Can a Keynesian remedy work for an economy facing a combination of inflationary pressure, a crisis of lending confidence and a decline in industrial output?

Prime Minister Manmohan Singh thinks so. On his way home from a recent trip to Japan and China, he said: “I think we are in a typical Keynesian situation where there is a lack of demand— private sector demand is very weak—but strong government demand, for both social services and for physical infrastructure, will provide the essential stabilizers that our country needs in a time like this." But a wrong diagnosis will lead to a bad remedy.

Illustration: Jayachandran / Mint

The one area that requires immediate attention is solving the crisis of confidence in bank lending and unclog credit markets. That and, for the time being, that alone has the potential to spur growth. Companies are desperate for credit. In spite of massive flushes of liquidity, credit availability remains scarce. While the cost of borrowing has been going up for more than a year, the situation is dire now. Adverse credit conditions derailing effective supply (effective potential output), and thus leading to inflation, is not unknown. In a 1987 paper, a former vice- chairman of the US Federal Reserve, Alan Blinder, analysed the phenomenon. Perhaps our policymakers should read that paper.

Solving this will require addressing the problem of a system-wide crisis of confidence. Boosting demand is hardly an answer to that. It will only create more inflation. Yet, apart from holding sporadic meetings with assorted bankers and officers, there has been no systematic attempt to find an answer. To be fair to the Prime Minister, it’s not easy to find an answer given the complexity of the problem, but the least he can do is not look in the wrong direction.

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