Page 60 - ES 2020-21_Volume-1-2 [28-01-21]

Does Growth Lead to Debt 02

Sustainability? Yes, But Not

Vice-Versa! CHAPTER

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“The state collects tax for the greater welfare of its citizens in the same way as the sun
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham

Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance.
This Chapter establishes clearly that growth leads to debt sustainability in the Indian
context but not necessarily vice-versa. This is because the interest rate on debt paid by
the Indian government has been less than India’s growth rate by norm, not by exception.
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic
Association: “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.” This
phenomenon highlights that debt sustainability depends on the “interest rate growth rate
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in
an economy.
In advanced economies, the extremely low interest rates, which have led to negative
IRGD, on the one hand, and have placed limitations on monetary policy, on the other
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a
negative IRGD in India – not due to lower interest rates but much higher growth rates –
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns
and economic crises.
The confusion about causality – from growth to debt sustainability or vice-versa –
is typical of several macro-economic phenomena, where natural experiments to identify
causality are uncommon. In the specific context of growth and debt sustainability, this
confusion also stems from the fact that the academic and policy literature focuses
primarily on advanced economies, where causality is entangled by lower potential growth
when compared to India. Indeed, the chapter studies the evidence across several countries
to show that growth causes debt to become sustainable in countries with higher growth
rates; such clarity about the causal direction is not witnessed in countries with lower
growth rates. By integrating ideas from Corporate Finance into the macro-economics
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to
understand why these differences can manifest between high-growth emerging economies
and low-growth advanced economies.

As the COVID-19 pandemic has created a significant negative shock to demand,
active fiscal policy – one that recognises that fiscal multipliers are disproportionately