Economy and All That JAZZ

First things first. “All that Jazz” is the title of a famous movie by Bob Fosse.

It is a  semi-autobiographical fantasy screenplay where Fosse acts as screen character Gideon. It is therefore a truly unsympathetic look at his own life. Gideon that we see in the movie is a constant womaniser, drug and alcohol abuser and chain smoker who has sex with a different dancer every night and virtually a reckless and a moral-less scoundrel.  It is a movie is an ultimate act of self-flagellation.

Foss died 7 or 8 years after the movie was made and the movie was released after his death.

Now what that has to do with the Indian economy? We will see at the end of this series of posts. We see the growth slowing down to 5% and some say even this is dubious. Inflation is no doubt very low and very benign - a silver lining. This is for sure as we see it in our direct experience.  Companies have excess capacity though they have not invested in creating fresh capacity last many many years-I have lost count of them. Cars are not selling, lowly biscuits are not selling, TurDAL is selling at pre 2010 prices.  India has always prided itself as a consumption-led economy and the robust domestic consumption led by growing population makes it different from other economies who have to export to keep their growth up- e.g. South Korea, Japan , even China.  

For example, Japan , is an ageing economy where no growth is possible. In fact, even by having the interest rates at ‘zero’ percentage for years, there is no appetite to borrow to both spend or invest amongst the Japanese. That is why they give us Indians loans at zero interest rates as that loans will be used by us to buy their products.The economy there sees growth in the product segments that cater to nonagenarians — diapers and all. Most of Europe is like this. This is also called as “Full Employment” in economics, as all factors of production viz. land, labour, capital and organisation are fully deployed to the optimum and there is no incentive or impetus to change the status quo. ( Actually there is no “Full Employment” , it is a theoretical construct)

There are two legs on which modern economy theory stands. One is Fiscal Policy and another is Monetary Policy.  Fiscal Policy refers to the spending of a Govt. In a developing economy, a Govt brings about growth through capacity building. Monetary Policy is the exclusive domain of the Central Bank of the country- viz the RBI.

Let us try to understand this by imagining a country called Utopia. Let us assume for a start that in Utopia there are 10 people , each earning Re.1 and spending Re1. The central bank also maintains money supply in the hands of Utopians at Rs.10.   This will make Utopia remain in what is known Perfect Equilibrium. 

Now in Utopia, one guy, who is the Govt, decides he need not restrict himself to spend only Re 1/- as he represents the sovereign. He thinks that there can be more land to be brought under a plough if he builds ‘capacity’ in the country by spending Rs.5/- on a dam. He budgets to spend this additional Rs 5 by borrowing from others Rs3/- at 10% and asking the Central Bank to create money for the deficit of Rs2/-. Now many people are willing to postpone consumption as there is a lucrative reward of 10% if they do so. There is a 20% increase in money supply as Central Bank created money of Rs.2/- from nowhere. Now the equilibrium has been shattered. The two rupees in circulation and the investment of Rs5/- is affecting different people differently. If there is a commensurate productivity ( known in technical terms as ICOR - Incremental Capital Output Ratio) , more goods come in supply after a lag. As a result, there could be more than 12 goods available for people buy. There is ‘real’ economic growth as a result of the actions of the Govt guy. If, on the other hand, the economic lacks productive capacity or has no supply of Land, Labour and Organizational ( entrepreneurial) skills, the excess supply of money brings in inflation - Rs,12 chasing Rs10 worth of goods. The more powerful in the economy increase their prices while the fellow with no bargaining power ( like the poor, illiterate , labour class or unorganised class) bear the brunt.

Another problem is that since the govt is borrowing at 10% , no other entrepreneur will be able to borrow at less than 10% as govt lending is risk free.  

This is happening in India. Our household , corporate and govt savings ( pubic sector dissavings) add up to around 2 - 2.5 lakh crore per year, while the govts ( state, centre and public sector) borrow the entire thing at more than 8% rate. This means , in spite of inflation being very low, just 2% or 3%, interest rates do not come down to 4% for the average Joe who wants to take a housing loan or buy a car. Under normal circumstances, a low inflation will allow RBI to ease credit availability by lowering its interest rate to banks. RBI must be able to lend to banks at 3.5% or 3.25% , which should make the banks bring down their lending rates to Average Joe to 4%. But with Govt itself borrowing at 8%, he does not get anything less than 10% - 14% which means cost of money is still high.  Whether it is the average Joe or the entrepreneur , if he has to borrow at such interest rates, he will do so only if the returns are much higher than that. Typically, infrastructure investments, which have long gestation, get affected. Who will borrow at 10% to invest in a road project whose pay back period gets interminably long because of his high interest rate ?

So the Monetary Policy of the RBI to infuse josh into the economy by lowering interest rates and push consumption and investment comes a cropper.

This illustration above generally explains the predicament we have seen in  the Indian economy historically. We have always had Aggregate Demand exceeding Aggregate Supply resulting in high inflation.  This is also true of all developing economies.  But what were are facing is, something else, at least in the medium term. We have lack of demand. We have 10 goods in circulation , but the demand is only for 8. We have 20% capacity unutilised. Car factories to biscuit makers to e-commerce companies see lack of demand. Are people saving and not spending?  No , in fact, the Domestic Household savings , which is normally around 15% has fallen to less than 10%. Corporates have some savings , but only IT companies have sparable cash, others don’t. Govt sector only wastes , or in other words has negative savings. If the households were to save 15% as before, even this 8 goods would not been sold, it would have been just 7 or 6 leading to more closures and more utilised capacity leading to a deflationary cycle - Closures leading to loss of jobs, loss of jobs leading to loss of incomes and loss of incomes leading to fall in demand leading to more closures! Why this is happening is a paradox, not explained by any theorist with sufficient empirical analysis. It is true that household savings is lowest now in India, in spite of aggregate demand being tepid or falling.

This means to increase investment in the economy, the govt has to borrow or tax more. But taxing more is not possible , may infect have more deflationary effect on the aggregate demand. Borrowing more will crowd out other borrowing and private investment will not happen at all.

So can the Govt leave more deficit uncovered. We have the FRBM Act ( Fiscal responsibility act ) which mandates the Govt to bring down the fiscal deficit to 3% in a glide path. This govt also swears by it. Leaving deficit uncovered will lead to inflation which hits poor the hardest and is the most unkind thing you can do to our poor and fixed income groups. 

                                                                                                                                                —to be continued.