoring for simplicity the non-food component of the employment-programme), which in turn would use it to repay bank-credit locked up in stock-holding. The government’s net indebtedness would not have gone up; its total interest payment obligation would not have gone up (would have even come down if government borrowing costs less than FCI borrowing); and yet rural poverty would have come down through the elimination (even if temporary) of the irrational spectre of unused rotting foodstocks in the midst of mass hunger. True, the fiscal deficit shown in the budget would have gone up, but attributing economic significance to this fact per se is precisely the fallacy we are talking about. The current budget however undertakes no such programme. On the contrary it does the very opposite: it attempts to bring down this wrongly-conceived notion of deficit by raising food prices for all and by virtually winding up the public distribution system for the so-called “above poverty line” population which actually includes vast numbers of the poor.

My second example relates to the power sector. There is an almost unanimous view in government and media circles that India desperately needs foreign capital to develop its power sector. But this need cannot be for technology (which we have) or for foreign exchange (which would not be required in the first place if domestically produced equipment is used). The only possible argument in support of this view can be that MNCs bring finance, that if they were not entrusted with the task then the government would have to finance these power projects from its budgetary resources, which typically would mean a larger fiscal deficit.

In short, power projects are being entrusted to MNCs in order to avoid a larger fiscal deficit. But, as long as unutilised capacity owing to deficient demand exists in the power equipment and its feeder units belonging to the public sector itself, to talk of the government’s experiencing a shortage of finance for power investment is meaningless. If the government borrowed Rs.100 and spent it on a power project then the bulk of it would come back as operating surplus to BHEL and other public sector enterprises, so that the net indebtedness of the government would not increase despite the apparent increase in the fiscal deficit. But by invoking a financial constraint where none exists, the government not only succumbs to MNCs’ demand for their “pound of flesh” (including guaranteed rates of return on inflated capital costs), but also perpetuates the demand constraint faced by the public sector units. What is more, this perpetuation would be used as an argument for declaring these units to be “sick” and for privatising them ‘for a song”. The most charitable interpretation one can place on government action is the one I have placed, namely that it betrays “astounding foolishness”.

Fallacy 3: Disinvesting public sector equity is a valid way of closing the fiscal deficit

I argued above that there could be only three possible adverse consequences of a fiscal deficit. Now, disinvestment of public sector equity, as compared to a fiscal deficit, makes no difference to wealth inequalities; the private sector only swaps direct or indirect claims upon the government for public sector equity. There is in other words a change in the form of wealth-holding, not in the magnitude or distribution of it as would happen with by a fiscal deficit. Likewise, while a fiscal deficit sets up interest payment obligations upon the government, disinvestment of public sector equity entails foregoing future incomes (on this more later), so that there is nothing to choose between the two in terms of the future fiscal strain. The claim that disinvestment of public sector equity is a valid way of closing the fiscal deficit, i.e. would somehow ameliorate the harmful consequences of a fiscal deficit, can be sustained therefore only if it entails less excess demand pressures than a corresponding fiscal deficit would.

This would indeed be the case if those who purchased public sector equity did so by reducing their consumption or investment. Now, to my knowledge, no protagonist of the sale of public sector equity has ever argued that such sale “crowds out” private investment (for then the case for such sale would be considerably weakened). And nobody surely believes that people stint on consumption to purchase public sector equity. The purchase of public sector equity in other words has scarcely any flow-expenditure-diminishing effect on the private sector.

It may be thought that while such purchase may not directly reduce flow private expenditure, if it is financed by borrowing then less credit may be available for deployment in other uses, resulting in an indirect curtailment of private flow expenditure. But this argument is both empirically questionable and logically untenable. It presupposes a supply constraint on credit, which is empirically questionable for large chunks of the nineties, including now. Besides, if indeed credit were supply-constrained, then the financing of the fiscal deficit itself would have curtailed private flow expenditure, so that the fiscal deficit would not have generated excess demand in the first place, and the need for covering it would not have arisen at all.

Now, if disinvesting public sector equity does not reduce flow private expenditure, then the claim that it is a valid way of covering the fiscal deficit falls to the ground. Instead of the government borrowing Rs.100, say, from the banks to finance its expenditure (which is what a fiscal deficit entails), someone else borrows Rs.100 from the banks, hands it to the government in lieu of public sector equity, and the government then spends it. The macroeconomic consequences, in terms of aggregate demand, are exactly the same in the two cases. If with a fiscal deficit there was going to be excess demand-generated inflation, then exactly the same denouement would follow from public sector disinvestment. If the poor were going to be hit by a fiscal deficit-caused inflation in the first scenario, they would be equally hit in the second. But the second scenario entails a gratuitous handing over of public sector equity to private hands on the basis of false claims (of avoiding the ill-effects of a fiscal deficit).

Fallacy 4: Selling Public Enterprises to Retire Government Debt reduces Future Fiscal Strain

This argument has been put forward quite explicitly by the Finance Minister himself in his recent budget speech. The price at which a public enterprise (or its equity) sells in the market is determined by the discounted value of its expected stream of returns. Suppose, for example, that a public enterprise is expected to fetch for an an infinite period in the future stream of returns of Rs.10 every year. If the interest rate is 10 percent, then its market value would be Rs.100 (we are ignoring risks for simplicity); and if these Rs.100 are used for retiring public debt, then the interest payments saved every year are exactly Rs.10. The government in other words has lost Rs.10 per annum of returns from the enterprise and has saved Rs.10 per annum of interest payments. It is neither better nor worse off; there is no easing of its fiscal strain in the future.

Selling public enterprises to retire debt would indeed be worthwhile if and only if the enterprise sells for a price higher than the market value figure obtained when the stream of returns expected from it (when it is under government ownership) is discounted at the rate of interest payable on public debt. This translates roughly into the proposition that such a course of action is worthwhile for the government, and would ease future fiscal strain, if the enterprise sells for a price higher than its current market value (at the interest rate on public debt). On the other hand if it sells for a lower price than its market value (at the public debt rate of interest), then the future fiscal situation is worsened.

Now, there is absolutely no reason why the enterprise should sell at a higher price than this market value; and none of those who advocate such sale has ever made out a case that this indeed would happen. On the contrary, as everybody knows and as testified to by a host of authorities from the Comptroller and Auditor General of India to an impeccable “liberaliser” like Mr.Chidambaram (in the GAIL disinvestment case), the sale of public sector equity is usually way below its market value, which only worsens the fiscal situation in the future. Not only then is there no case for selling public enterprises to retire public debt, but it is actually a “rip off” which only worsens the fiscal situation in the future.

One can go on with the list of fallacies. In fact a whole phoney macroeconomics is being propagated these days from the Bretton Woods institutions, which unfortunately, even in this country with its remarkable tradition of economics, has been swallowed not only by our Finance Ministry but even by large segments of the economics profession. How else can one explain the fact that despite evidence of growing rural poverty, of a “rolling back” of rural employment diversification, of an absolute drop in per capita real consumption expenditure in rural India (which my colleague Sheila Bhalla has called an “economic development disaster”), and of persisting industrial stagnation, the most significant problem of the economy highlighted in the media is the fiscal deficit! And that too in the midst of huge unutilised industrial capacity and unsold foodgrain stocks!

May be I am being unfair. My claim about the above propositions constituting fallacies is based on macroeconomics no more complex than IS-LM. I would like any of those who believe in the correctness of the above propositions to set out simply but rigourously, in the manner of IS-LM, what their macroeconomics is. Only one thing I cannot accept: a “liberal regime”, “the need to retain investors’ confidence” etc. cannot be premises of the argument, they can only be conclusions. “Liberalisation” has to be shown to be good for the people; people cannot be assumed to exist for making “liberalisation” work. For the rest, I go along with Joan Robinson: “Let a hundred flowers bloom. Let a thousand schools of thought contend. But let them all state their assumptions.”