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Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa! 57

would not care between investing in a firm having zero debt and one that chooses to have debt in
its capital structure. Similarly, under ideal conditions, the investors in a country, which includes
the citizens as equity holders via holders of fiat money, would not care about the amount of debt
raised by the country.
As with most theories, the practical utility of the Modigliani-Miller theorem arises from
understanding the precise set of conditions that lead to its failure, specifically from the ways in
which the postulated ideal conditions get violated in practice. In fact, as Miller (1988) reviewed,
“showing what doesn’t matter can also show, by implication, what does.” (emphasis in original)
Relaxing the assumptions that lead to the ideal conditions enables us to understand what practical
considerations do impact capital structure. These are absence of taxes, bankruptcy costs, agency
problems or asymmetric information and the presence of complete markets in the Arrow-Debrew
formulation. If all these assumptions hold, then investors/citizens can borrow on the same terms
as a firm/ sovereign.

In developing economies such as India, the presumption that citizens can borrow on the
same terms as the sovereign gets violated sharply because of the combination of bankruptcy
costs and asymmetric information, which in turn result in lack of access to credit markets for
large sections of the population. In developing economies such as India, the wedge between the
cost of borrowing for the sovereign and the cost to an average (common) citizen is much higher
than in developed economies. This wedge includes the costs faced by the average citizen on both
the intrinsic and extrinsic margins, i.e. the interest rate paid conditional on being able to borrow
and the cost from being credit rationed respectively. Therefore, the application of the homemade
leverage argument leads to the inference that fiscal multipliers would be significantly higher in a
developing economy such as India than in developed economies.
The Bolton (2016) analysis also highlights the importance of fiscal policy to fund capital
investment, especially during periods of economic crisis. The literature in corporate finance
highlights that financing constraints impact investment materially. As financing constraints faced
by the private sector get significantly exacerbated during an economic crisis, the role of the
sovereign in using fiscal policy to foster investment becomes particularly salient in a crisis. As
Bolton (2016) notes “If there is one deep, general, lesson from the global financial crisis of 2007-
09, it is that financial constraints matter: they bite a little most of the time, a lot some of the time
(and they are deadly in extreme crises). What is more, when they bite a lot the stagnation they
engender persists for long stretches of time... So, what makes corporate finance relevant is the
universal presence of financial constraints. At the margin, most economic decisions are affected
by financial constraints. Understanding these constraints, therefore, helps us better understand
economic decision-making. And understanding how to relax financial constraints helps us achieve
more efficient resource allocation.” Financial constraints faced by the private sector – including
firms and households – are particularly biting during periods of economic crisis and when they
bite a lot the stagnation they engender persists for long stretches of time. Therefore, the wedge
between the costs of borrowing for the sovereign and that for the citizens, including corporate
citizens, is disproportionately larger during periods of economic crisis.

Bolton (2016)’s analysis highlights potential inflation as the primary cost of raising debt
in the domestic currency. A domestic-currency sovereign bond is, in effect, a pay-in-kind note