Budget blues: Why govt isn’t the sole determinant of economic growth

Budget 2019: What economic issue failed to appear on the hustings during the election campaign? Not growth, not farmers’ distress, not jobs, not GST, nor demonetisation. It was inflation. The price of onions has scuttled governments in the past, but, this time, inflation was fast asleep, dormant. It was the best illustration of an intelligent policy formulation and implementation process in a long time. The legislation to give Monetary Policy Committee its autonomy and a clear remit obviously helped. Urjit Patel was known as an inflation hawk when he was a Deputy Governor at RBI and continued to be one as Governor.

RBI has been much criticised for keeping the real rate of interest too high. It has been blamed for thwarting growth. Growth numbers are in a meltdown at present because of what the former CEA has argued in a recent research paper. I share with many others my scepticism about his results for technical reasons, which I reserve for later. But if the Indian economy had an average of 7% for five years as I believe it did, how could the anti-inflationary stance of RBI have been growth-reducing?

Real interest rate, calculated simply as the nominal rate minus some measure of inflation, is only a first approximation. India has also had huge problems of fragility in the banking and non-banking credit markets. The NPAs of the PSU banks have begun to be brought under control with the IBC and NCLT. That fragility, by itself, should put a premium on the real rate of interest. RBI has also urged prudent regulation of the lenders. Add to that the ILFS collapse, and what we see is not that there was a shortage of credit, but rampant wild lending. RBI has been the responsible charioteer of the financial economy, keeping inflation low and preventing further deterioration of the PSU banks’ balance sheets. The non-banking sector needs better regulation.

There is great concern lately over the growth slowdown in the last two quarters. I believe this is a cycle, not a trend. First is the uncertainty around election of a new government. Secondly, the ILFS collapse frightened investors. Credit dried up. Many people ask the Budget to address the slowdown urgently. I believe it would be a mistake. The economy will recover partly by its own dynamic as the political uncertainty has come to an end. RBI is also cautiously driving the interest rate down.

The growth performance of the economy has been remarkable. It is good to see that now 7% GDP growth is regarded as the norm, and 6% invites comments such as ‘tottering economy’. The economy has structural problems, especially in the farming sector where there are far too many small farms that barely yield subsistence. There is a need to facilitate the transfer of subsistence farmers to more viable activity, preferably in rural areas near where they live. This is not a problem to be tackled in a Budget, but over the five years coming.

As to the technical debate about over/mis-estimation of growth rates, my view is that the problem is inherent if you seek to measure the real GDP. The problems of deflation are enormous. The data are fragile and aggregation difficult. An attempt to get a better handle on corporate earnings has led to debate about the validity of a new data set, etc. My view is that we should concentrate on measuring the nominal GDP that avoids problems of double deflation, etc. After all, we spend nominal income and the government collects its taxes and spends in nominal income terms. The attempt to get to real GDP is based on the idea that it is a better truer measure of welfare.

Keynes, in his General Theory (Chapter 4), argued that the search for real GDP is based on a misunderstanding of what income measures, it is measure of economic activity. We make our saving and investment decisions in nominal income terms. You can calculate nominal GDP immediately whereas it takes a while to get to GDP for any time period. Deflate it by the Consumers Price Index if you want to correct for inflation. Or deflate it by the exchange rate to check for excess inflation relative to the rest of the world. The prime minister chose the dollar value of nominal GDP in setting the target for the next five years, from $2.5 trillion to $5 trillion. That is the correct framework for policy.

Indian politicians and economic commentators have a very peculiar view of how the economy works, They put too much credulity in the idea that the government is the sole determinant of growth or stagnation. This is why there is a lot of hope and hype around the Budget. But, the economy is run by millions of us consumers, workers, business people, investors. The government can only operate at the margin to steer the economy slightly one way or another. Most governments misjudge the timing and extent of the intervention necessary. Finance minister Nirmala Sitharaman has experience of having worked in the private sector. I expect her to be aware of the pressure of being hyper-active. Finance ministers need to be aware of the Hippocratic Oath: Above all, do no harm.

(The author is prominent economist and Labour peer)