BackThat seventies feeling
The experience of the 1970s shows that faulty policy choices often lead to an economic mess a few years down the line
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It is no secret that the Indian economy has been in a fair bit of trouble in recent quarters. The latest economic review published by the Reserve Bank of India (RBI) in October shows why there is no easy way out of the current muddle.
Two of the several charts in that document deserve closer attention. The first one uses a standard statistical technique called the Hodrick-Prescott filter to show that the underlying trend growth rate is now back to the levels last seen in 1997. The second chart shows that inflation expectations of Indian households are climbing despite the brutal slowdown in growth (see charts).
This is not what is usually expected.
An economic slowdown means that demand is weak, which is why inflation also usually declines in tandem. And episodes of high economic growth tend to be inflationary because of strong demand pressures. Growth and inflation usually move in the same direction.
Consider two recent examples. The growth slowdown in the early years of this century was accompanied by modest levels of inflation. And the high inflation of the mid-1990s came at a time when the economy was accelerating.
A journey to an earlier era is needed to find a similar constellation of growth and inflation. The Indian economy right now seems to resemble the situation way back in the 1970s: Growth was dropping while inflation was accelerating.
The 1970s were a trying period for the entire world economy. This is the decade that gave us the first episode of stagflation, or the paradoxical combination of low growth and high inflation. India was no exception to global stagflationary pressures. Growth was very weak. Inflation was at its highest level since 1950. It is no wonder that the decade also saw a lot of political turmoil, with street protests led by Jayaprakash Narayan almost bringing down the elected government.
But what is often forgotten is that many other countries in the region managed to maintain high growth rates despite the global problem: South Korea, Singapore, Taiwan, Malaysia and Thailand, for example. Their economies continued to expand despite a very difficult global situation. So it is wrong to explain away the entire problem in India in that decade as merely a result of global factors that were outside the control of the government.
The quality of economic policy was also to blame.
The 1970s were years of transition. The Nehruvian growth strategy of earlier decades had worked very well at first but had run into trouble by the end of the 1960s. The early reforms of the 1980s were still some years away.
The 1970s was the decade when the worst features of Indian socialism under Indira Gandhi were on display: severe restrictions of capacity expansion, high levels of import duties that protected inefficient industries from global competition and the overall politicization of economic policy.
The roots of the economic crisis can be traced back to the late 1960s. Many other Asian countries had begun to move away from the old economic strategy as its limitations became evident. India had an opportunity to reform, along with its neighbours, in those years. However, Indira Gandhi chose radical politics as an alternative to economic reforms. The low point of that style of policy came with the disastrous decision to nationalize the wheat trade in 1973.
The current situation is not an exact mirror image of the 1970s. The two Manmohan Singh governments have done a lot of damage to the Indian economy, but there has been no movement back in time towards the licence raj. Protectionism is not on the horizon either. Even the most contentious decisions such as retrospective taxation have done less harm to economic freedom than what Indira Gandhi did in the 1970s.
Yet, the failure to push economic reforms after 2004 is now hurting the Indian economy. If Indira Gandhi chose her brand of radical politics over economic reform in the 1970s, then the United Progressive Alliance (UPA) led by Sonia Gandhi has also made a similar choice of preferring spending on politically-attractive schemes rather than build the productive potential of the Indian economy.
The current combination of low growth and high inflation means that demand management is no longer a credible solution. A demand stimulus—either through an increase in the fiscal deficit or a reduction in interest rates—could push growth for some time but will also further fan the inflationary fire. And a demand contraction to control inflation will further restrict economic growth.
The solution thus lies on the supply side rather than the demand side. There has to be a switch from consumption demand to investment demand that builds up the productive potential of the Indian economy.
For that to happen, the Indian government needs to get its own fiscal house in order. The investment cycle has to turn. Businesses need to be convinced that it is worth investing in capacity creation once again. There are overdue policy reforms that can build the next phase of competitiveness.
The experience of the 1970s shows that faulty policy choices often lead to an economic mess a few years down the line. It happened in that decade. And it is happening in the current one as well.
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