India’s Economic Revival

Relevance: Mains: G.S paper III: Indian Economy

Why in news?

• Apart from the trade war, media in the United States is actively discussing this in the context of a relative fall in the returns of long-term government bonds vis-à-vis bonds of shorter maturity; the so-called “inverted yield curve.”

Analysis

• The experience of government responses since the global recession of 2008, which preferred monetary easing over a genuine fiscal stimulus across the globe, does not inspire much confidence.
• Indian policymakers too do not seem to have learnt much from the global failure of monetary policy as a way out of a slowdown.
• There seems to be a general consensus among the policymakers, despite concrete evidence to the contrary, that economic activity can be manoeuvred through changes in the interest rates.

Latest Development

• The Reserve Bank of India has accepted the government’s view and decreased the repo rates by 35 bps (100 bps = 1 per cent) in its last monetary policy review meeting.
• The expectation is that credit-financed private investment and consumption would pick up as a result of a fall in the cost of credit and bring the Indian economy back on its feet.

Why consumption cannot revive the economy

• A relationship between consumption and current income, that acts like a principle in is that consumption and current income is a cyclic process. So, when the expectations of future incomes is less, consumption will be unsuitable for revival
• It is for this reason that Keynes called consumption a passive factor when it came to the question of how to revive a flailing economy.

Role of Investors (Borrower)

• Two factors that is considered for investing is the profitability and the interest rate.
• When a company is running below capacity, it makes no sense to the invester, creating more capacity by investing only because the cost of loans have come down.
• Credit and its cost may be a necessary condition, but not a sufficient one to influence investment.
• This means that investment too is indirectly a function of demand, past and current, and therefore cannot expect investments to happen when the credit costs are reduced.

Roles of Banks and NBFCs (Lenders)

• For the fall in repo rate to percolate down to the borrower (like the investors), the banks and the NBFCs has to reduce their rate of interest charged: There can be 2 types of cases

1. The lenders have to bring down their rates, which may not necessarily happen for various reasons.
   • Lenders may want a higher margin of security during difficult times because of piling non-performing assets and failing non-bank lending institutions.
2. Even if they bring it down, like it is happening now, at least with some public sector banks, the banks may go slow on the volume of the credit.
   • So, the banks may bring their lending rates down, but still be wary of lending except to very creditworthy borrowers.

• What matters for the expansion is not just the incremental cost, but the volume of loans too.
• Therefore, even the necessary condition, that is reducing the credit cost may not get created.

Way Forward

• Keynes had argued that fiscal policy is far more effective since it directly influences the level of activity.
• Indeed, fiscal expenditure has the potential to revive the economy, but, unfortunately, because of the Fiscal Responsibility and Budget Management Act, that has been given up.
• The Fiscal Responsibility and Budget Management (FRBM) Act was enacted in 2003 which set targets for the government to reduce fiscal deficits.
• A fixation of the deficit target to 3.3% of the gross domestic product in the last budget means that the government expenditure itself becomes a function of the current income.
• Unless these self-imposed constraints are broken, there is hardly any scope for revival and the recession would have to run its full course before revival begins.
• The Indian economy is not just in a trough of a usual business cycle, it is also going through a structural crisis, that is, it is a crisis of both the trend and the cyclical component of economic activity.
• While the cyclical component can be tackled through tinkering fiscal policy, the trend in the economy requires deeper intervention.
• It would require identifying sources which can deliver equitable and sustainable growth. Perhaps, this is an opportune time for a new green deal.
• The government could, among other initiatives, aggressively invest in green infrastructure as a specific form of fiscal intervention.
• Such expenditure has the usual benefit of generating a multiplier, but it has several additional benefits. Green growth is usually more inclusive both because of its higher employment elasticities as well as its environment-conserving potentialities.
• In short, without a comprehensive plan about the future of the Indian economy, quick-fixes alone will not serve us well in the long run, but then we have a government in power which does not believe in plans anymore!

Difference between monetary and fiscal policy

• Monetary policy involves changing the interest rate and influencing the money supply.
• Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.

Monetary policy

• Monetary policy is usually carried out by the Central Bank/Monetary authorities and involves:

• • Setting base interest rates
  • Influencing the supply of money.
• The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates.
• Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower inflation.
• If the economy went into recession, the Central Bank would cut interest rates.

Fiscal policy

• Fiscal policy is carried out by the government and involves changing:

• • Level of government spending
  • Levels of taxation
• To increase demand and economic growth, the government will cut tax and increase spending (leading to a higher budget deficit)
• To reduce demand and reduce inflation, the government can increase tax rates and cut spending (leading to a smaller budget deficit)