Home / Opinion / Columns /  A demand shock could follow the supply squeeze of our lockdown

It has been six months since Prime Minister Narendra Modi announced a severe national lockdown from 25 March, in response to the covid pandemic. The economic experience of these past six months can provide important clues for the difficult journey ahead, even as various measures of economic activity gradually improve.

India saw the sharpest decline in economic output among major economies in the three months to June. It was also one of the very few countries that saw inflation climb in the same period. Such behaviour is contrary to what textbooks tell us to expect. A drop in economic activity should normally be accompanied by a decline in price pressures.

One explanation for the odd behaviour of the Indian economy is that the severity of the lockdown disrupted domestic supply chains more than it disrupted consumer spending. In other words, the aggregate supply shock was bigger than the aggregate demand shock. Various measures of economic activity based on high-frequency data suggest that output is now gradually returning to February levels, though it is very unlikely that it will normalize before the end of this fiscal year. The Indian economy is thus almost certain to contract over the year.

What next? Some economists believe that the current combination of declining output plus rising inflation will eventually lead India into a stagflation trap. A more likely result is that the supply shock we saw over the past six months will be replaced by a demand shock in the coming months. Veronica Guerreri of the University of Chicago’s Booth School of Business, Guido Lorenzoni of Northwestern University, Ludwig Straub of Harvard University and Ivan Werning of the Massachusetts Institute of Technology have recently proposed the idea of a paradoxical “Keynesian supply shock", or a situation where an initial supply shock creates a deflationary demand shock in its wake.

The four economists have argued that a supply shock which affects different sectors of the economy asymmetrically will result in an eventual demand shock in the presence of incomplete markets. Those interested in the nuances of their theoretical argument can read their original working paper published in April by the National Bureau of Applied Economic Research, titled Macroeconomic Implications of Covid-19: Can Negative Supply Shocks Create Demand Shortages?

An emerging market economy is structurally different from an advanced economy, but it is still worth considering the possibility of a two-stage economic shock in India, with a supply shock being followed by a demand shock. A good place to start is the labour market. The monthly employment estimates from the Centre for Monitoring Indian Economy (CMIE) show that the national unemployment rate has fallen from a peak of 23.52% in April to 8.35% in August.

This recovery in the labour market is good news. However, a lot depends on the specifics. There are three important issues in this context. First, it is still not clear whether the millions who have got back their jobs are now working at monthly wages that are at the same level as February, or lower. Second, it is likely that there has been an increase in disguised unemployment as people move back to overcrowded farms as a last resort. In a recent report, Citigroup chief India economist Samiran Chakraborty has written on the possibility of a reversal of the Lewisian model, in which the process of development moves people from farms to higher productivity activities.

Third, Mahesh Vyas of CMIE says that India’s recovery in organized sector jobs—in factories as well as offices—has been slower than the recovery in unorganized sector jobs. The lack of jobs in the better-paying organized sector matters for consumer demand. In a survey of chief executive officers (CEOs) conducted by this newspaper in collaboration with consulting firm Bain, 56% of them said their companies had cut wage costs through either salary cuts or layoffs. Further, 66% of them said they were worried about weak consumer demand. This is the classic fallacy of composition at play—where a rational decision at the level of the individual firm is harmful in the aggregate when all firms do the same.

The country’s weak labour market will very likely nudge households towards caution. This column has been making the case for many months that precautionary savings will rise in the face of economic uncertainty. Weekly data from the Reserve Bank of India as well as weekly data released by the government on Jan Dhan accounts show that households are preferring to keep money in their bank accounts rather than spend it.

Aggregate bank deposits have increased by 6.8 trillion since April 2020, compared to an increase of 1.5 trillion in the same period of the previous fiscal year. Other data shows that consumer deleveraging had already begun in fiscal year 2019-20, with the financial liabilities of households dropping from 4% of gross domestic product (GDP) in 2018-19 to 2.9% of GDP in 2019-20, the lowest in a decade.

Interestingly, even the country’s poor, who have the highest marginal propensity to consume, seem to have opted to keep much of the money handed to them by the government through its May 2020 stimulus package in their accounts, rather than spend it. This is partly understandable, given the fact that the government was giving free food to those most in need.

A sense of caution in households and corporate boardrooms will weigh down on domestic demand even as the supply side of the economy recovers. This has profound implications for macroeconomic policy.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics

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