Does Growth lead to Debt Sustainability? Yes, But Not Vice- Versa! | Economic Survey & Government Reports - UPSC PDF Download

 Page 1


CHAPTER
02
Does Growth Lead to Debt 
Sustainability? Yes, But Not  
Vice-Versa!
iztkukeso HkwR;Fk± l rkH;ks cfyexzghr~A
lglzxq.keqRlz"VqeknRrs fg jla jfo%AA û&ûøAA
“The state collects tax for the greater welfare of its citizens in the same way as the sun 
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham
Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the 
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance. 
This Chapter establishes clearly that growth leads to debt sustainability in the Indian 
context but not necessarily vice-versa. This is because the interest rate on debt paid by 
the Indian government has been less than India’ s growth rate by norm, not by exception. 
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic 
Association: “If the interest rate paid by the government is less than the growth rate, 
then the intertemporal budget constraint facing the government no longer binds.” This 
phenomenon highlights that debt sustainability depends on the “interest rate growth rate 
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in 
an economy.
 In advanced economies, the extremely low interest rates, which have led to negative 
IRGD, on the one hand, and have placed limitations on monetary policy, on the other 
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a 
negative IRGD in India – not due to lower interest rates but much higher growth rates – 
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns 
and economic crises.
 The confusion about causality – from growth to debt sustainability or vice-versa – 
is typical of several macro-economic phenomena, where natural experiments to identify 
causality are uncommon. In the specific context of growth and debt sustainability, this 
confusion also stems from the fact that the academic and policy literature focuses 
primarily on advanced economies, where causality is entangled by lower potential growth 
when compared to India. Indeed, the chapter studies the evidence across several countries 
to show that growth causes debt to become sustainable in countries with higher growth 
rates; such clarity about the causal direction is not witnessed in countries with lower 
growth rates. By integrating ideas from Corporate Finance into the macro-economics 
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to 
understand why these differences can manifest between high-growth emerging economies 
and low-growth advanced economies.
 As the COVID-19 pandemic has created a significant negative shock to demand, 
active fiscal policy – one that recognises that fiscal multipliers are disproportionately 
Page 2


CHAPTER
02
Does Growth Lead to Debt 
Sustainability? Yes, But Not  
Vice-Versa!
iztkukeso HkwR;Fk± l rkH;ks cfyexzghr~A
lglzxq.keqRlz"VqeknRrs fg jla jfo%AA û&ûøAA
“The state collects tax for the greater welfare of its citizens in the same way as the sun 
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham
Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the 
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance. 
This Chapter establishes clearly that growth leads to debt sustainability in the Indian 
context but not necessarily vice-versa. This is because the interest rate on debt paid by 
the Indian government has been less than India’ s growth rate by norm, not by exception. 
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic 
Association: “If the interest rate paid by the government is less than the growth rate, 
then the intertemporal budget constraint facing the government no longer binds.” This 
phenomenon highlights that debt sustainability depends on the “interest rate growth rate 
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in 
an economy.
 In advanced economies, the extremely low interest rates, which have led to negative 
IRGD, on the one hand, and have placed limitations on monetary policy, on the other 
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a 
negative IRGD in India – not due to lower interest rates but much higher growth rates – 
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns 
and economic crises.
 The confusion about causality – from growth to debt sustainability or vice-versa – 
is typical of several macro-economic phenomena, where natural experiments to identify 
causality are uncommon. In the specific context of growth and debt sustainability, this 
confusion also stems from the fact that the academic and policy literature focuses 
primarily on advanced economies, where causality is entangled by lower potential growth 
when compared to India. Indeed, the chapter studies the evidence across several countries 
to show that growth causes debt to become sustainable in countries with higher growth 
rates; such clarity about the causal direction is not witnessed in countries with lower 
growth rates. By integrating ideas from Corporate Finance into the macro-economics 
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to 
understand why these differences can manifest between high-growth emerging economies 
and low-growth advanced economies.
 As the COVID-19 pandemic has created a significant negative shock to demand, 
active fiscal policy – one that recognises that fiscal multipliers are disproportionately 
44 Economic Survey 2020-21   V olume 1
higher during economic crises than during economic booms – can ensure that the full 
benefit of seminal economic reforms is reaped by limiting potential damage to productive 
capacity. As the IRGD is expected to be negative in the foreseeable future, a fiscal policy 
that provides an impetus to growth will lead to lower, not higher, debt-to-GDP ratios. 
In fact, simulations undertaken till 2030 highlight that given India’ s growth potential, 
debt sustainability is unlikely to be a problem even in the worst scenarios. The chapter 
thus demonstrates the desirability of using counter-cyclical fiscal policy to enable growth 
during economic downturns.
 While acknowledging the counterargument from critics that governments may have 
a natural proclivity to spend, the Survey endeavours to provide the intellectual anchor 
for the government to be more relaxed about debt and fiscal spending during a growth 
slowdown or an economic crisis. The Survey’ s call for more active, counter-cyclical fiscal 
policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring 
that has created an asymmetric bias against fiscal policy.
2.1 Amidst the Covid-19 crisis, fiscal policy has assumed enormous significance across the 
world. Naturally, the debate around higher Government debt to support a fiscal expansion is 
accompanied by concerns about its implications for future growth, debt sustainability, sovereign 
ratings, and possible vulnerabilities on the external sector. This chapter examines the optimal 
stance of fiscal policy in India during a crisis and establishes that the growth leads to debt 
sustainability in the Indian context and not necessarily vice-versa.  
2.2 While fiscal policy is especially salient during an economic crisis, in general, fiscal policy 
must be counter-cyclical to smooth out economic cycles instead of exacerbating them. As seen 
for the United States and United Kingdom, the correlation between private sector and public 
sector net balances is almost perfectly negative (-0.9) (Figure 1b and 1c). In India, however, 
fiscal policy has not been counter-cyclical in general (Figure 1a).
Figure 1: Trends in Government and Private sector balances
Figure 1a: India (FY 1987 – FY 2019)
Source: RBI, MoSPI 
Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross Domesic 
Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital formation)
Private sector net balance = Private sector Gross Domesic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).
Page 3


CHAPTER
02
Does Growth Lead to Debt 
Sustainability? Yes, But Not  
Vice-Versa!
iztkukeso HkwR;Fk± l rkH;ks cfyexzghr~A
lglzxq.keqRlz"VqeknRrs fg jla jfo%AA û&ûøAA
“The state collects tax for the greater welfare of its citizens in the same way as the sun 
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham
Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the 
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance. 
This Chapter establishes clearly that growth leads to debt sustainability in the Indian 
context but not necessarily vice-versa. This is because the interest rate on debt paid by 
the Indian government has been less than India’ s growth rate by norm, not by exception. 
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic 
Association: “If the interest rate paid by the government is less than the growth rate, 
then the intertemporal budget constraint facing the government no longer binds.” This 
phenomenon highlights that debt sustainability depends on the “interest rate growth rate 
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in 
an economy.
 In advanced economies, the extremely low interest rates, which have led to negative 
IRGD, on the one hand, and have placed limitations on monetary policy, on the other 
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a 
negative IRGD in India – not due to lower interest rates but much higher growth rates – 
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns 
and economic crises.
 The confusion about causality – from growth to debt sustainability or vice-versa – 
is typical of several macro-economic phenomena, where natural experiments to identify 
causality are uncommon. In the specific context of growth and debt sustainability, this 
confusion also stems from the fact that the academic and policy literature focuses 
primarily on advanced economies, where causality is entangled by lower potential growth 
when compared to India. Indeed, the chapter studies the evidence across several countries 
to show that growth causes debt to become sustainable in countries with higher growth 
rates; such clarity about the causal direction is not witnessed in countries with lower 
growth rates. By integrating ideas from Corporate Finance into the macro-economics 
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to 
understand why these differences can manifest between high-growth emerging economies 
and low-growth advanced economies.
 As the COVID-19 pandemic has created a significant negative shock to demand, 
active fiscal policy – one that recognises that fiscal multipliers are disproportionately 
44 Economic Survey 2020-21   V olume 1
higher during economic crises than during economic booms – can ensure that the full 
benefit of seminal economic reforms is reaped by limiting potential damage to productive 
capacity. As the IRGD is expected to be negative in the foreseeable future, a fiscal policy 
that provides an impetus to growth will lead to lower, not higher, debt-to-GDP ratios. 
In fact, simulations undertaken till 2030 highlight that given India’ s growth potential, 
debt sustainability is unlikely to be a problem even in the worst scenarios. The chapter 
thus demonstrates the desirability of using counter-cyclical fiscal policy to enable growth 
during economic downturns.
 While acknowledging the counterargument from critics that governments may have 
a natural proclivity to spend, the Survey endeavours to provide the intellectual anchor 
for the government to be more relaxed about debt and fiscal spending during a growth 
slowdown or an economic crisis. The Survey’ s call for more active, counter-cyclical fiscal 
policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring 
that has created an asymmetric bias against fiscal policy.
2.1 Amidst the Covid-19 crisis, fiscal policy has assumed enormous significance across the 
world. Naturally, the debate around higher Government debt to support a fiscal expansion is 
accompanied by concerns about its implications for future growth, debt sustainability, sovereign 
ratings, and possible vulnerabilities on the external sector. This chapter examines the optimal 
stance of fiscal policy in India during a crisis and establishes that the growth leads to debt 
sustainability in the Indian context and not necessarily vice-versa.  
2.2 While fiscal policy is especially salient during an economic crisis, in general, fiscal policy 
must be counter-cyclical to smooth out economic cycles instead of exacerbating them. As seen 
for the United States and United Kingdom, the correlation between private sector and public 
sector net balances is almost perfectly negative (-0.9) (Figure 1b and 1c). In India, however, 
fiscal policy has not been counter-cyclical in general (Figure 1a).
Figure 1: Trends in Government and Private sector balances
Figure 1a: India (FY 1987 – FY 2019)
Source: RBI, MoSPI 
Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross Domesic 
Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital formation)
Private sector net balance = Private sector Gross Domesic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).
45 Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa!
Figure 1b: United States (1987?–?2019) Figure 1c: United Kingdom (1987?–?2019)
Source: BEA (US)
Government net Balance =Total Government Receipts- 
Total Government Expenditure
Private Sector Net Balance= Gross Private Domestic 
Investment - Gross Private Savings (Domestic business, 
households & institutions)
Source: UK Economic Accounts (ONS) & OBR (UK)
Public Sector net Balance = Net lending by General 
Govt and Public Corporations
Private Sector Net Balance = Net lending by Households, 
Non Profit Institutions serving the Households and 
private Non Financial Corporations
2.3 While counter-cyclical fiscal policy is necessary to smooth out economic cycles, it becomes 
critical during an economic crisis (Box 1). This is because fiscal multipliers, which capture 
the aggregate return derived by the economy from an additional Rupee of fiscal spending, are 
unequivocally greater during economic crises when compared to economic (Box 2). In a country 
like India, which has a large workforce employed in the informal sector, counter-cyclical 
fiscal policy becomes even more paramount. In advanced economies, where the public and 
private sector labour markets are not too segmented, fiscal spending can increase public sector 
employment, reduce the supply of labour in the private sector, bid up wages, and thereby crowd 
out private sector employment. However, in a country like India, where the private and public 
sector labour markets are largely segmented, such crowding out of private sector employment 
is minimal (Michaillat, 2014). Thus, debt-financed public expenditure is more cost-effective to 
employ during recessions than during economic booms. 
Box 1: Relevance of Counter-cyclical Fiscal Policy 
 Indian Kings used to build palaces during famines and droughts to provide employment and 
improve the economic fortunes of the private sector. Economic theory, in effect, makes the same 
recommendation: in a recessionary year, Government must spend more than during expansionary 
times. Such counter-cyclical fiscal policy stabilizes the business cycle by being contractionary 
(reduce spending/increase taxes) in good times and expansionary (increase spending/reduce 
taxes) in bad times. On the other hand, a pro-cyclical fiscal policy is the one wherein fiscal policy 
reinforces the business cycle by being expansionary during good times and contractionary during 
recessions (Figure A).
Page 4


CHAPTER
02
Does Growth Lead to Debt 
Sustainability? Yes, But Not  
Vice-Versa!
iztkukeso HkwR;Fk± l rkH;ks cfyexzghr~A
lglzxq.keqRlz"VqeknRrs fg jla jfo%AA û&ûøAA
“The state collects tax for the greater welfare of its citizens in the same way as the sun 
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham
Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the 
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance. 
This Chapter establishes clearly that growth leads to debt sustainability in the Indian 
context but not necessarily vice-versa. This is because the interest rate on debt paid by 
the Indian government has been less than India’ s growth rate by norm, not by exception. 
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic 
Association: “If the interest rate paid by the government is less than the growth rate, 
then the intertemporal budget constraint facing the government no longer binds.” This 
phenomenon highlights that debt sustainability depends on the “interest rate growth rate 
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in 
an economy.
 In advanced economies, the extremely low interest rates, which have led to negative 
IRGD, on the one hand, and have placed limitations on monetary policy, on the other 
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a 
negative IRGD in India – not due to lower interest rates but much higher growth rates – 
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns 
and economic crises.
 The confusion about causality – from growth to debt sustainability or vice-versa – 
is typical of several macro-economic phenomena, where natural experiments to identify 
causality are uncommon. In the specific context of growth and debt sustainability, this 
confusion also stems from the fact that the academic and policy literature focuses 
primarily on advanced economies, where causality is entangled by lower potential growth 
when compared to India. Indeed, the chapter studies the evidence across several countries 
to show that growth causes debt to become sustainable in countries with higher growth 
rates; such clarity about the causal direction is not witnessed in countries with lower 
growth rates. By integrating ideas from Corporate Finance into the macro-economics 
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to 
understand why these differences can manifest between high-growth emerging economies 
and low-growth advanced economies.
 As the COVID-19 pandemic has created a significant negative shock to demand, 
active fiscal policy – one that recognises that fiscal multipliers are disproportionately 
44 Economic Survey 2020-21   V olume 1
higher during economic crises than during economic booms – can ensure that the full 
benefit of seminal economic reforms is reaped by limiting potential damage to productive 
capacity. As the IRGD is expected to be negative in the foreseeable future, a fiscal policy 
that provides an impetus to growth will lead to lower, not higher, debt-to-GDP ratios. 
In fact, simulations undertaken till 2030 highlight that given India’ s growth potential, 
debt sustainability is unlikely to be a problem even in the worst scenarios. The chapter 
thus demonstrates the desirability of using counter-cyclical fiscal policy to enable growth 
during economic downturns.
 While acknowledging the counterargument from critics that governments may have 
a natural proclivity to spend, the Survey endeavours to provide the intellectual anchor 
for the government to be more relaxed about debt and fiscal spending during a growth 
slowdown or an economic crisis. The Survey’ s call for more active, counter-cyclical fiscal 
policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring 
that has created an asymmetric bias against fiscal policy.
2.1 Amidst the Covid-19 crisis, fiscal policy has assumed enormous significance across the 
world. Naturally, the debate around higher Government debt to support a fiscal expansion is 
accompanied by concerns about its implications for future growth, debt sustainability, sovereign 
ratings, and possible vulnerabilities on the external sector. This chapter examines the optimal 
stance of fiscal policy in India during a crisis and establishes that the growth leads to debt 
sustainability in the Indian context and not necessarily vice-versa.  
2.2 While fiscal policy is especially salient during an economic crisis, in general, fiscal policy 
must be counter-cyclical to smooth out economic cycles instead of exacerbating them. As seen 
for the United States and United Kingdom, the correlation between private sector and public 
sector net balances is almost perfectly negative (-0.9) (Figure 1b and 1c). In India, however, 
fiscal policy has not been counter-cyclical in general (Figure 1a).
Figure 1: Trends in Government and Private sector balances
Figure 1a: India (FY 1987 – FY 2019)
Source: RBI, MoSPI 
Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross Domesic 
Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital formation)
Private sector net balance = Private sector Gross Domesic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).
45 Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa!
Figure 1b: United States (1987?–?2019) Figure 1c: United Kingdom (1987?–?2019)
Source: BEA (US)
Government net Balance =Total Government Receipts- 
Total Government Expenditure
Private Sector Net Balance= Gross Private Domestic 
Investment - Gross Private Savings (Domestic business, 
households & institutions)
Source: UK Economic Accounts (ONS) & OBR (UK)
Public Sector net Balance = Net lending by General 
Govt and Public Corporations
Private Sector Net Balance = Net lending by Households, 
Non Profit Institutions serving the Households and 
private Non Financial Corporations
2.3 While counter-cyclical fiscal policy is necessary to smooth out economic cycles, it becomes 
critical during an economic crisis (Box 1). This is because fiscal multipliers, which capture 
the aggregate return derived by the economy from an additional Rupee of fiscal spending, are 
unequivocally greater during economic crises when compared to economic (Box 2). In a country 
like India, which has a large workforce employed in the informal sector, counter-cyclical 
fiscal policy becomes even more paramount. In advanced economies, where the public and 
private sector labour markets are not too segmented, fiscal spending can increase public sector 
employment, reduce the supply of labour in the private sector, bid up wages, and thereby crowd 
out private sector employment. However, in a country like India, where the private and public 
sector labour markets are largely segmented, such crowding out of private sector employment 
is minimal (Michaillat, 2014). Thus, debt-financed public expenditure is more cost-effective to 
employ during recessions than during economic booms. 
Box 1: Relevance of Counter-cyclical Fiscal Policy 
 Indian Kings used to build palaces during famines and droughts to provide employment and 
improve the economic fortunes of the private sector. Economic theory, in effect, makes the same 
recommendation: in a recessionary year, Government must spend more than during expansionary 
times. Such counter-cyclical fiscal policy stabilizes the business cycle by being contractionary 
(reduce spending/increase taxes) in good times and expansionary (increase spending/reduce 
taxes) in bad times. On the other hand, a pro-cyclical fiscal policy is the one wherein fiscal policy 
reinforces the business cycle by being expansionary during good times and contractionary during 
recessions (Figure A).
46 Economic Survey 2020-21   V olume 1
Fiscal policy 
(FP) stance
Recession (? GDP) Expansion (? GDP) Outcome
Pro-cyclical Contractionary FP
? Govt. Expenditure
or /and
? Taxes
Expansionary FP
? Govt. Expenditure
or/and
? Taxes
Deepens recessions and 
amplifies expansions, thereby 
increasing fluctuations in the 
business cycle.
Counter-cyclical Expansionary FP
? Govt. Expenditure
or/and
? Taxes
Contractionary FP
? Govt. Expenditure
or /and
? Taxes
Softens the recession and 
moderates the expansions, 
thereby decreasing fluctuations 
in the business cycle.
Figure A: Business Cycle under Various Fiscal Policy Stance
Channels of Transmission
 Recalling the National Income identity , Y= C+I+G+X-M , the net effect of a recession on 
the private sector may be in terms of lower private consumption (C), lower private investment 
(I), risk aversion by the private sector and pessimistic expectations/sentiments. In such a scenario, 
adopting a counter cyclical policy by expanding the Government Expenditure – both consumption 
and investment - will support the GDP and minimise the output gap (as seen in the figure above). 
This happens primarily through the following channels:
 (i) An expansion in Government expenditure can cushion the contraction in output by 
contributing to the GDP growth, by offsetting the decline in consumption and investment; 
and also by boosting private investment and consumption through higher spending 
multipliers during recession. (Auerbach and Gorodnichenko (2012), Riera-Crichton, 
Vegh and Vuletin (2014), Jorda and Taylor (2016), Canzoneri et al (2012)).
 (ii) Through risk multiplier by compensating for greater risk-aversion of private sector to bring 
back ‘animal spirits’.
Page 5


CHAPTER
02
Does Growth Lead to Debt 
Sustainability? Yes, But Not  
Vice-Versa!
iztkukeso HkwR;Fk± l rkH;ks cfyexzghr~A
lglzxq.keqRlz"VqeknRrs fg jla jfo%AA û&ûøAA
“The state collects tax for the greater welfare of its citizens in the same way as the sun 
evaporates water, only to return it manifold in the form of rain.” (Chapter 1, Shloka 18)
— Mahakavi Kalidasa’s Raghuvansham
Does growth lead to debt sustainability? Or, does fiscal austerity foster growth? Given the 
need for fiscal spending amidst the COVID-19 crisis, these questions assume significance. 
This Chapter establishes clearly that growth leads to debt sustainability in the Indian 
context but not necessarily vice-versa. This is because the interest rate on debt paid by 
the Indian government has been less than India’ s growth rate by norm, not by exception. 
As Blanchard (2019) explains in his 2019 Presidential Address to the American Economic 
Association: “If the interest rate paid by the government is less than the growth rate, 
then the intertemporal budget constraint facing the government no longer binds.” This 
phenomenon highlights that debt sustainability depends on the “interest rate growth rate 
differential” (IRGD), i.e. the difference between the interest rate and the growth rate in 
an economy.
 In advanced economies, the extremely low interest rates, which have led to negative 
IRGD, on the one hand, and have placed limitations on monetary policy, on the other 
hand, have caused a rethink of the role of fiscal policy. The same phenomenon of a 
negative IRGD in India – not due to lower interest rates but much higher growth rates – 
must prompt a debate on the saliency of fiscal policy, especially during growth slowdowns 
and economic crises.
 The confusion about causality – from growth to debt sustainability or vice-versa – 
is typical of several macro-economic phenomena, where natural experiments to identify 
causality are uncommon. In the specific context of growth and debt sustainability, this 
confusion also stems from the fact that the academic and policy literature focuses 
primarily on advanced economies, where causality is entangled by lower potential growth 
when compared to India. Indeed, the chapter studies the evidence across several countries 
to show that growth causes debt to become sustainable in countries with higher growth 
rates; such clarity about the causal direction is not witnessed in countries with lower 
growth rates. By integrating ideas from Corporate Finance into the macro-economics 
of Government debt a la Bolton (2016), the Survey lays the conceptual foundations to 
understand why these differences can manifest between high-growth emerging economies 
and low-growth advanced economies.
 As the COVID-19 pandemic has created a significant negative shock to demand, 
active fiscal policy – one that recognises that fiscal multipliers are disproportionately 
44 Economic Survey 2020-21   V olume 1
higher during economic crises than during economic booms – can ensure that the full 
benefit of seminal economic reforms is reaped by limiting potential damage to productive 
capacity. As the IRGD is expected to be negative in the foreseeable future, a fiscal policy 
that provides an impetus to growth will lead to lower, not higher, debt-to-GDP ratios. 
In fact, simulations undertaken till 2030 highlight that given India’ s growth potential, 
debt sustainability is unlikely to be a problem even in the worst scenarios. The chapter 
thus demonstrates the desirability of using counter-cyclical fiscal policy to enable growth 
during economic downturns.
 While acknowledging the counterargument from critics that governments may have 
a natural proclivity to spend, the Survey endeavours to provide the intellectual anchor 
for the government to be more relaxed about debt and fiscal spending during a growth 
slowdown or an economic crisis. The Survey’ s call for more active, counter-cyclical fiscal 
policy is not a call for fiscal irresponsibility. It is a call to break the intellectual anchoring 
that has created an asymmetric bias against fiscal policy.
2.1 Amidst the Covid-19 crisis, fiscal policy has assumed enormous significance across the 
world. Naturally, the debate around higher Government debt to support a fiscal expansion is 
accompanied by concerns about its implications for future growth, debt sustainability, sovereign 
ratings, and possible vulnerabilities on the external sector. This chapter examines the optimal 
stance of fiscal policy in India during a crisis and establishes that the growth leads to debt 
sustainability in the Indian context and not necessarily vice-versa.  
2.2 While fiscal policy is especially salient during an economic crisis, in general, fiscal policy 
must be counter-cyclical to smooth out economic cycles instead of exacerbating them. As seen 
for the United States and United Kingdom, the correlation between private sector and public 
sector net balances is almost perfectly negative (-0.9) (Figure 1b and 1c). In India, however, 
fiscal policy has not been counter-cyclical in general (Figure 1a).
Figure 1: Trends in Government and Private sector balances
Figure 1a: India (FY 1987 – FY 2019)
Source: RBI, MoSPI 
Note: Govt net balance = (Public Sector Financial & Non-Financial Corporations and General Govt Gross Domesic 
Saving) – (Public Sector Financial &Non-Financial Corporations and General Govt Gross Capital formation)
Private sector net balance = Private sector Gross Domesic Saving – Private sector Gross Capital formation
For Households, total savings does not include gold and silver (to make it comparable).
45 Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa!
Figure 1b: United States (1987?–?2019) Figure 1c: United Kingdom (1987?–?2019)
Source: BEA (US)
Government net Balance =Total Government Receipts- 
Total Government Expenditure
Private Sector Net Balance= Gross Private Domestic 
Investment - Gross Private Savings (Domestic business, 
households & institutions)
Source: UK Economic Accounts (ONS) & OBR (UK)
Public Sector net Balance = Net lending by General 
Govt and Public Corporations
Private Sector Net Balance = Net lending by Households, 
Non Profit Institutions serving the Households and 
private Non Financial Corporations
2.3 While counter-cyclical fiscal policy is necessary to smooth out economic cycles, it becomes 
critical during an economic crisis (Box 1). This is because fiscal multipliers, which capture 
the aggregate return derived by the economy from an additional Rupee of fiscal spending, are 
unequivocally greater during economic crises when compared to economic (Box 2). In a country 
like India, which has a large workforce employed in the informal sector, counter-cyclical 
fiscal policy becomes even more paramount. In advanced economies, where the public and 
private sector labour markets are not too segmented, fiscal spending can increase public sector 
employment, reduce the supply of labour in the private sector, bid up wages, and thereby crowd 
out private sector employment. However, in a country like India, where the private and public 
sector labour markets are largely segmented, such crowding out of private sector employment 
is minimal (Michaillat, 2014). Thus, debt-financed public expenditure is more cost-effective to 
employ during recessions than during economic booms. 
Box 1: Relevance of Counter-cyclical Fiscal Policy 
 Indian Kings used to build palaces during famines and droughts to provide employment and 
improve the economic fortunes of the private sector. Economic theory, in effect, makes the same 
recommendation: in a recessionary year, Government must spend more than during expansionary 
times. Such counter-cyclical fiscal policy stabilizes the business cycle by being contractionary 
(reduce spending/increase taxes) in good times and expansionary (increase spending/reduce 
taxes) in bad times. On the other hand, a pro-cyclical fiscal policy is the one wherein fiscal policy 
reinforces the business cycle by being expansionary during good times and contractionary during 
recessions (Figure A).
46 Economic Survey 2020-21   V olume 1
Fiscal policy 
(FP) stance
Recession (? GDP) Expansion (? GDP) Outcome
Pro-cyclical Contractionary FP
? Govt. Expenditure
or /and
? Taxes
Expansionary FP
? Govt. Expenditure
or/and
? Taxes
Deepens recessions and 
amplifies expansions, thereby 
increasing fluctuations in the 
business cycle.
Counter-cyclical Expansionary FP
? Govt. Expenditure
or/and
? Taxes
Contractionary FP
? Govt. Expenditure
or /and
? Taxes
Softens the recession and 
moderates the expansions, 
thereby decreasing fluctuations 
in the business cycle.
Figure A: Business Cycle under Various Fiscal Policy Stance
Channels of Transmission
 Recalling the National Income identity , Y= C+I+G+X-M , the net effect of a recession on 
the private sector may be in terms of lower private consumption (C), lower private investment 
(I), risk aversion by the private sector and pessimistic expectations/sentiments. In such a scenario, 
adopting a counter cyclical policy by expanding the Government Expenditure – both consumption 
and investment - will support the GDP and minimise the output gap (as seen in the figure above). 
This happens primarily through the following channels:
 (i) An expansion in Government expenditure can cushion the contraction in output by 
contributing to the GDP growth, by offsetting the decline in consumption and investment; 
and also by boosting private investment and consumption through higher spending 
multipliers during recession. (Auerbach and Gorodnichenko (2012), Riera-Crichton, 
Vegh and Vuletin (2014), Jorda and Taylor (2016), Canzoneri et al (2012)).
 (ii) Through risk multiplier by compensating for greater risk-aversion of private sector to bring 
back ‘animal spirits’.
47 Does Growth Lead to Debt Sustainability? Yes, But Not Vice-Versa!
 (iii) Through expectation multiplier by building confidence in tough times: Governments adopting 
counter-cyclical fiscal policy are able to credibly exhibit their commitment to sound fiscal 
management. As a result, rational agents in the economy would expect the economy not to 
fluctuate as much and therefore their private actions would reinforce this, in turn enabling 
stronger macroeconomic fundamentals (Konstantinou and Tagkalakis (2011), Alsina et al. 
(2014)).
 Numerous studies in economic literature establish this relationship both theoretically and 
empirically. Ozkan and McManus (2015) study the impact of cyclicality of fiscal policy on 
macroeconomic outcomes for 114 countries over 1950–2010 and establish that following a pro-
cyclical fiscal stance leads to lower economic growth, higher volatility in output and higher levels 
of inflation. In contrast a counter-cyclical fiscal policy stance with policy actions against the cycle 
acts as a stabiliser by reducing output volatility and keeping growth on a steady path. Similarly 
a study by Kharroubi  and Aghion (2008) shows that industries have grown faster in economies 
where fiscal policy has been more countercyclical, both in terms of output and productivity .
 For India, in the current scenario, when private consumption, which contributes to  
54 per cent of GDP is contracting, and investment, which contributes to around 29 per cent is 
uncertain, the relevance of counter-cyclical fiscal policies is paramount. In fact as Krugman 
prescribed, a sustained, productive program of permanent stimulus directed towards public 
investment, in both physical and human capital, is the need of the hour (Krugman 2020).
Box 2: Higher Fiscal Multipliers During Economic Slowdown
 Most studies aimed at estimating the variation in effects of fiscal policies with country’s 
position in the business cycle, concur that the fiscal policies are considerably more effective in 
recessions than in expansions (Barro and Redlick (2011), Auerbach and Gorodnichenko (2012), 
Fazzari et al. (2015), Ramey and Zubairy (2015)). Auerbach and Gorodnichenko (2012(i), (ii)) in 
their seminal paper show large differences in the size of spending multipliers in recessions and 
expansions for the OECD countries and the US, with higher fiscal multipliers during recessionary 
regimes. These results are maintained after allowing for different multipliers for different 
components of government spending. They derive the point estimates of the maximum output 
multiplier (over the first 20 quarters) is estimated to be 0.57 during expansions and 2.48 during 
recessions in the US. 
 Riera-Crichton, Vegh and Vuletin (2014) condition the fiscal policy on both the state of 
the business cycle, and the sign/size of the fiscal intervention, and find that fiscal expansions 
in recessions are much more expansionary than fiscal expansions in booms. Jorda and Taylor 
(2016) use the propensity-score based methods for time series data to show that a one per cent 
of GDP fiscal consolidation translates into a loss of 4 per cent of real GDP over five years 
when implemented in a slump, and just 1 per cent in a boom.
 Different studies attribute this phenomenon of counter-cyclicality of the fiscal multipliers to 
different channels. Some of these are: