The past several weeks have been dominated by concerns about an energy shock, a weakening rupee, the possibility of a truant monsoon and latent inflationary pressures as a result of these dislocations.
The nationwide debate is rightly focused on what combination of fiscal, monetary and exchange rate policy should be crafted to simultaneously maintain an internal balance as well as external balance for the Indian economy. The general thumb-rule is that fiscal and/or monetary policy should be activated for the former while a flexible exchange rate is the principal tool for the latter.
However, the immediate focus on macro stability should not take attention away from other important challenges. One set of interconnected challenges comprises stagnant real incomes, declining net financial savings rates of households, increasing household leverage and the welcome increase in female labour force participation.
The common element running through all these is the economic behaviour of households in response to an income surprise.
Economists have for long debated what drives household decisions on consumption, savings and work. John Maynard Keynes argued that household spending (and thus savings too) is dependent on household income.
Important nuances were added with the passage of time. The classic starting point is a book written by the American economist James Duesenberry in 1949, Income, Saving and the Theory of Consumer Behaviour.
Duesenberry wrote that consumption is driven not by absolute income as Keynes had said, but by relative income. There were two parts of this — how your income compares with your own past peak and also how it matches up with others in society.
This gives rise to two phenomena he identified. First, the demonstration effect. People benchmark their consumption against social peers. Second, the ratchet effect. Consumers find it hard to immediately reduce expenditure to match a decline in income. They try to maintain their habitual consumption level by reducing savings and/or by borrowing. In other words, consumer spending goes up quickly but it is more inertial on the way down.
The ratchet effect seems to have played out in India over the past few years. Though Duesenberry concentrated his research on how consumer spending adjusts to an absolute fall in income, his basic insight can be adapted to the milder case of stagnant real incomes as well.
Data shows that Indian households have sustained consumption by reducing savings as well as by borrowing more. The demonstration effect may also be in play as social media has exposed the young across the income spectrum to dreams of better living.
More recent research by economists shows that a lot depends on how individuals and households interpret income growth that is below previous expectations. Two variants of this hypothesis are worth mentioning here.
First, households tend to maintain their earlier spending on consumption despite an income shock because they believe that the dislocation is temporary. Second, people are unable to distinguish between a micro shock that affects them alone and a macro shock that alters the overall trajectory of income growth. These two hypotheses are interconnected.
Think of it this way. Suppose you get a surprise bad month. Your freelance work dries up or there is a sudden drop in the price of what you produce. That is a transitory shock. It is a temporary hit to your income that you expect to recover from. People barely change their spending in response. They dip into savings, borrow a little, and hope that life will be back to normal soon. Consumption is maintained despite the income surprise.
Now suppose your employer cuts your salary. It is a permanent income shock. The money is gone for good, every year, for the rest of your working life. You can’t just wait it out. You do cut spending in response, but not by the full extent of the salary cut. At least initially, you may use buffers such as working extra hours, dipping into savings or borrowing. For the poor, government welfare spending acts as an income buffer.
It is thus likely that Indian households are interpreting the recent stagnation in real earnings as a temporary phenomenon that can be managed through either using their precautionary savings or borrowing more to maintain their consumption level.
The strong growth momentum by the Indian economy as a whole may also be fanning the hope that it will eventually be reflected in household finances through either higher income growth or a narrowing of the gap between the micro and macro realities. This is especially true of households in the middle of India’s income pyramid.
Family labour supply can also adjust in response to an income shock. It could mean more work hours put in by family members who are currently working. Or it could mean those who are not in the formal labour force join it to support household income.
In a country such as India, that inevitably means more women coming into the labour force to support family income. In other words, female labour supply often acts as an endogenous insurance buffer for households facing income stress.
The income stagnation experienced by the vast majority of Indian households, both rural and urban, since the pandemic and their rational attempts to adjust to the new reality could help explain some of the salient trends in the Indian economy today.
The author is executive director at Artha India Research Advisors.