How to tackle economic slowdown

With Brahminical tradition and obeisance to authorities running deep in Indian ethos, it is not surprising that in the debate on India's economic slowdown, both the dominant and minority views largely reflect well-entrenched orthodoxies, the IMF paradigm and naïve Keynesianism.

It is also not uncommon to come across policy packages which, in keeping with our penchant for reconciliation, constitute a cocktail of the two orthodoxies.

What seems lacking in most instances, however, is an appreciation of how far the canonical theories or policy prescriptions are relevant in the Indian context.

Practically all votaries of the International Monetary Fund school ascribe the relatively poor performance of the economy since the mid '90s to drying up of reforms initiatives and fiscal profligacy.

The remedy, according to this line of reasoning, lies in restraining government expenditure, sale of public enterprises, withdrawal of all subsidies, putting legal caps on government borrowing and public debt, and dismantling the remaining barriers to free trade and cross-border capital flows.

In view of slackening of demand and considerable excess capacity Indian industries are saddled with, die-hard Keynesians on their part do not see any problem in pursuit of expansionary fiscal and monetary policies.

Some proponents of big bang reforms, apart from favouring low-tax regimes, a la supply-side economics, do not hesitate to invoke the argument relating to role of tax cuts in raising consumption demand and countering recessionary tendencies.

Such Keynesianism may not, however, be as inconsistent with the IMF approach as may appear at first sight: boosting consumption of the rich is after all perceived to be a most effective way of benefiting the poor through both trickle-down and envy-cum-aspiration effects!

Since the present writer is generally branded an orthodox Keynesian, it behoves us to indicate first why an expansionary policy, irrespective of its contents and without being backed by other measures, is unlikely to be effective in attaining full-capacity production or putting the economy on a high growth trajectory.

Consider for example the case of consumption-led expansion, assuming that ours is indeed a typical case of Keynesian demand deficiency.

Full employment attained through such a programme will be characterised by low saving, poor growth and inadequate provisioning of public services including education and health care -- problems which did not concern Keynes but are central for countries like India.

Hence arises the need for dovetailing even anti-cyclical policies to longer-term strategies for growth, poverty eradication and improving the quality of life.

What is no less important to appreciate, Indian economy is marked by coexistence of and inter-dependence between demand- and supply-side bottlenecks.

Even now overall farm production (if not its composition) is crucially dependent on climatic and other supply side factors.

Adverse supply shocks in agriculture reduce its purchase from the rest of the economy and sets a negative multiplier process in motion. What expansionary policies can at best do is to neutralise this negative impact.

This normally creates inflationary pressure; but with fairly large food stocks, foreign exchange reserves and capital inflows, tackling incipient inflation, through release of grains or additional imports, should not as of now be too difficult for the government.

However, even with such a constellation of favourable factors, agriculture lies outside the scope of Keynesian policies.

Moreover, parts of the Indian non-agricultural sector are also bedevilled by supply-side failures.

Many studies including Reserve Bank reports have drawn attention to the way inadequate availability of electricity and of road, railway or port facilities tended to limit output in certain sectors, even while industries producing capital goods, steel, cement or automobile were hit by demand deficiency.

Particularly important is the inability of a number of small and medium enterprises to cater to potential demand due to dearth of working capital finance.

Cut-back in output in some sectors, arising from physical or financial bottlenecks, deepens demand deficiency problems in industries not facing supply-side constraints.

The reinforcing mechanism is also characterised by sluggish investment, with all its short- and long-run contractionary consequences.

There is little incentive for producers experiencing shortage of demand, inputs or working capital to add to their capacity.

Among those who do not face these bottlenecks and are willing to invest, many stumble at the hurdle of securing long-term funds or of legal complexities.

It is, thus, not difficult to discern why orthodox Keynesian measures can play only a limited role in reversing economic slowdown.

Even if the initial impact of say fiscal expansion is on demand-constrained industries, supply-side bottlenecks operating elsewhere truncate the multiplier process.

Indian experience also highlights how, in the absence of an economy-wide well-functioning financial system, effects of cheap money policy remain circumscribed, with very little easing of credit constraint producers and investors are subject to.

What of IMF-type measures in the Indian context? Some of the most crucial factors behind the slowdown, let us note, owe their origin to mindless implementation of these policies.

Focus on fiscal deficit overshadowing all other considerations and fond faith in private initiatives replacing public ones led the government to sharply reduce infrastructural investment, even while it let its consumption expenditure reach dizzy heights.

Financial reforms were no doubt necessary to bring down inefficiency and corruption; but there was little realisation that such reforms on their own would dry up sources of long-term finance; pose serious hurdles to medium and small enterprises in meeting working capital requirements; make new units difficult to set up; and enhance pro-cyclicity of credit.

Capital market liberalisation without adequate safeguards have also led to a series of scams, to siphoning of funds through public issues by thousands of fly-by-night operators with impunity, and hence to severe erosion of investors' confidence.

Add to that, the impact of a tax system inspired by supply-side economics, and the long slowdown with budgetary mess would not appear strange.

It is heartening to see that after prolonged huffing and puffing the government has at last made a big push in road building short-term benefits of which are already felt in industries like steel, cement and engineering (which have been free from capacity or working capital constraints).

Unfortunately, similar priority is yet to be given to investment in railways, irrigation, power and other infrastructural facilities; crash programmes for education and health; buoyancy of revenue system; simplifying legal process for hassle-free pursuit of economic activities; and curbing public consumption.

Nor can one overemphasise urgency of repairing one of the weakest links in our macroeconomic chain, viz., credit delivery system.

Korea's resurgence since 1998, it is worth noting, has been led by small and medium enterprises, thanks to policies aimed at large-scale diversion of credit in their favour at the expense of conglomerates.

The programme suggested by our analysis aims not only at removal of obstacles to full employment, but more importantly at creating an environment where private producers, assured of government's commitment to preventing overall demand deficiency and ensuring adequate supply of infrastructural facilities, skilled labour and credit, are induced to undertake long-term investment and make the growth process self-sustaining.

The programme may raise fiscal deficit in the short run; but in view of FCI stocks and the country's import capacity, the inflationary effect if any can be easily neutralised.

So far as long-term budgetary viability is concerned, our perception is, "Take care of revenue deficit and growth, fiscal deficit will take care of itself".

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