Thinking about thresholds

Targets for debt and deficit are less important than their trajectories

Chief Economic Advisor Arvind Subramanian recently warned against fetishising any particular target for the fiscal deficit, or indeed any particular level of the debt-to-gross domestic product ratio. He argued that the fiscal deficit target of 3 per cent of gross domestic product (GDP) had not emerged from any particular theory, but from the historical experience of Europe. Mr Subramanian has a good point, and one that should spark off discussions at the highest level of government. While focusing on a numerical target as a percentage of GDP may be useful as a signal to investors and to global capital, such targets have no power in and of themselves. Figures such as the 3 per cent of GDP target that are, essentially, pulled out of a hat should be constantly subject to questioning and analysis, especially in contexts different from those in which they evolved. What was seen as being appropriate for a developed economy, such as those in Europe, is not automatically correct or necessary in a rapidly growing developing economy such as India.

 
Mr Subramanian also has a point in arguing that 60 per cent of GDP as an “ideal” threshold for public debt has similar flaws. The question of whether there is a threshold of public debt above which growth is pulled down has itself become controversial in recent years. Work by the Harvard economists Kenneth Rogoff and Carmen Reinhart in 2010 suggested this level was 90 per cent; this work was challenged as not being robust to alternative specifications of the data. Eventually, economists at the International Monetary Fund, using their own dataset, found “no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised”. In any case, they had been rarely enforced or met. Since 1999, half of the EU’s members have missed the 60 per cent debt target half of the time, the IMF economists found. In other words, let alone 60 per cent of GDP, 90 per cent of GDP is not in and of itself an issue.

 
What matters for both deficit and debt consequences when it comes to evaluating growth-supporting policy is instead the broad trajectory of debt as a percentage of GDP — a conclusion that is sound in theory, and has been found to be empirically true as well. To avoid a debt trap, such as many developing economies suffered in the early 1980s, what is necessary is to ensure that growth is faster enough so that government borrowing does not constrain the availability of capital. Looked at another way, the interest rate should not be approaching or exceeding the level of growth in nominal GDP. India does not seem to be in that situation. Thus, when evaluating the effects of, say, a fiscal expansion on the economy’s medium-term prospects, there should theoretically be less of an emphasis on any particular target, and more on what it will do to the future trajectory of debt (and rates) versus growth. Remember, India has lived with a general government deficit, of Centre and states, of well over 6 per cent without any major effects on growth — though inflation has remained stubbornly high as a consequence. Any such targets are guideposts, and should not be treated as hard and fast rules. So long as the trend is moving in the right direction, towards lower deficits and lower debt, it is the quality of government expenditure —growth-supporting, capacity-creating — that should be the focus.