The United States is going through tumultuous times, which many describe as a signal of double-dip depression, reminiscent of what the US witnessed during the second recession of 1931-1933 which resulted in the Great Depression. Is the US going to repeat similar policy mistakes that it had committed then? We believe that if the conservative ideology prevails, it is quite possible to witness a similar situation. Since the US economy is one of the leading economies of the world, this could have severe fallout on the rest of the world, including India.
The role of government policy is quite critical in the trajectory of an economy. This was best exemplified during the Great Depression of the 1930s. After the initial decline during the mid-1929 to mid-1931, there was some revival of expectations of the people about the future of the economy. US Federal Reserve, however, took this as a sign of end of the recession and implemented a tight monetary policy (by increasing interest rates) to avoid inflationary pressures. Such an ill-formulated policy led the economy into double-recession which continued till 1933 when Roosevelt brought ‘The New Deal’, which meant the government intervened directly in economic activity through expansionary fiscal policy. Even then, the effect of the depression was so severe that it took the World War II, with heavy dose of government expenditure in armaments, to overturn the fortunes of the world economy.
Why is the US government repeating its own mistakes by implementing contractionary fiscal and monetary policies today? We believe that at the heart of it is the crisis in economic theory and, hence, the policy prescriptions.
What does debt ceiling mean and entail?
Government borrows from the general public, within and outside the economy, to fund the excess of expenditure over its income (from taxes). At any given point of time, the outstanding commitment of the government to its debtors is the total debt. The ceiling to the level can be fixed at any arbitrary level. In this case the US congress had set it at US$ 14.3 trillion.
If the government is bound by legislature to incur debt only upto this level, it means that it cannot borrow from the market once it hits this level. But then how does the government honour the impending payments that it has already committed itself to? It could be done either through rationing of payments by prioritizing them (implicit default) or default (explicit) on its past commitments, say reneging on its promise made to social security recipients. In either of the cases, the economy runs a risk of a slowdown.
What could the government do to avoid it? It could either increase the debt ceiling with or without strings attached and/or it could restructure its income-expenditure policies to bring the debt level down. The deal struck between the Obama administration and the Republicans on July 31 opted for a combination of both. With the promise of cutting down fiscal spending by $2.4 trillion over the next 10 years, US Congress has allowed a two-step increase in the debt ceiling. There are two questions that need to be answered here: one, how did they reach here; two, what are the implications of this deal?
How did the US get here?
We believe it is the result of dominant orthodoxy in economic theory that has been used both by the Republicans and the media to create the public hysteria around the rising debt levels. The crux of this orthodoxy is that capitalism is a self-equilibrating system that settles at full employment if left to its own. Any state intervention which distorts the incentive structure of the free markets would result in sub-optimal social outcomes. The state should at best be an 'enabler' by ensuring proper conditions and incentive structure which maintain the free play of markets. One might think that I am just making up an argument when I say that this is the dominant framework at a time when there has been such a high level of unemployment in the world economy since 2007. But I am not. Let’s see how.
The main postulates of this orthodoxy and their role in the current debt crisis are as follows.
First, they argue that government spending has no effect on total demand because it reduces either current consumption or investment by the same amount. Current consumption could decrease because ‘rational’ agents expect that an increase in government spending today would be reflected in tax increases in the future. Hence, they reduce current consumption to save for the future (Ricardian Equivalence). Current investment could be ‘crowded-out’ because an increase in demand for loans by the government to fund this expenditure pushes the interest rates up, thereby, increasing the cost of private investment. The only way in which fiscal policy can be effective, according to this theory, is by 'enabling' the agents to increase consumption demand through tax reductions.
Imprint of this dogma was written all over the stimulus package of the Obama administration which consisted of bailing out the financial corporations, retaining the Bush tax cuts with least focus on expenditure directly affecting employment. This route of fiscal expansion from the tax angle has its flip sides. One, in conditions of dampened expectations and past commitments towards mortgage payment, as is the case for the household sectors, tax relaxation might have very marginal effect on the consumption demand. Two, unlike in the case of government spending, this does not generate the Keynesian multiplier. In other words, such a fiscal stimulus increases the debt without a commensurate increase in the output.
Second, monetary policy is effective if used counter cyclically across the business cycle. An expansionary monetary policy (decreasing the interest rates) during recessions creates conditions for favourable expectations of capitalists to invest and uplift the economy. There are two problems with this argument. One, this is critically dependent on the assumption that private investment is sensitive to interest rates, which might not be the case, especially in conditions of dampened expectations about the future market. Two, even if this were the case, there is a lower bound to interest rates, it cannot go below zero, and by then if investment does not pick up to the extent possible, the economy might remain stuck at low levels of output and employment (Liquidity Trap). This is currently the situation with the US where despite the Federal Reserve maintaining very low federal funds rate since 2007, private investment (or consumer credit) has not picked up to reverse the downward slide in the economy.
Third, one of the roles of the government, it is argued, is to ensure that rigidities in markets, especially the labour market, should be removed. With downward flexibility to real wages in the labour markets, the economy would get stuck with unemployment and, hence, at lower than potential output (resulting in recessions). Since labour unions force a downward rigidity in real wages, the policy prescription would be to restrict unionization. Since early 1980s, this has been the unofficial government policy with the rate of unionization going down in the private sector from close to 25% in 1980 to less than 7% in 2008. Among other things, this has resulted in stagnant or declining real wages in the US since the early 1980s even as the income at the top was getting concentrated. Contrary to the mainstream orthodoxy, the truth is that a decline in real wages leads to a decline in the purchasing power in the hands of the workers and hence in the aggregate demand, thereby, pulling the economy away from equilibrium.
Implications of this deal
In the immediate run, this deal has helped the government escape from the debt crisis. However, it does not bode well for either the US economy or rest of the world in the medium-to-longer run. As for the US economy, it has bound, as mentioned above, the government to cut down expenditure by $2.4 trillion over the next 10 years out of which the first $900 billion-$1 trillion has to come from cutting down on special government programs catering to the poor and the middle class. This ‘austerity’ package for the US would have severe adverse impact on the overall demand in the economy. That this would come in the middle of a recession, which the US has still not been able to recover from, is alarming. The US, in effect, has committed to put the brakes even as the economy has not picked up speed.
Despite this deal, the credit rating agencies have raised a red flag by bringing down the ratings of government bills. This is likely to create panic in the financial markets, thereby, dampening the expectations about recovery. A decline in the ratings of government bonds by default means an indication for increase in interest rates that the investors would demand to compensate for the increased risk. This would have a dampening effect both on private investment and consumer credit.
Impact on the Indian Economy
The situation that US finds itself in would have a direct effect on the developing countries, especially with whom it has strong financial and trade relations such as India. Austerity measures often are also a prelude to inward looking economic strategies, a danger which is looming large over the US economy. With the US dollar under pressure, any ‘closure of frontiers’ by the US would have a cascading effect on the export-oriented economies on this side of the Atlantic.
In specific for India the future seems tentative if these events affect the main sources of growth in India: credit-financed consumption of the elites, construction, tourism, IT sector, real estate etc.. All or at least some of these could be affected through the following routes.
First, credit-financed expenditure in real estate and consumer goods by the middle and the rich classes has been driven by the appreciation of housing prices and availability of cheap credit in the economy. For both, the role of capital inflows from abroad (FIIs) has been significant. On the one hand, these flows have been greatly responsible for the bullish run in the Indian stock markets (including of stocks of real estate sector companies) in the recent past, which increases the wealth effect on consumption. On the other hand, increased foreign exchange reserves generated from such inflows have increased the credit-creating capacity of the economy. Therefore, any panic in the financial markets in India and abroad, as witnessed over the last couple of days, would precipitate capital outflows. They could have a medium-term lagged effect on credit-financed expenditure.
Second, these outflows in turn would put pressure on the value of Indian Rupee. In order to check this outflow, returns on these assets have to be increased. In an attempt to do so, the interest rates (return on financial assets) need to be increased which could have an adverse impact on private investment or credit for consumption. Given that the latter is one of the important sources of the Indian growth story, this could have a severe impact on the growth front. That the Finance Minister, Chairman of the Planning Commission, the Reserve Bank of India are all trying to pacify the nerves of international investors is itself a sign of fragility in the capital markets. But if these efforts, including increasing the interest rates, also cannot stop the outflow, it would precipitate a dramatic capital outflow from the economy creating pressure on the value of the Rupee.
Third, slowdown in economic activity in the US directly impacts on India’s exports. On the one hand, it could adversely affect merchandise exports from India. The best example of this was the diamond industry which faced massive closure and unemployment in the wake of the financial crisis in the US. On the other hand, it could show in the slowdown in the IT-sector. It would definitely affect the BPO sector, which is intricately linked to the demand created in the areas of tourism, luxury consumption etc. in the US.
Despite the pronouncements from the government about ‘sound fundamentals’ of the Indian economy, capital flows, which have their own independent trajectory, have a capacity to create havoc on an economy which is intricately linked to it. Overcoming this crisis requires challenging not only the policy prescriptions required to woo international finance capital and breaking its umbilical cord with the Indian economy but the theoretical orthodoxy that dominates the discipline of economics.
This article has appeared in Tehelka's financial newspaper 'The Financial World' on Aug 10, 2011.