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Ideas of India: Fiscal Dominance—A Theory of Everything

Oct 15, 2020

Ideas of India is a new podcast in which Mercatus Senior Research Fellow Shruti Rajagopalan examines the academic ideas that can propel India forward. You can subscribe to the podcast on AppleSpotifyGoogleOvercastStitcher, or the podcast app of your choice.

In this episode, Shruti spoke with Viral Acharya about his new book, Quest for Restoring Financial Stability in India. Acharya is the C. V. Starr Professor of Economics in the Department of Finance at New York University Stern School of Business. He is also an academic adviser to the Federal Reserve Banks of New York and Philadelphia. He served as a deputy governor of the Reserve Bank of India from January 2017 to July 2019. His primary research interest is theoretical and empirical analysis of systemic risk of the financial sector. This transcript has been slightly edited for clarity.

 SHRUTI RAJAGOPALAN: Viral, thank you so much, and welcome to the show.

VIRAL ACHARYA: Thank you, Shruti. It’s my pleasure to be on your podcast.

On Fiscal Dominance

RAJAGOPALAN: Your book outlines your theory of fiscal dominance. When I started reading it, I thought, in one sense, it’s a continuation of some of the past work. In the Indian context, for instance, Urjit Patel and Willem Buiter have done their work on fiscal dominance over monetary policy. Of course, there is Urjit Patel’s book, Overdraft, which is much more focused on the impact of fiscal dominance on banking regulation, a function of the RBI [Reserve Bank of India].

I initially thought your argument is along similar lines. As I read more carefully and got to the end, to me, it seemed that you are a little more radical than your colleagues. Because you’re not just talking about fiscal dominance over monetary policy, or even specifically about banking regulation.

The kinds of impact that fiscal dominance has on India’s economic growth or the current growth slump, or on its public finance and central and state relations, on private sector crowding out, even the nature of government spending and welfare entitlements. And by the end of it, I felt like your argument is a radical case made by a central banker to severely limit most of India’s government spending and not just narrowly about fiscal dominance.

ACHARYA: Absolutely, Shruti, that’s very well put. What I would say is that when the size of the state in terms of its borrowings and deficit becomes so large as it is in case of India, where even pre-COVID, the fiscal deficit numbers on a true consolidated basis were already in the range of 8% to 10% of GDP with demands increasing by the day—of course, post-COVID, these numbers are projected to be as high as 14% to 15% of GDP.

Now, when the government borrowing programs become so large, what I’m trying to highlight in the introductory chapter of the book is that it has a tendency to permeate every single aspect of financial sector policy, and you are spot on, which is that it is this everything aspect.

From the vantage point that I had, I found that the Reserve Bank of India is, of course, in charge of supervision and bank regulation as you mentioned. It is the debt manager for the government of India. It regulates the debt markets, so it sets the rules under which the debt markets are going to be governed. These rules can also get skewed in favor of government borrowing compared to borrowings by the private sector for example. It’s in charge of the external sector, so what kind of external debt the government issues can also be a pressure point between the central bank and the government interactions.

Other financial regulators, such as the Securities and Exchange Board, are in charge of disclosure notes should publicly listed companies disclose if they have missed a payment on a bank loan. Now, in developed economies, you would think that any materially relevant information should be disclosed by the firm to its public investors, such as bondholders or shareholders, for efficient allocation of capital, for ensuring that minority investors are not taken advantage of by those who are privy to this insider information, and so on.

Yet, in India, whether you disclose defaults by publicly listed companies in a timely manner to the markets or not is driven by, what will that do to the credit rating of the company? How will that lead to capital requirements for public sector banks? What will that mean for the annual budget allocation? How much of a compromise would that lead to on the government’s desire to spend, say, on populist subsidy programs?

The reason why I point out this example is because it shows that something that looks so distant from the government budgets, which is the quality of disclosure of information on a stock exchange, is also actually intimately compromised by the end budgetary recalculations and the desire of what the budget should be in the minds of the government.

I think this is the main thesis. I want to actually make it clear that just fixing one aspect of this problem, which is you go narrowly in the direction of supervision or regulation of bond markets, this is not going to fix it because then it’s like a whack-a-mole problem. You kind of whack-a-mole and it springs up somewhere else because the fiscal is so deeply permeating the rest of the system. It’s always trying to get everything in the rest of the system to its advantage.

I think even as an economic framework, we need to do more along these lines in our conceptual thinking, in our theoretical models, and in teasing out how the interactions between the government and different parts of the economy work. It has its own conflicted objectives of being popular, for example, or running certain kinds of programs that will bring it the votes from a particular constituency that it’s trying to swing over in its favor. I think I wanted to offer an organizing framework, a set of principles that would help us think through. I think the sum total of it is that the fiscal stability and financial stability in India are now intimately linked.

This is a theme that I’ve been developing in my research over a period of time, that there is a nexus between the sovereign and the financial sector through its choice of the rules of the game, through its compromise of the central bank and other financial sector regulators, through its crowding out of the private sector, a form of financial repression basically. The governments get deeply intertwined with the bank balance sheets.

They want banks and others in the financial sector in one way or the other to make it easy for the governments to borrow. What that leads to is that when the governments doesn’t continue on a path of stable debt finances or there’s an external shock or there’s a shock like the pandemic that actually completely knocks off you from your steady-state path, then you have a serious problem. Because not only will the government face these problems, now it will impose a huge collateral damage to the financial sector in the process.

This nexus then starts creating what some people have called a doom loop or forward-backward linkages or a diabolical loop. There’s all kinds of fancy terms that economists have come up with. In some of my work, notably with Raghuram Rajan in a series of papers—first, a joint paper with him, then in a separate paper with him and one of my PhD students, Jack Shim—what we are trying to argue that by creating this nexus, governments actually first increase their debt capacity because you create a clientele in the economy that is repressively required to buy the government bonds in one way or the other.