In a statement published in the newspapers today RBI governor D. Subbarao is quoted as saying “Large borrowings by the government run against the low interest rate environment that the Reserve Bank is trying to maintain to spur investment demand in keeping with the stance of monetary policy.” On this basis Subbarao claims that the new government should not provide further fiscal stimulus to the economy.
First, even if Subbarao’s claim regarding the contradiction between expansionary fiscal policy and low interest rates were to be true, his conclusion would not follow since in that case we would have to compare the relative effectiveness of fiscal and monetary policy in fighting recession. And it is quite possible that in that comparison fiscal policy would come out the winner. In the case of a fiscal stimulus, at least the direct demand generated does not depend significantly on the behavior of the private sector. On the other hand a policy of low interest rates can boost demand only if the private sector is willing to borrow and invest, which it may not be given the pessimism the prevails in a recessionary environment. So, even if there were a contradiction between counter-recessionary monetary and fiscal policies, a high government expenditure-high interest rate regime might be preferable to a low government expenditure-low interest rate regime.
However, in reality, this choice does not need to be made. High government expenditure financed by borrowing does not by itself lead to high interest rates. Macroeconomists have known this for three quarters of a century now. Yet the fallacy, of which Subbarao has made himself the latest proponent, continues to resurface. One may speculate about the social reasons for this, and I will give in to that temptation at the end of this note. But before doing that let us run through the economic logic once.
A direct way of seeing why Subbarao is wrong is to note that the short-term nominal interest rate is not a market-determined price at all—it is an administered price of which Subbarao himself is the administrator. The interest rate at which RBI lends and borrows determines the interest rates which prevail in the economy. If the interest rate for private sector loans is significantly lower than what the RBI offers to those who lend to it, people would borrow from the private sector and lend to the RBI. If the interest rate for private sector loans is significant higher than what the RBI charges from those who borrow from it, people would borrow from the RBI and lend to the private sector. Thus whatever interest rate the RBI charges on its loans becomes the interest rates which prevails throughout the economy.
Of course loans made to the private sector would always carry a higher interest rate than loans to the RBI since private loans are risky whereas there is no risk in lending to the RBI. But since there is no reason why this risk premium demanded from the private sector would depend in any way on the level of the government’s fiscal deficit, we ignore variations in it in our discussion below and assume that a change in RBI’s interest rates translates into a one-is-to-one change in the interest rates for the private sector. We can also ignore for simplicity the lags that exist between changes in interest rates by the RBI and changes in retail interest rates.
So if Subbarao wants interest rates to be low, he just needs to announce low interest rates. How much the government does or does not borrow should not have any impact on the effectiveness of his choice. If the quantity of government bonds that are outstanding exceeds the amount of bonds people are willing to hold at the interest rate fixed by the RBI, they will offset this excess holding of bonds by borrowing an equivalent sum from the RBI and vice versa.
One may object that borrowing from the RBI (which creates money) is not a perfect substitute for government bonds. In our response, we distinguish between short-term and long-term government bonds. The only difference between short-term bonds and money is that money is slightly more liquid, i.e., slightly more acceptable in exchange. However, in an economy like ours with developed financial markets this liquidity advantage is likely to be small and therefore substitution between money and short-term government bonds is unlikely to have large consequences. The case of long-term bonds is different, since holding long-term bonds involves taking interest-rate risk while holding money does not. So in case the government borrows by issuing long-term bonds the substitution argument made earlier in this paragraph may not hold. But what is happening in this case is a change in maturity structure of the net stock of financial assets in the economy, something completely different from interest rate policy which Subbarao mentions in his statement.
Sometimes defenders of Subbarao’s position speak in terms of increased government borrowing pre-empting a larger proportion of the total credit available in the economy. So far in our argument we have assumed that the RBI is willing to lend and borrow as much as the private sector demands at the interest rate it has fixed. The amount of credit available in the economy can therefore be restricted only if either RBI actually restricts the amount it is willing to lend or if not all agents in the private sector have access to the RBI’s borrowing window and those who do have access are not willing to borrow on behalf of those who don’t.
In the first case, where the RBI is lending too little, the remedy is simple—the RBI needs to lend more rather than asking the government to borrow less. The second case is more realistic and interesting. As things stand, only banks can borrow from the RBI. It may be the case that banks refuse to lend to the rest of the private sector, instead deciding to hold government bonds. But in this case the excess holding of government bonds is just the symptom, the real problem is banks refusing to lend to businesses. Trying to treat just the symptom by restricting the stock of government bonds will be counteracted by banks running down their reserves or by their turning around and lending to the RBI. The true cure would involve either making businesses credit worthy again, in which demand injection through fiscal stimulus can only help, or in more extreme cases by the central bank opening up its borrowing window to a larger class of private agents, as the US Fed seems to be doing.
Thus, there is no reason why larger borrowing by the government need raise interest rates in the economy. This fact has been known to economists at least since the time of Keynes. Then why does a person holding as important an economic position as the governorship of the Indian central bank repeat such a fallacious argument? One possibility is the strong hold of prejudice, in this case the prejudice in favor of a small government, among even those who are otherwise highly trained.
However, there is a more worrying interpretation. Even if high government borrowing by itself has no harmful consequences, it certainly is disliked by the financial markets. Given the vulnerability of the economy to hot money flows, the RBI governor’s desire for a smaller deficit may be a sincere attempt on his part to keep foreign investors happy. But in that case, would it not be better to control footloose capital directly rather than placating it by placing restrictions on a democratically elected government and imposing real costs on the people of the country by recommending deflationary fiscal policies in the midst of a recession?