Here’s how fiscal prudence could foster India’s emergence as an innovation-driven economy

Subscribe to enjoy similar stories.Vikram Sarabhai, when pressed on why a poor country should spend on space research, offered an elegant rebuttal. He said that we are not in competition with economically advanced nations. We are endeavouring to apply the most advanced technologies to the real problems of humankind.

He died in 1971, the year India ran an enormous fiscal deficit to finance the Bangladesh war. The two are unconnected. But the question his interlocutors were really asking was: Can a fiscally stretched economy afford to innovate? It turns out to be the wrong question.

The right one runs the other way. A paper published this year in Oxford Economic Papers by Can Sever of the International Monetary Fund (IMF) titled ‘Government Debt and Innovation-Led Growth’ offers a formulation of why. The mechanism is not a ‘crowding out’ in the simple textbook sense of higher interest rates displacing private investment.

Research and development (R&D) investment is a real option. However, it is irreversible, distant in its returns and acutely sensitive to variance in future payoffs. When government debt rises, policy uncertainty rises with it.

It translates to distortionary taxes to service public debt and sovereign risk premiums feeding through to corporate borrowing costs, apart from tough questions about future spending priorities. For an R&D-intensive company weighing whether to build a laboratory or a production line, elevated debt raises the option value of waiting. And waiting, in the field of innovation, often means not doing it at all.Sever tests this using a variant of the identification strategy proposed by Raghuram Rajan and Luigi Zingales in their 1998 paper on financial dependence and growth.