Both overheated and lacking heat

On the day the finance minister presented the Budget in Parliament, it was also reported that GDP growth for October-December 2012 grew at 4.5%, its lowest in a decade. It is now likely that growth for the full fiscal year will come in around 5% or lower, way below the 9% growth that many felt had become the ?new normal?. At the same time, consumer price rise by most measures has been in double-digits for over a year, and in fact rose a lot last year while GDP growth fell.

The combination of a weak economy and high inflation can be broadly termed stagflation. The phenomenon became widely recognised and the term came into vogue after OPEC raised crude oil prices four-fold in October 1973 and, subsequently, GDP fell in the US and other developed economies, while inflation soared. The macroeconomic outcomes were attributed to the OPEC-induced supply shocks, while the term itself was often attributed to the noted Keynesian economist Paul Samuelson. It bears pointing out that the word ?stagflation? was first used in November 1965 in the British Parliament by Iain Macleod, then shadow Chancellor of the Exchequer. More crucially, robust evidence indicates that the OPEC explanation of the mid-1970s stagflation is flawed.

Swaminathan Aiyar in his article a day before the Budget analyses this phenomenon of falling GDP growth, coupled with high inflation. He first argues that the situation is not one of stagflation because India is still growing at a substantial 5%, whereas during 1973-75 output fell in the US and other countries. More crucially, he points to India?s labour shortages indicating overheating, while stagflation should entail high unemployment. His overall conclusion seems to be that the economy is more overheated than lacking heat, and he conjectures that the GDP data will get revised upwards. (?Overheated or Lacking Heat??, Economic Times, Feb 27, 2013.)

His overall conclusion can be questioned. For starters, Swami has correctly identified and grappled with the somewhat paradoxical and difficult present situation. By contrast, the Economic Survey released the same day does not broach the topic of stagflation, let alone examine it. A quick scan reveals no mention of the ?S? word.

Nevertheless, like many others analysing India?s economy at present, Swami has missed out on the ramifications of the inflation-adjusted Phillips curve (IAPC), perhaps the most important concept in macroeconomics. I will later explain, based on the dynamics of the IAPC, how an economy can display symptoms of overheating and yet also lack heat. (The textbook term for IAPC is Expectations Augmented Phillips Curve.)

Swami?s first point?that 5% growth is too high to constitute stagflation?is definitional. Granted, the term came into use following the drop in output in the US of 1973-75 when inflation soared. But a drop from, say, 2% growth to minus 1% in the US is quite similar to a drop from, say, 8% to 5%, as in India at present. In both cases, GDP growth falls by 3 percentage points; the economic impact is broadly similar. In characterising stagflation, we should pay attention to the magnitude of the drop, and not get fixated on the absolute benchmark of zero, used to officially define a recession in the US.

In general, comparing different sectors, an economy can be both overheated and lacking heat, as currently in India. At one level, there are two economies: that of (rural) Bharat and (urban) India. Due to massive welfare spending, Bharat has been sizzling while the manufacturing sector and corporate India is now wilting. As an aside, the Bollywood blockbusters of yesteryears were mostly set in five-star hotels, now they are mostly filmed in Bharat.

However, the Bharat-India dichotomy is not the main reason for the economy to reflect both the consequences of overheating and also lack heat. While the weakness of growth in 2011-2012 was mostly in capital goods expenditure, for the fiscal year just ending (2012-2013) the slowdown in growth, and more so the sub components of consumption in the GDP accounts is very broad-based, well-documented in the latest Economic Survey. The exorbitant growth in rural welfare spending has somewhat tapered off. Sectoral imbalance is not the problem.

Instead, we need to examine the IAPC. The IAPC implies that when an economy grows faster than its potential, the economy overheats and so inflation rises. This inflation gets embedded in wage and other contracts, which, in turn, slowly works its way into actual inflation. Thus, when the economy slows down, and aggregate demand falls relative to aggregate supply, this weakness puts downward pressure on inflation. Nevertheless, overall inflation will rise if the upward push from inflation adjustment (first variable in the IAPC) exceeds the downward pull from a weak economy (second variable in the IAPC).

To take a numerical example, suppose GDP growth falls from 9% to 5%, and this fall lowers inflation by 2 percentage points. Simultaneously, expected inflation due to past overheating and also the reaction to, suppose, recent diesel price hikes, rises by 3 percentage points. On balance, inflation will rise by 1 percentage point along with the large drop in growth, which is a case of mild stagflation.

These opposing effects are partially manifest in the huge divergence between the inflation measure that has been the stated and most often actual focus of policy, certainly in mid-2011 (WPI non-food manufacturing, what RBI thinks is ?core? inflation, around 4% now) and the CPI, which reflects a wide range of items that directly or indirectly incorporate inflation adjustment, is now running close to 11% all India. From the RBI survey, expected inflation has been above 11% in recent quarters.

Conceptually, the occurrence of stagflation can be explained as purely due to monetary tightening in response to an overheated economy, without any supply shock. Indeed, interest rate hikes contributed to a mini stagflation in the US between 1967-1968 and 1970, well before OPEC?s actions.

Returning to India?s economy, it should be emphasised that the occurrence of stagflation does not depend on why growth has fallen. The huge drop in investment, which started the process, could have been because RBI raised rates and tightened since early 2010, or due to other autonomous reasons?be it ?policy paralysis?, bruited by Dr Kaushik Basu, or real business cycle factors such as technological gestation lags in capital goods, the bunching of orders (as for durable goods), or over-expansion of capacity and market saturation, as for telecom connections.

My own view, in sync with the mainstream, is that some combination of all these factors have led to the downturn. But this does not have much connection, if any, with the stagflation. A comparison of India with China is quite informative. China?s economy has also been slowing after several years of double-digit growth, as its enormous investment boom has tapered off, and as the People?s Bank of China has been using various policy tools over the years to curb rising property prices. But as the accompanying table shows, China?s inflation ending December 2012 has fallen, along with slowing growth. This is what normally happens when growth slows, and has also happened in most other Asean economies, where policymakers in recent years did not allow much overheating, if at all.

As an auxiliary matter, the role of policy paralysis, like that of Mark Twain?s reported demise, seems to have been greatly exaggerated. As Swami has pointed out, unlike in the past, power generation has grown faster than manufacturing, so power generation cannot be the main bottleneck. A comparison of the volume of unused coal block allotments versus pending or rejected applications for such blocks would be informative in this regard.

This article draws upon a seminar, ?Understanding India?s Stagflation? at IIM Bangalore, December 2012, Chapter 6 of the author?s textbook in progress, and ?Debunking Supply Shock Myths?, September 2008. More details on the website economicsperiscope.com

The author is a professor of economics at IIM, Bangalore