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56 Economic Survey 2020-21 Volume 1

iN iNDiA, GROwTH LEADS TO DEBT SuSTAiNABiLiTY, NOT ViCE-VERSA

2.11 How does the consistently negative IRGD affect the relationship between debt and growth
in India? Does higher growth lead to lower debt or lower debt cause higher growth? Conceptually,
causality could flow in either direction. The argument supporting higher debt leading to lower
growth is as follows: higher levels of public debt are accompanied by more taxes in the future
to pay for the debt, thereby leading to lower lifetime wealth, which may decrease consumption
and savings, eventually resulting in lower aggregate demand and growth rates. If higher public
debt (i.e. lower public savings) is not accompanied by increase in private savings, it may also
lead to lower total savings in the economy. This may put upward pressure on the interest rates,
resulting in crowding out of investment and thus negatively impacting the growth rates. On the
other hand, as described in Box 3, higher GDP growth leads to lower public debt through the
increase in the denominator, i.e. GDP.

Box 4: The Modigliani-Miller theorem, Principles of
Corporate Finance and Sovereign Debt

“As others have done before, one can think of countries as corporations. While obviously highly
reductive, consolidating all agents in a country into a single representative decision-maker has the
advantage of bringing out in a simple way the economic objectives of a nation and the constraints
that it faces, in particular its financial constraints. The drawback, as with corporations, is that the
consolidation buries all inside agency and governance issues.” (emphasis added)
– Patrick Bolton, Presidential Address to the American Finance Association titled “Debt and
Money: Financial Constraints and Sovereign Finance”, 2016

Before the Global financial crisis, macroeconomics largely ignored the role of finance and
the financial sector. However, recent macroeconomic research incorporates the role of finance in
the macro-economy. So, to think carefully and clearly about a country’s fiscal policy and how
the same can impact its investment policy, a corporate finance perspective a la Patrick Bolton
(2016)’s presidential address at the American Finance Association is useful. The study postulates
that fiat money in a country resembles the equity in a corporation because a Rupee of fiat money
enables the owner to a lay a one Rupee claim on the country’s output just like a share of common
stock entitles the holder to a pro-rata share of residual cash flows of a firm; higher the fiat currency
owned by a citizen, greater the claims that the citizen can lay on the country’s output. By drawing
this clever parallel, Bolton (2016) employs the principles of corporate finance to theoretically
model the choice of sovereign debt for a country.

To think about sovereign debt in this framework, it is useful to start with the Modigliani-Miller
theorem (Modigliani and Miller, 1958), which provides the conceptual bedrock for thinking about
debt and capital structure. The theorem posits that, under certain ideal conditions described below,
the amount of debt or the capital structure of a firm (or a sovereign by extension) is irrelevant.
The theorem employs the concept of “homemade leverage” to arrive at this important conclusion.
Homemade leverage is a financial concept that holds that as long as investors can borrow on the
same terms as a firm, which prevails only under ideal conditions, they can artificially duplicate
the effects of corporate leverage by creating their own homemade leverage to either nullify or
duplicate any debt-equity choice made by the firm. Therefore, under ideal conditions, investors