Two weeks ago, I asked a Union minister in Delhi when the government was going to lower the interest rates.
“Lower them?” He asked in tonnes of incredulity. “When there is so much inflation?” I tried to tell him that India was not suffering from inflation; that the 6.28 per cent inflation of April had been caused solely by a single large bump in the prices of foodgrains, fruits and vegetables which began in that month and continued till September. I pointed out that the absolute increase in the price index since October 2006 had been less than two per cent and concluded by predicting that in a month the inflation rate would crash to between two and three per cent, but he remained sceptical.
When I asked the same question a few days later to the head of one of Delhi’s more important think tanks, he too looked at me as if I was out of my mind. When I asserted that there was no inflation in India because the core rate had not budged from 2-3 per cent since 2005, he looked nonplussed. After a considerable pause he replied, “Credit had been growing by 30 per cent every quarter for three quarters, prices were rising. The Reserve Bank had to intervene to check the rise.”
I gave up, told him to watch the rate of inflation crash in a month, and enjoy the recession that he and his ilk had unleashed upon the economy.
My prediction came true last Friday. Not only did the inflation rate drop to 3.32 per cent, but analysts for the first time predicted that it would continue to drop till March, when the last of the ‘base effect’ on price indices would be flushed out. One business newspaper even predicted that in March the government’s economists would start taking the credit for having acted in time to avert an unsustainable boom, and thereby ensured future growth. Its correspondents were wrong in their prediction by six months. Last week the Deputy Governor of the RBI, Rakesh Mohan made precisely this claim.
The newspaper’s prediction is likely to go awry for another reason. By March the government’s economists will not be taking credit for stopping inflation. They will be running for cover to avoid being blamed for needlessly plunging a surging economy into recession.
I have been warning readers of this column for the last eight months that the savage increases in the Cash Reserve Ratio since January, to reduce the availability of credit at precisely the moment when rising demand had tightened conditions in the money market, would send interest rates through the roof and push the economy into recession. In the following months I traced the decline in automobile and two-wheeler demand, the sudden rise in bad housing loans (as judged from interviews with builders and softening prices — the government of course does not believe in collecting such data). But the Prime Minister’s panel of economic advisers thought otherwise. Y V Reddy had made the right move, they stated. Inflation had risen to an unacceptable level, and had to be curbed. It may not be a coincidence that the head of the panel is another former governor of the Reserve Bank, Rangarajan.
July’s figures for industrial production have laid that controversy to rest. Industry’s growth has almost halved from 13.2 to 7.1 per cent. Manufacturing has fallen even more steeply from 14.3 to 7.2 per cent. To no one’s surprise, the decline has been sharpest across the entire range of consumer durables, where a 16.8 per cent growth in July 2006 has been replaced by a 3.2 per cent decline.
Economists, however, are a stubborn lot. Yes the growth rate has been reduced — Ahluwalia concedes that it might come down to between 8 and 8.5 per cent this year. But that does not mean that we are in for a recession. This decline bears a disturbing resemblance to the one that occurred in 1996. In March of that year the rise in industrial production touched 16.2 per cent. By November it had fallen to 3.5 per cent. It stayed around that figure for the next six years!
The reason that happened, and is likely to happen again, was described long ago by the British Nobel laureate J R Hicks. A slowdown in the growth of consumer demand makes manufacturers postpone modernisation and additions to capacity. This gets translated into an absolute fall in the production of capital and intermediate goods. That decline leads to a further fall in demand for raw materials and intermediates, and a slowdown in the growth of employment. This comes around full circle and reduces consumer demand a second time. This is the cycle of recession. Hicks called the trigger described above “the accelerator”.
If one looks closely at the available data and news reports from industry associations one finds that the accelerator is already working full blast in the construction industry, and is beginning to take hold in the auto industry. If we persist in the folly of high interest rates (I mean high relative to the US and other major currencies) it will spread to all the consumer goods industries. But will the government take anticipatory action, or will it wait for calamity to strike and then blame everything on the US sub-prime loan crisis? Judging from Chidambaram’s recent assertion that he does not see as yet any slowdown in investment, it could be the latter. For by the time he does “see” the decline in investment, it will be far too late to reverse it.
