On Fiscal Deficits and Real Interest Rates

The theoretical perception underlying the strategy of the 2001-2002 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.