Public Finance
The distinction between the functions of creating money on the one hand, and collecting taxes, public spending and borrowing on the other, is based on assumptions about scarcity-based constraints that are carried over from the legacy monetary framework. As per (at least) one prominent interpretation of money (Modern Monetary Theory), these constraints do not apply to the contemporary fiat framework, and, by extension, to public finance as well. This interpretation is strongly contested by neoclassical economists.
At present, the functional approach to public finance is situated in the binary framing of fiscal vs monetary dominance. This narrative is entrenched in realism about moral hazards like the political business cycle [1]. However, several economic factors mitigate against this binary. Some of these factors are: permanent market failures; public investment and necessary capital formation; distribution of income and wealth; and, emergencies and countercyclical intervention. Apart from these, there are political and legal/constitutional aspects that need to be considered as well. The separation between the monetary and fiscal regimes is, therefore, not an end in itself – a diversity of aspects and consequences become relevant in its wake.
3. Public finance
3.1 Measuring and constraining fiat money
Prior to the contemporary fiat framework, the issuance of money was correlated with the value of a tangible commodity (primarily gold), a framework commonly known as the gold standard. The money in circulation was, therefore, a function of the total value of gold that it represented. The requirement to finance wars was the primary reason for the debasement of currency in this framework, and it ultimately broke down during World War I due to excessive money printing. From 1946 to 1971, the United States managed a modified gold standard known as the Bretton Woods system, in which the value of the US dollar was pegged against the US Treasury’s gold reserves. Due to persistent drawdown of gold reserves in the 1960s, this arrangement was deemed unfeasible and was abandoned in 1971. The Bretton Woods system established the US dollar as the global reserve currency, but this hegemony did not end with it [2].
Although the safeguard inherent within the gold standard had worked unevenly and was eventually abandoned, it did act as a theoretical constraint on inflationary behaviour by governments. The shift to fiat money removed the fetter placed on money by a finite amount of precious metal. The potential for an unlimited supply of money under the fiat system presented problems of both pricing and quantity: on what basis could the value and the amount of money created be measured and constrained? Since the money in circulation will be used to make a demand upon the goods and services produced within the economy, the spectre of inflation is ever-present wherever money is an intangible article of faith in the financial, economic, and legal systems administered by the State.
The gradual (and uneven) transition from the ‘metallism’ of commodity-based to fiat money was explained by an alternative interpretation of money known as ‘chartalism’, which provided the background in which the ancestor theories of Modern Monetary Theory (MMT) first arose. According to Georg Friedrich Knapp’s State Theory of Money, money is a means of payment created by law, and so are its attributes. This was followed by Abba Lerner’s Functional Finance Theory, which focused on the functional aspects of public finance, as opposed to its dogmatic aspects. MMT is the most recent (and prominent) of these heterodox approaches, and is discussed in section 3.5 below. It should be noted at this point, though, that the chartalist theories are predominantly (economically) Keynesian and (politically) progressive in their outlook [3]. This has had a significant bearing on the criticism or support which their ideas have received.
3.2 Fiscal and monetary dominance
Central banks became indispensable to the functioning of fiat currency systems, as they ‘managed’ fiat money through the targets and instruments of monetary policy. In the absence of a tangible constraint on money supply (as under the gold standard), the initial target of monetary policy in the fiat system was the quantity of money [4], which gave way to price stability as the primary criterion of monetary policy [5]. The central banks of some countries target the exchange rate of their currency for reasons of trade stability and for being export-competitive [6], but this cannot be at the expense of the primary inflation-targeting which they must achieve. As the monetary mechanism corresponds with the real-world production cycle, secondary responsibilities, such as maintaining employment and GDP growth, are also included within the remit of central banks [7].
In the aftermath of the Great Recession and COVID-19, governments have been increasingly assertive about public spending and the need to manage public expectations about economic indices such as employment and GDP growth. As per some interpretations, this amounts to ‘fiscal dominance’ of the treasury, replacing the ‘monetary dominance’ of the central bank as a safeguard [8]. The conventional wisdom on the subject has been that fiscal dominance over the central bank leads to sub-optimal economic outcomes [9]. Proponents of Monetarism have assiduously maintained that intervention through public spending leads to inflation in the long run. The Monetarist belief that central banks can deliver on their identified mandate of economic management without significant fiscal intervention is a contrarian interpretation of the statistical model known as the Phillips Curve. This model postulates an inverse relationship between unemployment and inflation [10], which reinforced the view that monetary policy is sufficient for manipulating this trade-off. The empirical evidence for this relationship (the Samuelson-Solow interpretation), was challenged by Milton Friedman [11]. As mentioned in Part 2 of this series (paragraph 2.2), the erratic trade-off between employment and inflation may be due to conditions of market failure, and it may not be within the scope of a central bank’s authority to intervene and redress these conditions directly.
3.2.1 Coordination
The moral hazard of public choice and the limitations inherent to the pricing of money apply equally to both monetary and fiscal policy. Either channel of the combined monetary-fiscal mechanism is susceptible to reckless credit or monetary expansion in pursuit of special interest, or ‘irrational exuberance’. The resultant misallocation may either precipitate or contribute to asset bubbles and economic downturns. Both market players and public institutions possess limited information and expertise in determining pricing and other decisions, as well as limited access to the means of intervention necessary for policy implementation. Unilateral fiscal decisions, such as corporate tax cuts or monetary decisions on interest rates, may worsen both inflation as well as wealth and income inequality – outcomes which reduce welfare and are undesirable. A disjointed taxation regime – such as high taxes on necessary consumption – can lead to inflation just as effectively as monetary policy actions [12]. Coordination of monetary and fiscal policy towards common ends is the pragmatic functional response to the specific attributes of the fiat money system [13].
At present, monetary-fiscal coordination is prescribed during financial and economic crises in most jurisdictions. In India, as per the RBI Act, this ‘coordination’ may even amount to a temporary takeover of the RBI by the Union government. In any case, the RBI is obligated to support the fiscal and credit policy measures that are taken by the government during a crisis. This is one of the most controversial provisions of the RBI Act. The specifics of this coordination are decided by the Monetary Policy Committee (MPC); these decisions are then implemented by the RBI. During the Pandemic, the MPC and RBI worked together to address challenges such as currency volatility, capital outflows and immediate liquidity. The monetary measures that were undertaken included foreign exchange swaps; long-term repo operations; open market operations; reduction in the cash reserve ratio; and widening of the monetary policy corridor. At the same time, counter-cyclical and targeted fiscal measures were initiated, which included: additional funding for NABARD, SIDBI, NHB and EXIM; cash transfers to the vulnerable; distribution of foodgrains; and medical insurance for workers. The RBI supported the fiscal interventions made by the Union and state governments through outright and special open market operations; increased overdraft facilities and Ways and Means Advances; and additional liquidity facilities. These measures did help to mitigate the destructive impact of the crisis.
However, it bears mentioning that fiscal-monetary coordination is necessary, but not sufficient, for addressing macroeconomic outcomes such as prices, debt, employment, output, growth, market failures, and inequality. Rent-seeking market behaviour is possible in the absence of proper enforcement of laws on competition, collective bargaining, minimum wages, and cost internalisation. The partial repeal of the Glass-Steagall Act, 1933 in the US removed the safeguard against risky and speculative investment, which was an enabling condition for the Great Recession. The Dodd-Frank Act, 2010, was meant to redress this lapse but it was insufficient for that purpose. Corporate lobbying and direct influence over regulation, credit rating, accounting and audit have all contributed to the market failures and misallocations which we witnessed in 2008 and beyond. Poor financial regulation by the government is outside the scope of the fiscal-monetary mechanism and cannot be entrusted to either central banks or the Treasury. The unilateral monetary and fiscal interventions during the crises in favour of capital and wealth; and the lack of securities and regulatory safeguards on share buybacks, dividends, and end-use of stimulus money has been a failure of coordinated governance.
3.3 Public spending and austerity
Various interpretations of the role played by the State exist within the social contract tradition. In the social contract envisaged by Thomas Hobbes in Leviathan [14], state obligation is restricted to the protection and security of citizens, while John Locke referred to the public good in The Second Treatise of Government [15]. Whether Locke intended the term to mean anything more than national defence and protection from crime ‘against the laws of nature’ is met with a conflict of opinion. Adam Smith, in The Wealth of Nations [16], extended the argument by identifying certain necessary goods that will not be provided without state intervention due to the misalignment of the social and private cost-benefit calculus. The common good being the criterion for governance has also been a recurring theme in political philosophy over the years. More recently, John Rawls argued that a priori principles of justice are the basis for the social contract in A Theory of Justice [17]; the principle objective of public decision-making is about the composition and distribution of essential ‘primary goods’ [18].
Within neoclassical economics, ‘public goods’ have been construed rather narrowly, as defined by Paul Samuelson. He identified public goods with the attributes of non-excludability and non-rivalrousness, which lead to a market failure in pricing. It is not possible to restrict the consumption of a non-excludable good by placing barriers to access, and the consumption of a non-rivalrous good by one person will not diminish the supply available to others [19]. Market-based pricing for national defence, law and order, and public sanitation is therefore not feasible; they cannot be provided as private goods by market agents [20]. However, this restricted approach identifies only two of the various possible definitional attributes which could result in pricing failure, leading to the falsifiable inference that all remaining ‘private goods’ could be provided effectively by the market mechanism. In his study of the healthcare sector, Kenneth Arrow identified how market failure is multi-dimensional and context-dependent on the characteristics of specific economic sectors, and that healthcare suffers from fundamental market failure which makes it unfit for the market mechanism [21]. The implications of fundamental market failures may well necessitate that these goods be provided directly by way of public spending; the view that the market would be able to provide these goods more ‘efficiently’ is untenable and paradoxical.
Minimal state intervention through public spending and investment has been the principle prescription of ‘supply-side’ (or trickle-down) economics [22]. The Great Depression in the late 1920s allowed for an alternative, demand-side view to emerge. The fiscal-led demand stimulus prescribed by John Meynard Keynes addressed the shortcomings of supply-side policies, which was meant to ensure adequate capital formation and circulation of income. Keynesianism, and by extension, fiscal dominance – was the preferred approach that yielded strong economic growth in the US as well as Western Europe in the post-war period. In the US, public spending increased due to the Vietnam War and the Great Society program. The oil shock and the following Great Recession in the 1970s led to a resurgence of a ‘new’ supply-side economics. ‘Fiscal austerity’ and the Monetarism of Milton Friedman were the most influential ideas during this period. Economic stimulus through public spending and investment was rejected in favour of maintaining price stability by targeting money supply [23]. The combination of fiscal austerity and an aversion to fiscal dominance were transplanted in the UK and (later) exported to other countries, including India [24].
Viewing public spending exclusively in the context of fiscal responsibility negates its economic, political, and legal substance. Public spending is not simply about providing goods and services in a narrow sense; it is one-half of the contemporary money creation mechanism. In the OECD and industrialised economies, public spending accounts for about half of economic output. Public spending does not merely add to GDP numbers; this expenditure ensures that economic activity is feasible in the first place. The legal and regulatory framework required for addressing market failure, as well as the laws, regulations and other institutions which construct the attributes of market and capital, depend on public spending for their existence and functioning. Adequate institutional budgets are necessary for the maintenance of public order, rule of law, regulation and democracy, which are the underlying ‘hidden variables’ of a healthy economic, political, and legal system.
The government has a responsibility to provide not only identified public goods, but also much-needed private goods which suffer from various market failures (such as food, education, and healthcare). Entrusting the market to provide these goods is dissonant reasoning. Also, public sector employment is counter-cyclical (Keynesian), aimed at mitigating against the slack in income and employment during business cycle downturns. Both lending by banks and borrowing by private firms contract during an economic recession. On the consumption side, the demand which would otherwise exist fails to materialise due to a contraction in employment and income. It is paradoxical to expect private capital formation and consumer spending when a cyclical contraction is underway.
While the prospect of resource misallocation is real, the private sector may be unable to provide adequate capital formation in priority sectors due to their capital-intensive nature and other factors. Public sector undertakings may be required to fulfil this capital formation role which is needed from an investment multiplier perspective. Some of the outcomes that our constitutional rights and statutory entitlements guarantee, depend on capital formation and the provision of goods and services with such investment multiplier effect (transportation, communication, energy, and housing). The Indian Constitution is explicit about the need for social welfare and counter-cyclical relief [25]. If these outcomes are left to the market and private capital, it amounts to negating rights and entitlements and depriving them of substantive meaning.
3.4 Public revenue, control and rent
Within the conventional framework of public finance, public spending is funded by either revenue or debt. The bulk of revenue receipts is composed of taxes [26]. Residuary sources of government revenue include interest receipts, dividends, and profits from public sector enterprises, and other receipts collected for services provided by the State. Both the necessity and the ability to raise non-tax revenue reflect the expansion of the State’s role within the economy in supporting economic production and welfare [27]. This expanded remit also provides the backdrop for the moral hazard of special interest or pork barrel spending, as explained in Part 2 of this series. In India, public sector undertakings (‘PSUs’) have operated in capital-intensive and priority sectors, and their profits and dividends are regularly transferred to the Consolidated Fund. In addition, the RBI also transfers its surplus earnings to the Union government every year [28].
There is another source of funding which has been advocated and pursued as per the neoliberal, market-favouring consensus: the sale of state-owned capital assets [29]. This is prescribed as a correlate of ‘fiscal discipline’ (reduced public spending), especially as part of the ‘structural adjustment’ of economies faced with the contingency of seeking monetary assistance from the multilateral Bretton Woods institutions: the World Bank and the International Monetary Fund (‘IMF’). Fiscal austerity and consolidation (including the strategic sale of PSUs); defunding of social security; and legal, financial, labour, and environmental deregulation – are major aspects of these structural adjustment programs. In India, government divestment in PSUs can be traced back to the decision to ‘liberalise’ the economy in the early 1990s. The pace of this divestment has ebbed and flowed over the years but has gathered momentum in recent years [30]. This increased momentum, however, may have stalled due to the adverse economic and financial conditions at present.
3.4.1 Whether such divestment as a source of funding is valid and desirable
Privatisation of government-run companies has been prescribed as a justified means of funding public expenditures. The justification involves three central arguments: moral hazard, limitation, and efficiency. The moral hazard of public choice, the limitations of public intervention, and the prospect of misallocation have been addressed in Part 2 of this series; the efficiency argument follows from it and has been addressed in 3.3 above. Economic misallocation due to ‘zombie’ public sector companies subsisting on politically motivated lending is a legitimate concern. A notable example is China, where public enterprises have engaged in massive investment projects in the aftermath of the Great Recession. Many of these projects (especially in real estate) may be over-investment fuelled by dubious lending under political instructions [31]. Despite this, the investments made in conventional and renewable energy, transportation infrastructure, supply chains, steel and other inputs have been decisive in ensuring China’s manufacturing and export dominance in recent years. Also, the potential economic misallocation this may represent is not peculiar to the public sector. Rent-seeking and market failures reduce efficiency in the private sector as well. The moral hazard of misallocated lending due to low-interest rates or other monetary policies, as witnessed during the Japanese asset bubble, is not dissimilar to China. Inefficiencies, misallocation, market failure, and moral hazard do not selectively apply to the public sector alone.
3.4.2 Fiscal policy, stimulus and distribution
Neoclassical economics provides a description of a production cycle in which factor income (which is distributed to the various factors of production) enables capital formation and consumption [32]. The assumption is that if there are negligible market failures and ‘distortions’ through regulatory intervention, the so-called ‘free market’ will allocate both income and wealth efficiently and as deserved. This has been the reasoning for the assumption that control and ownership of capital, and the returns they generate, are attained under rules that are fair, competitive, and equal for everyone. This is a narrow and dogmatic interpretation of causality. The efficiency of the free market is predicated on context-dependent assumptions, which is why market outcomes vary across countries. An agnostic attitude towards the distribution of wealth and control over the means of economic production is untenable when faced with the knowledge of how income and wealth are accumulated within contemporary systems.
The fiscal interventions made during the Great Recession and COVID-19 crisis were heavily influenced by free-market reasoning and, therefore, benefited the wealthy at the expense of workers and consumers. This pertained to both stimulus spending and revenue decisions. Belief in trickle-down meant that tax cuts and incentives for large corporations and owners of capital were expected to increase both production as well as demand; whereas, the primary outcome of these actions was the widening of the already vast income and wealth gap [33]. It is clear that the free-market prescriptions for fiscal policy played a negative role in the economic recovery from the crisis.
It has been previously mentioned that market failures of information and bargaining (market power) in both supply (prices) and demand (wages) lead to economic rent and a failure of income distribution. While rent disgorgement would partially redress the need for redistribution of income, the distribution of wealth is even more significant. Today, thanks to the pioneering work of Thomas Piketty [34], Katharina Pistor [35] and others, the narrative of capital has been substantially updated for the 21st century. The expansion of capital in the modern economic framework is not necessarily due to productivity and value creation – rent-seeking by exploiting market failures, preferential rules and the absence of regulation – are equally relevant factors. The capitalist in the 21st century does not merely receive an outsized share in the distribution of factor income. Apart from asymmetric market power, increasing one’s share in the wealth pie almost invariably depends on the concentration of political power (cronyism and lobbying); the enclosure of resources through the market, political and legal access; the ability to influence legislation, regulation, and policy-making; and, access to sophisticated means of accounting and legal coding of markets, financialisation, transaction, and tax arrangements. Selling productive assets to fund state expenditure is yet another means of enclosure, transfer, and concentration of economic power. This further exacerbates political inequality and poses an existential threat to democratic self-determination.
Democratic self-determination is predicated on the principle of ‘one person, one vote’. In the Federalist Papers, Madison explained that preferential access to legislative, policy, and executive institutions through both lobbying and funding of elections amounts to ‘State capture’; the framework of separation of powers is meant to curb this precise possibility [36]. In Citizens United v Federal Election Commission, the United States Supreme Court allowed corporate funding to influence electoral outcomes. The belated action by the Indian Supreme Court in the Electoral Bonds Case demonstrates a similar failure to appreciate the reasoning of Madison, Piketty, Pistor, and others about the need to fragment the political and economic power of capital.
3.5 Public debt, liquidity and risks
Borrowings from domestic as well as external sources cover the shortfall in revenue for government spending [37]. These borrowings add up to what is referred to as ‘public debt’. The excess of borrowings over revenue in a given accounting period is the ‘fiscal deficit’, resulting in an increase in public debt. The need for revenue funding of public spending is the most significant aspect of the legal framework relating to public finance. In a nominal sense, the accounting treatment of public debt is the same as for households, individuals, or firms; this is a legacy feature of the monetary system which is a carryover from the pre-fiat money era.
Article 292 of the Constitution of India empowers the Union government to borrow both within and outside the country, subject to limits that may be laid down by Parliament. State governments are empowered to borrow within India, but not externally [38]. The need to maintain public debt within limits was enacted as a statutory obligation for the Union government by the FRBM Act, 2003. This legislation sets a target for fiscal discipline [39]. The Act also prohibits the government from directly borrowing from the RBI, subject to exceptions [40]. This puts an end to the direct monetisation of public debt by the RBI, thereby making monetary policy nominally independent of fiscal direction. The commitment towards fiscal targets (and the prohibition against debt monetisation) were decisively breached when the government was forced to engage in massive fiscal stimulus during the Great Recession, and has been mostly honoured in the breach ever since, especially during the Pandemic response [41].
The prohibition against primary subscription to government debt by the RBI, and the requirement for a secondary subscription instead, makes effective management of public debt necessary [42]. In India, the RBI, the Finance Departments (Union and state), the legislature and the CAG have defined ex ante and ex post roles in the management of public debt. The specifics about issuance of public debt are contained in the RBI Act and the Government Securities Act, 2006, read with the Government Securities Regulations, 2007. The RBI has three specific functions in this regard: first, as an adviser for the financial and liquidity conditions that are relevant to issuance of debt; second, as the issuing and redemption agent; and third, as the fiscal agent, it receives and makes payments to investors and holds government deposits.
3.5.1 Discipline vs austerity
Fiscal discipline is a prudent safeguard due to the potentially unconstrained nature of the fiat money system. Monetary exuberance is a well-recognised cause of financial boom-bust cycles, where asset prices, economic demand and ‘growth’ figures are artificially inflated. Fiscal profligacy has a similar misallocative effect on the economy. Fiscal discipline is also emphasised for economic competitiveness in the race for foreign investment. More specifically, it is a constituent parameter for sovereign credit rating [43], thereby materially influencing a country’s cost of external borrowings, trade, and investment competitiveness. Positive sovereign ratings may initiate a positive feedback cycle, but this ambitious spending can lead to the moral hazard of over-leveraging. Profligate external or internal borrowing can worsen the fiscal situation, leading to a reverse cycle of downgrading [44]. Once again, the misallocation of debt and investment is the main reason for such crises.
The bias for fiscal discipline has mutated into a near-permanent preference for ‘fiscal austerity’ in some countries. This is a founding principle of the neoliberal economic order and is prescribed to all governments by multilateral finance institutions like the World Bank and the IMF. This supply-side prescription has modified/supplanted the macroeconomic approach of Keynesianism, in which fiscal measures, including stimulus, are emphasised. The verdict on such extreme measures is mixed – in some cases (like India in the early 1990s), reduction in public debt did correlate with better immediate outcomes – but the correlation was more likely due to the other aspects of the ‘liberalisation’ policy – increased foreign investment; easing of the licensing, regulatory and compliance regime; and overall favourable external economic conditions. In the long term, austerity has negatively impacted (at least) distributive equality wherever it has been applied [45].
The spread between external and internal debt is instrumental to fiscal policy. The economic implications of external public debt in foreign currency may well be different than internal debt. Most public spending occurs in domestic currency, which is controlled by central banks and sovereign states. This is where the conventional neoclassical view of money and taxes has been criticised and challenged for its inadequacies. The most prominent detractors have been the advocates for MMT, which is a heterodox explanation for the fiat system. It reframes the fundamental assumptions of monetary and fiscal policy – the spend-tax cycle, money multiplier, and debt monetisation being the most prominent of them.
In the conventional narrative of public finance, spending follows taxes or revenue; this linear correlation has been challenged by MMT, which explains how public spending precedes taxes or revenue in the fiat system [46]. The nexus between taxes and spending has not only been challenged on mechanistic grounds, but also due to the unconventional method of quantitative easing, which amounts to bypassing fiscal and debt limits [47]. In the absence of a direct relationship between public spending and taxes, the question of public debt becomes a grey area. What is the acceptable level and purpose(s) of public debt? Given that price stability is the primary target of monetary policy, it is self-evident that a central bank’s interest in public debt is about its correlation with price levels and secondary targets such as employment, output, or exchange rates. Public spending and revenue decisions ultimately determine public debt and are, therefore, nominally constrained by statutory fiscal and revenue deficit targets. However, the budgeting and appropriations process of the elected government and legislature do not require an interface or formal consultation with the central bank on the subject. Institutional and legal prerogatives evidently prevail over macroeconomic strictures when it comes to public finance.
3.5.2 Fiscal space and debt retirement
The MMT interpretation of fiscal latitude is derived from earlier works like Abba Lerner’s Functional Finance Theory. Lerner emphasised that public finance is functional in nature, regardless of its impact on the public budget [48]. According to this functional approach, the soundness of fiscal policy is to be judged by its results for prices and employment, and not theoretical dogma. This was an endorsement for the Keynesian preference for full employment – which is characteristic of MMT as well. In the Functional Finance interpretation, public debt in domestic currency (and held locally) is not a real constraint, provided it adheres to the limits of its ‘fiscal space’. The prospect of price instability is negated through the liquidity management function of taxes, which can modulate aggregate demand as needed. In a similar vein, the functional approach rejects the conventional argument that bond sales are a necessary financing operation. Proponents of MMT instead argue that bond sales are required for managing interest rates and liquidity.
The treatment of direct monetisation of public debt in MMT literature is also different. Quantitative easing through asset purchase programs has been a prominent feature of public money ever since the Great Recession. This practice has been criticised due to concerns about macroeconomic stability, but MMT advocates have a remarkably sanguine view on it. Taking the example of Japan, they have argued that public debt can, and is, retired wherever possible, with no ill-effects [49]. This view is treated with incredulity by conventional macroeconomists; and yet, the massive stimulus response to the Great Recession and the Pandemic may well have forced the hands of many governments, which will be tempted to experiment with the same strategy as Japan.
3.5.3 Liquidity and risks
The present structure of public debt and its interaction with public money are aimed at ensuring proper liquidity management. If treasury instruments are not offered to the public, crediting money into government accounts will create additional liquidity, which may affect interest rates and inflation. The sale of treasury instruments and collection of taxes ensure that any excess liquidity is drained out of the system. Both neoclassical and MMT literature are in agreement about the need for coordination between the central bank and treasury for debt and liquidity management. Their disagreements are about the causal aspects of bank reserves, spending, taxes, inflation, etc.
Given the legal requirements for debt issuance, central bank-treasury coordination is also important for managing the cost and risks associated with public debt. The market for public debt is competitive, and the demand for sovereign debt is influenced by several factors, including: interest rates; default, exchange and refinancing risks; and economic performance. The temporal spread of debt issuance is crucial due to the differing demand for short, medium and long term debt. Cost minimisation entails accurate assessment of debt requirement and planned issuance of debt for the appropriate tenure. Apart from cost, the supply of debt is also exposed to rollover (maturing debt rolling over into newer debt), exchange (exchange rate volatility) and sudden-stop (sudden cessation of capital flow) risks. In order to minimise costs and mitigate risks, debt management strategy should focus on diversification of investor base, managing the maturity profile of debt, the timing of issuance, consolidation of debt stock and managing the composition of different instruments [50].
Regardless of whether (or not) one subscribes to the liquidity and interest management hypothesis of MMT, issuance of debt and taxation does have a potential for ‘crowding-out’ private investment and spending. Credit expansion and money creation by either the fractional reserve or public spending channels can precipitate an economic cycle leading/contributing to the contraction of demand, income, employment and output, along with price instability. That neither credit expansion nor public spending be misallocated is, therefore, the common cause for both central banking and public finance. There are disagreements about and nuances to the supply and demand side interpretations of what is ‘misallocation’ [51], but that is a larger, on-going debate with no prospect of one view decisively prevailing over the other. What we can conclusively state is that the moral hazards and limitations of both central banks and political incumbents can be responsible for these perverse outcomes.
This part of the series addressed the constraint problem of fiat money, monetary-fiscal dominance vs coordination, and the classification of public finance. The next part will address the building blocks which are needed for designing the appropriate safeguards for public money.
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[1] Refer 2.1.1 of Part II; Eric Dubois, ‘Political Business Cycles 40 Years After Nordhaus’ (2016) Public Choice 235.
[2] Dollar hegemony is a controversial subject. While apologists point towards trade (currency of exchange) and economic (stability) reasons for this dominance, detractors insist that it is enforced through the coercive means of US military and diplomatic power.
[3] L. Randall Wray, ‘From the State Theory of Money to Modern Money Theory: An Alternative to Economic Orthodoxy’ in David Fox and Wolfgang Ernst, Money in the Western Legal Tradition: Middle Ages to Bretton Woods (Oxford University Press 2016)
[4] In the backdrop of stagflation in the 1970s, Milton Friedman explained how the prevailing conditions were attributable to expansion in the role of government after the Great Depression, which had led to increase in money supply. He argued that the Federal Reserve should restrict growth in the quantity of money to control inflation. As per the rule proposed by Friedman, the targeted growth rate of money should equal the growth rate of real GDP. Following the Federal Reserve, central banks in most jurisdictions (including India) adopted the quantity of money as the formal anchor of monetary policy. The predominant supply-side macroeconomic theory is Milton Friedman’s ‘Monetarism’. “Monetarism deals with one narrow but very important subject: the relationship between quantity of money on the one hand and, on the other, such economic variables as total income, the level of prices, economic fluctuations, and interest rates.” (Milton Friedman and Donald W. Paden, ‘A Monetarist View’ (1983) 14 The Journal of Economic Education 44).
[5] Garreth Rule, Understanding Central Bank Balance Sheet (Bank of England 2015).
[6] Central banks choose between fixed and floating exchange rate regimes of various kinds – currency unions, currency pegs against a single or basket of currencies, soft and hard exchange rate targets. Over the years, there has been a reduction in the countries that employ exchange rate targeting as the formal anchor of monetary policy (Thorarinn G. Petursson, ‘Exchange Rate or Inflation Targeting in Monetary Policy?’ (2000) 2(1) Monetary Bulletin <https://www.cb.is/library/Skraarsafn—EN/FromOldWeb/Acrobat-(PDF)/mb001_6.pdf>
[7] As per section 2A of the Federal Reserve Act, 1913, the Federal Reserve is entrusted with maintaining “long run growth of monetary and credit aggregates commensurate to the economy’s long run potential to increase production, to promote maximum employment, stable prices, and moderate long term interest rates”. Price stability and supporting the general economic policies of the EU are the primary objectives of the ESCB, as per Art. 282 of the Treaty on the Functioning of the European Union. The preamble to the RBI Act (post the 2016 amendment) states that “the primary objective of the monetary policy is to maintain price stability while keeping in mind the objective of growth”.
[8] The concern that central bank autonomy is infringed upon by the treasury is especially pronounced at the conservative end of the political spectrum – fiscal conservatives argue in favour of low taxes, low fiscal deficits and monetary autonomy. (James A. Dorn, ‘Fiscal Dominance and Fed Complacency’ (Cato Institute, 2021)).
[9] Fiscal dominance has been curtailed in India through a series of measures over the past two decades – market-based determination of interest rates through auction of government debt; phasing out of automatic monetisation of fiscal deficits; and, prohibition against monetisation of public debt as per the Fiscal Responsibility and Budget Management Act, 2003. (‘RBI report (n 11); Rahul Bajoria, The Story of the RBI (Rupa & Co. 2018)).
[10] Alban W. Phillips, ‘The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957’ (1958) 25 Economica 283.
[11] Friedman highlighted a fundamental defect in the Phillips Curve – that it does not account for the difference between nominal and real wages. Based on this, he identified the conditions in which the curve would hold good. (Milton Friedman, ‘The Role of Monetary Policy’ (1968) 58 The American Economic Review 1). For a detailed review of the Keynesian-Monetarist debate on the Phillips Curve, see, Robert L. Hetzel, ‘The Monetarist- Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation’ (2013) Economic Quarterly 83.
[12] High import duties and taxes on food items and fuel have been primarily responsible for surging inflation in India in recent times.
[13] Abba Lerner, ‘Functional Finance and the Federal Debt’ (1943) 10 Social Research 38.
[14] Thomas Hobbes, Leviathan (first published 1651, Penguin English Library 1981).
[15] Locke employed the term in a political, rather than an economic sense. (John Locke, Second Treatise of Government (first published 1690, Hackett Publishing Company 1980)).
[16] Adam Smith, The Wealth of Nations (first published 1776, The Modern Library 1937).
[17] Ordered for lexical priority, the principles are – the greatest equal liberty principle; the difference principle; and, the equal opportunity principle. This has distributive implications for how public spending is to be directed. (John Rawls, A Theory of Justice (Harvard University Press 1971)).
[18] The primary goods identified by Rawls are rights, liberties, opportunities, income, wealth and self-respect.
[19] As per Samuelson, the optimal level of provision for public goods (known as the Samuelson condition) is reached when the marginal willingness to pay equals the marginal cost of producing an additional unit of that good.
[20] As the sole provider of public goods, the state acquires a de facto monopoly and this presents a pricing problem. Ramsay pricing and optimal taxation are proposed solutions to this problem, but since it effectively advocates exploiting price inelasticity, both its morality and applicability are dubious. (Kenneth E. Train, Optimal Regulation: The Economic Theory of Natural Monopoly (MIT Press 1991) Chapter 4).
[21] Kenneth Arrow, ‘Uncertainty and the Welfare Economics of Medical Care’ (1963) 53(5) The American Economic Review 941.
[22] It has its origins in the laissez-faire economics of the 19th century, more specifically, in Say’s law markets. Say’s law was summarised by John Meynard Keynes as “supply creates its own demand” in the General Theory of Employment, Interest and Money (1936).
[23] In A Monetary History of the United States, 1867-1960 (1963), Friedman argued that the Great Depression was caused by a contraction of money supply, and not by under- investment, as reasoned by Keynes.
[24] Reduction in public spending and an independent monetary policy are crucial aspects of the ‘structural adjustment’ programs which debtor countries are required to implement as a condition for receiving financial assistance from the World Bank and the IMF.
[25] See, Articles 38, 39 and 41 of the Indian Constitution.
[26] Tax revenue includes collection from a variety of duties, surcharges and cesses.
[27] The dynamic complexity of modern economies engenders both disproportionate externalities, as well as an ever-changing landscape of market failure. This necessitates more, rather than less, public intervention. Balancing this growing need for intervention with the case for free-market liberty is the principal challenge of public decision-making.
[28] As per section 47 of the RBI Act, 1934. In 2019, the government insisted on and secured a one-time transfer of Rs.526.37 billion from the RBI under the revised Economic Capital Framework. This measure was controversial, as the RBI had earlier insisted that the money was part of its contingency buffer, leading to a question mark over the autonomy of the RBI. (Anirban Nag, ‘How RBI is Managing to Give Modi Govt. the Rs 1.76 Lakh Crore Record Windfall’ The Print (29 August 2019)).
[29] This is classified as non-debt capital receipts in the budget documents. As per Budget 2022-23, the proceeds from strategic disinvestment are slated to be channelised into a “National Investment Fund’ and will be utilised for infrastructure investment, education, healthcare and railways.
[30] The preferred divestment route has evolved over time. The NDA government (1999- 2004) relied on direct sale to private entities, which is potential cronyism. In more recent years, floating public offerings on the stock exchange has been preferred, although opaque routes such as buybacks by PSUs, block deals and sales to exchange traded funds have also emerged since 2014. For a detailed breakup of PSU divestment see Aparajita Verma, ‘Data: The History of Disinvestment in India and Political Trends’ Factly (12 February 2021).
[31] Qiuying Qu, Zombie Firms and Political Influence on Bank Lending in China (Working Paper, Department of Economics, Columbia University, 2018) <https://econ.columbia.edu/wp-content/uploads/sites/41/2018/10/Job-Market-Paper-Qiuying- Qu-190110.pdf> accessed 15 March 2023.
[32] Assuming that income is generated during the production of goods and services and that the different factors of production earn rent, wages and profits, depending on their respective contribution to production. The prices of the factors are supposed to be as per the rules of demand and supply, determined by their marginal productivity. (Paul Lincoln Kleinsorge and others, ‘Distribution Theory’, Encyclopedia Britannica (1999)).
[33] David Hope and Julian Limberg, The economic consequences of major tax cuts for the rich (International Inequalities Institute Working Papers no.55, London School of Economics and Political Science. 2020) <http://eprints.lse.ac.uk/107919/> accessed 28 February 2023.
[34] Thomas Piketty, Capital in the Twenty-First Century (Harvard University Press 2014).
[35] Katharina Pistor, The Code of Capital: How the Law Creates Wealth and Inequality (Princeton University Press 2019).
[36] See, The Federalist Papers: No. 10 lt;https://avalon.law.yale.edu/18th_century/fed10.asp> accessed 27 July 2026 and The Federalist Papers: No. 51 & https://avalon.law.yale.edu/18th_century/fed51.asp> accessed 27 July 2026.
[37] The main sources of domestic borrowings are market loans; short-term treasury bills; post office, national savings certificate, provident fund and other small savings schemes; and floating rate savings bonds. External borrowings are from multilateral lenders (World Bank, IMF, ADB, etc.) and bilateral arrangements (Germany, France, Japan, Russia and EU Investment Bank). There is an additional arrangement between the government and RBI known as the Market Stabilisation Scheme, which is aimed at sterilisation (liquidity absorption) in the face of foreign capital inflows, in order to maintain money supply at a given level.
[38] As per Article 293 of the Constitution of India. The Union government facilitates access to ‘structural adjustment loans’ from multilateral and bilateral institutions by extending sovereign guarantee; the interest cost and exchange rate risk are passed on to the states. (Finance Commission, Report of the 12th Finance Commission (2005-10) (Finance Commission 2004) Chapter 11).
[39] States in India have their respective fiscal responsibility legislations. The Balanced Budget and Emergency Deficit Control Act, 1985 and the Stability and Growth Pact set similar fiscal targets for the United States and the EU, respectively.
[40] As per section 5(2) of the FRBM Act, the RBI can extend Ways and Means advances to the Central Government.
[41] Fiscal deficit targets have not been met in the United States and EU as well, since at least the Great Recession.
[42] As per section 5(3) of the FRBM Act, this prohibition is subject to the exceptions in the proviso to section 4(2).
[43] Antonio Afonso, Pedro Gomes and Philipp Rother, ‘What Hides Behind Sovereign Debt Ratings?’ (Working Paper Series 711, European Central Bank 2007).
[44] Meryem Duygun, Huseyin Ozturk and Mohamed Shaban, ‘The Role of Sovereign Credit Ratings in Fiscal Discipline’ (2016) 27 Emerging Markets Review 197.
[45] Fiscal consolidation has resulted in reduced wage income, while having negligible impact on profits and rent. Laurence Ball and others, ‘The Distributional Effects of Fiscal Austerity’ (2013) United Nations Department of Economic and Social Affairs Working Paper No. 129.
[46] Warren Mosler, ‘Soft Currency Economics’ (1995) Macroeconomics, University Library of Munich, Germany.
[47] Wenhao Li and Sebastian Merkel, ‘Quantitative Easing and Government Debt Sustainability’ (2026) National Bureau of Economic Research Working Paper 35421.
[48] L. Randall Wray, ‘Functional Finance: A Comparison of the Evolution of the Positions of Hyman Minsky and Abba Lerner’ (2018) Levy Economics Institute and Bard College Working Paper No. 900.
[49] Stephanie Kelton, The Deficit Myth: MMT and the Birth of People’s Economy (Hachette Book Group 2020) Chapter 3.
[50] Charan Singh, Debt Management in India (Cambridge University Press 2018) Chapter 7.
[51] Supply-side preference is for spending, money creation and credit expansion in favour of capital and productivity; the demand-side focus is on the conditions of capital formation and demand.