Dynastic madness will ensure that political stability is with us for the next five years. The apologists are cranking out spineless spin – lack of organization, too many “old” advisers, not the right coalitions – to explain why the Congress was kicked on its backside into near oblivion. Only in the land of sycophants does introspection mean other people’s faults rather than the presence of the pretender. Which means that in 2004, the Nehru-Gandhi firm is likely to be fighting it out with the Communists for seats, and irrelevancy. A perfect stable political environment, therefore, for Mr. Vajpayee to kick-start policies that will result in the next decade being known as India’s decade, much as the eighties and nineties are known as China’s decades. A sustained GDP growth rate of 7-9 percent is well within our grasp, though our reach is closer to double-digit levels.

What economic reforms are necessary to achieve this potential? No prizes for saying that “the fiscal deficit “ (FD) has to be brought down. This is the much parroted line, especially by the lazy ones. But why is it that FD’s are bad – because they lead to “crowding out” of investments. Why does the private sector get crowded out – because of higher real interest rates. The core effect of higher FD is higher real interest rates. This is why FD’s are bad; this is why it is a parrotable no-brainer to conclude that a reduction in fiscal deficits will lead to lower real interest rates and higher, and more efficient, growth.

The causation is explicitly from high FD’s to high interest rates. In all economies – except India. Here, the control, policy, non-market variable is the interest rate on postal deposits and provident funds. Yes, Sita, in India, provident funds are mandated to yield a princely12 percent, a situation identical to the UTI scandal of guaranteed returns. The postal deposits are also mandated to yield 11.5 percent. (It is another matter that there are no government securities that yield such high double-digit real rates of return.) But the real princes who benefit from these high deposit rates are the state governments who get correspondingly higher deposits. And where have all the deposits gone? Into state expenditures and deficits.

Note the direction of causation. These deposit (nee chit, nee Ponzi) schemes set a floor to the interest rates in the economy, a floor unchanged by any monetary policy pursued by the RBI. In most economies, there is a 2 % gap between deposit and lending rates; in inefficient India, the gap is 3 percent. Which means that the borrowing rate for most firms is upwards of 15 percent, which is a 13 percent real borrowing rate – which is unheard of in any part of the civilized world. The high interest rate on savings deposits is the borrowing rate of the government.
These high rates lead to high interest payments, and to high deficits. Today, interest payments account for more than 80 percent of the entire fiscal deficit of the economy, up from 34% in the early eighties. The FD has stayed the same – down only 1 % from 10.5 % in the early eighties.

When inflation is 10 percent, it makes sense to have deposit rates at 12 percent; but it is extraordinarily nutty to have them at 12 percent when the inflation is at 2 percent. But where should such rates be when inflation is at 4 percent or 6 percent? These are difficult questions, which is why mere mortals in the rest of the world do not answer them – they let the market do the talking, and the setting. Not so in India where interest rate setting is a prelude to deficit setting, and then for the objections afterwards for a high deficit. It does not get crazier than this.

Note that in the land of constantly high FD, the policy variable is the mandated interest rate on deposits and provident funds and associated schemes. High interest rates attract more of your and my money; today, such deposits are more than 40,000 crores per year, and the accumulated “small savings” debt is more than 400,000 crores. This is close to 25 percent of all government liabilities. But why are deposit interest rates set so high, if they are so bad? To attract “revenue” for state expenditures. This “revenue” is then taken by the states as a
license to run a large deficit, a license they exploit all the way to corruption. Na rahe ga bans na rahe gi bansuri. If the state governments (or the central government) did not get easy money to spend, how could it run up large deficits? The state governments are answerable to no one until elections five years later. So they keep spending, and keep increasing the total outstanding deficit. If deposit rates were not high, small savings would not attract the money, the state governments would be forced to curtail expenditures, and the deficit would be tautologically lower. Hence, the conclusion that high interest rates cause high deficits.

Some guide to where interest rates on deposits might “settle” in a market economy is provided by data on the rest of the non-crazy world. There, real interest rates on deposits range between 0 and 3 percent; the former level in a recession, the latter in a boom. By this historical reference, real deposit rates in India should be close to 2 percent, or around 4 to 5 percent nominal, given an inflation rate of 2-3 percent.

No logic yields a number even close to 12 percent. High interest rates result in higher deposits results in higher expenditures which results in higher interest payments, which results in higher fiscal deficits. This is the old corrupt economics of the state, something that the new government should change. It should be mentioned here that the Finance Ministry did embark on the path of lowering deposit rates on postal savings in February. Unfortunately, for the economy, tea parties came in the way of good policy. It is time for the government to catch up with its promise.