Macroeconomics literature is abundant with discussion on debt sustainability and its impact on growth. Debt-growth dynamics plays a role in the country’s fiscal policy whether executed in the cyclical or counter-cyclical direction. There is stream of thought that argues lower public debt leads to higher economic growth. Yet there is little literature on the causality. There is a possibility of high economic growth leading to lower public debt than otherwise. To achieve lower public debt, is high growth sine qua non? Or alternatively, does lower debt cause higher growth rates? Naturally, there merits a discussion on the causal linkages between the two. The current round of Economic Survey 2020-21 goes at length into this discussion and some interesting pointers emerge from the same. This discussion is naturally paramount in the current pandemic induced crisis wherein fiscal expansion is widely perceived as a tool of alleviate distress relative to the monetary instruments. Therefore, it would be prudent to discuss the findings of the Economic Survey with reference to the linkages between debt and growth.
The economic survey builds a strong case for fiscal expansion during times of slump. The counter cyclical measure would ensure the aggregate demand would increase and given the intricacies of the Indian labour market, there is a little chance of crowding out of the private sector labour market. Countercyclical fiscal policies are known to higher fiscal multipliers relative to cyclical fiscal policy. The survey goes a step further in arguing through evidence from literature on little supporting existing for the belief that increased government borrowings would result in the crowding out of the loanable funds market in countries like India. The survey begins building its case through the linkages between primary deficit, government debt in the current year, the government debt in the immediate preceding year, real cost of government debt and real growth rate. It of course extends the formulation to the nominal context as well without any changes in the underlying conclusions.
It posits the debt to GDP ratio of a country remains stable if the primary deficit maintains a certain level. Mathematically, if the changes in government debt to GDP remains were to be zero over the years or in other words, the debt to GDP ratio were to remain constant year over year, the following identity would hold good
Pbt = (rt-gt) * dt-1 / (1+gt)
Where Pbt is the primary balance as percentage of GDP for year t, rt is the real cost of government debt or in other words real interest rate for year t, gt is the real growth rate for the year t, dt-1 is the debt as percentage of GDP in the year (t-1) or the previous year.
When g is greater than r, the threshold level of the primary deficit remains positive. As long as the primary deficit falls below this threshold, the debt levels remain sustainable. If the primary deficit were to remain a constant fraction of the GDP, it is found that (r-g) is a sufficient statistic to illustrate the sustainability of the public debt. For public debt to sustain, the real growth in the economy must be higher than the real interest cost of the servicing the public debt. Therefore this leads to a new term called IRGD, expanding of which leads to interest rate- growth differential. If the differential is negative, the economy can sustain the levels of the debt. It borrows from the quote from Blanchard (2019) in his Presidential Address to the American Economic Association which states “ If the interest rate paid by the government is less than the growth rate, then the intertemporal budget constraint facing the government no longer binds” There would obviously be a question about the quantum of debt that would be sustainable. In this regard, the survey finds support in the literature from corporate finance. The celebrated Modgliani-Miller theorem on the value of the firm and linkages with the capital structure come to the rescue. The celebrated theory posits capital structure irrelevance in the value of the firm. If this were to be applied into the national context, the principle would hold good. This of course does account for the conditions that are essential for the irrelevance theorem to hold good.
Having introduced these terms, the survey goes to examine the empirical relationship between the government debt and the growth rate. It seeks to examine the causal relationship between the two. Like India, evidence from other countries too point towards a lower or declining public debt levels relative to the negative IRGD. In other words, as the growth is higher than real interest rate, the debt levels demonstrate a decline. Both within country and across country variations point towards a similar conclusion that the variability in IRGD is function primarily of the variation in g. As they examine the real interest rates, real growth rates and IRGD of different countries, India is one of the few which have demonstrated a negative IRGD at least since 2003. It’s the lowest for the OECD economies. There would be a question of sustainability as indicated above. The possibility of higher debts leading to higher taxes, lower disposable income, lower consumption and thus lower aggregate demand. Yet as pointed earlier, the survey seems to support the extension of the capital irrelevance theorem into the national income statistics dynamics.
The survey through an examination of data through the last two and half decades or so points out that higher GDP growth rates have consistently led to lower public debt, yet there is no evidence for the reverse. Further statistical tests using lagged correlations too point out in India an existence of the causal relationship between higher GDP growth rates resulting in lower public debt to GDP levels. The survey seeks validation from the evidence found in other countries. There is of course certain mixed results with some inconclusive evidence. There seems to be no correlation between IRGD trends and the changes in debt to GDP ratio in countries like UK or US. Yet, when one decomposes the data, results identical to India are found when only high growth periods are examined. Yet, the growth rats are relatively higher compared to normal growth rates. Thus statistical significance while existing doesn’t indicate much about causality of the IRGD and debt to GDP ratio changes in the advanced economies. There is a possibility which the economic survey recognises that the fiscal contours, intended uses and the resultant outcomes are very different from ones in India.
The evidence thus available and linking with related theories of capital irrelevance, lack of evidence of crowding out, countercyclical fiscal multiplier levels, segment private and public labour markets all point towards a strong case for fiscal expansion during times of economic slump. The year 2020 was in particular harsh due to uncontrollable factor of COVID-19 and the consequent lockdowns. The monetary policy would have its limitations. There emerged an increasing role for the fiscal space. The increased fiscal spending essentially through cash transfers potentially creates conditions for a high fiscal deficit and thus high public debt levels leading to future implications. The chapter in the economic survey seeks to make a case for fiscal expansion stating that countercyclical expansion leads to growth and thus results in lower public debt levels rather than otherwise. It is the growth that should be the focus and not the levels of public debt which will correct themselves if the growth is taken care of. This seems to be the sum and substance of the survey in its exposition on public debt – growth dynamics.
The chapter on public debt growth dynamics in the economic survey 2020-21 is available here.
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