Each passing week brings more news that the global economy is on the mend. This is just a year after investment bank Lehman Brothers fell with a thud, the financial markets seized up and economic activity shrivelled.
The credit for this initial recovery should go to policymakers around the world, who basically threw away the old rule books and innovated as they stumbled through the wreckage that was partly of their own making.
Economists have a lot to answer for. In a lucid article on the dismal state of the dismal science that he wrote this month for The New York Times Magazine, Paul Krugman ploughed into the “romanticized and sanitized version of the economy (that) led most economists to ignore all the things that can go wrong.”
“They often turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets—especially financial markets —that can cause the economy’s operating system to undergo sudden, unpredictable clashes; and to the dangers created when regulators don’t believe in regulation,” wrote Krugman.
But let us also remember that Krugman had said in the darkest moments of January that the global economy was slouching towards a Great Depression Ver 2.0. That danger seems to have been averted, yet there are a host of challenges ahead.
Most economists worry that the recovery is likely to be a very weak one. Job losses continue to mount, though admittedly employment is a lagging rather than leading indicator of economic activity. Inflation could spike —into double digits, said former Federal Reserve chairman Alan Greenspan in a videoconference with investors in Mumbai on Monday—unless monetary and fiscal screws are tightened over the next year. Private spending will have to pick up as governments necessarily cut back support to their economies.
India faces more or less the same set of challenges. Reserve Bank of India (RBI) governor D. Subbarao has already spoken of the need to tighten monetary policy in the near future while finance minister Pranab Mukherjee realizes that the economy could be headed into a debt trap if the fiscal deficit is not brought down over the next three years.
The question is whether corporate and consumer spending will be strong enough to fill the gap created by cuts in government spending.
But while spending trends will help us understand how quickly and sustainably the Indian economy will bounce back in the quarters ahead, I feel that more attention needs to be lavished on savings trends that will determine long-term growth. And the news may not be very good here.
India’s post-2004 growth acceleration was based on a secular rise in savings and investment rates which, combined with the global boom, helped push economic growth to near double-digit rates. The gross savings rate moved from around 23% of gross domestic product (GDP) in 2001-02 to around 35% in 2007-08. Much of this increase was because of the increase in corporate and government savings.
It is likely that both have peaked for now, thanks to the deterioration in corporate balance sheets and the increase in the government’s revenue deficit. And what about household savings?
The latest RBI annual report released at the end of August has data on household financial savings that is worrisome. Savings in financial assets as a percentage of GDP dropped from 11.5% in 2006-07 and 2007-08 to 10.9% in 2008-09, led by a collapse in investments in shares and debentures. Now, it is possible that Indian households moved some of their savings into physical assets such as housing and gold. But the anecdotal evidence does not suggest that households bought huge amounts of real estate or gold in 2008-09.
The bigger possibility is that household savings have started dropping, though we will know for sure only when the government statistics office releases the final numbers. Add the fall in household savings to the parallel drop in corporate and government savings, and we may be facing a situation where gross domestic savings as a percent of GDP are dropping for perhaps the first time this decade. That is not good news for long-term economic growth.
The only positive in the data on household finances: financial liabilities have fallen, both in absolute terms and in relation to the size of the economy, an indication that households are cutting back on bank debt.
Does this mean that Indian households have adjusted to lower earnings growth in the slowdown by cutting savings rather than spending? It is a possibility that needs to be revisited as more data comes out. But in case this is indeed so, then the strong growth in consumer demand in the run-up to Diwali may be as much bad news as it is good news.
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