The residents of the island of New Guinea first saw the white man in 1930. The white men were strangers to New Guineans. The New Guineans had never gone to far off places and most of them lived in the vicinity of where they were born, at most making it to the top of the hill around the corner. Given this, they were under the impression that they were the only living people.
This impression turned out to be wrong and the New Guineans started to develop stories around the white men who had come visiting. Jared Diamond writes in The World Until Yesterday that the New Guineans told themselves that “Ah, these men do not belong to earth. Let’s not kill them – they are our own relatives. Those who have died before have turned white and come back.”
The New Guineans tried to place the strange looking Europeans into “known categories of their world view”. But over a period of time they did come to realise that Europeans were human after all. As Diamond writes “Two discoveries went a long way towards convincing New Guineans that Europeans really were human were that the feces scavenged from their campsite latrines looked like typical human feces (i.e., like the feces of New Guineans); and that young New Guinea girls offered to Europeans as sex partners reported that Europeans had sex organs and practiced sex much as did New Guinea men.”
To the men and women of New Guinea, Europeans were what former American defence secretary Donald Rumsfeld called the “unknown-unknown”. As Rumsfeld said “[T]here are known knows; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown-unknowns-there are things we do not know we don’t know.”
People take time to adjust to unknown-unknowns, like the New Guineans did. But there are also situations in life in which individuals, institutions and even countries tend to ignore the chance of something that they know can happen, just because it hasn’t happened in the recent past or it hasn’t happened to them specifically. For such people, institutions and countries, the option tends to become an unknown-unknown even though it is not one in the specific sense of the term.
Take the case of film director Sajid Khan whose most recent movie was Himmatwala. Before the movie was released the director often said “I can’t say I am a great director but I am the greatest audience, since childhood I have done nothing other than watching films. Cinema is my life. I can never make a flop film because I make film for audience and not for myself .”
Of course this statement was right before Himmatwala released. Khan’s previous three outings as director Heyy Babyy, Housefull and Housefull 2 had been a huge success. Himmatwala fizzled out at the box office and its first four day collections have been nowhere near what was expected. As the well respected film trade website Koimoi.com points out “The numbers are too bad for a film like Himmatwala, which was expected to create shattering records at the Box Office being a ‘Sajid Khan Entertainer’ and moreover due to the coming together of two successful individuals – actor Ajay Devgn and director Sajid Khan for the first time. However, the formula didn’t work this time it seems!”
Khan’s overconfidence came from the fact that none of his previous films had flopped and that led him to make the assumption that none of his forthcoming films will flop as well. He expected the trend to continue. Khan had become a victim of what Nobel prize winning economist Daniel Kahneman calls the ‘availability heuristic’.
Kahneman defines the availability heuristic in Thinking, Fast and Slow as “We defined the availability heuristic as the process of judging frequency by “the ease with which instances come to mind.”” In Khan’s case the instances were the previous three movies he had directed and each one of them had been a superhit. And that led to his overconfidence and the statement that he can never make a flop film.
Nate Silver summarises the situation well in The Signal and the Noise. As he points out “We tend to overrate the likelihood of events that are nearer to us in time and space and underpredict the ones that aren’t.” And this clouds our judgement.
Another great example is of this are central banks around the world which have been on a money printing spree. As Gary Dorsch, Editor, Global Money Trends points out in a recent column “So far, five central banks, – the Federal Reserve, the European Central Bank, Bank of England, the Bank of Japan and the Swiss National Bank have effectively created more than $6-trillion of new currency over the past four years, and have flooded the world money markets with excess liquidity. The size of their balance sheets has now reached a combined $9.5-trillion, compared with $3.5-trillion six years ago.”
This money has been pumped into various economies around the world in the hope that banks and financial institutions will lend it to consumers and businesses. And when consumers and businesses spend this borrowed money it will revive economic growth. But that has not happened. The solution that central banks have come up with is printing even more money.
One of the risks of too much money printing is the fact it will chase the same number of goods and services, and thus usually leads to a rise in overall prices or inflation. But that hasn’t happened till now. The fact that all the money printing has not produced rapid inflation has led to the assumption that it will never produce any inflation. Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, has even gone to the extent of saying that he was 100% sure he could control inflation.
Mervyn King, the Governor of the Bank of England, has made similar statements. “Certainly those people who said that asset purchases would lead us down the path of Weimar Republic and Zimbabwe I think have been proved wrong ,” he has said. What this means is that excess money printing will not lead to kind of high inflation that it did in Germany in the early 1920s and Zimbabwe a few years back.
King and Bernanke like Sajid Khan are just looking at the recent past where excess money printing has not led to inflation. And using this instance they have come to the conclusion that they can control inflation (in Bernanke’s case) as and when it will happen or that there will simply be no inflation because of money printing (in King’s case).
As Albert Edwards of Societe Generale writes in a report titled Is Mark Carney the next Alan Greenspan “King’s assertion that because the quantitative easing(another term for money printing) to date has not yet produced rapid inflation must mean that it will never produce rapid inflation is just plain wrong. He simply cannot know.” Nassim Nicholas Taleb is a lot more direct in Anti Fragile when says “central banks can print money; they print print and print with no effect (and claim the “safety” of such a measure), then, “unexpectedly,” the printing causes a jump in inflation.” Just because something hasn’t happened in the recent past does not mean it won’t happen in the future.
People who make economic forecasts are also the victims of what we can now call the Sajid Khan syndrome. They expect the recent trend to continue. The Indian economy grew by 8.6% in 2009-2010 and 9.3% in 2010-2011. And the Indian politicians and bureaucrats told us with glee that the Indian economy had decoupled from the world economy, which was growing very slowly in the aftermath of the global financial crisis.
Montek Singh Ahluwalia, the deputy chairman of the Planning Commission is a very good example of the same. In a television discussion in April 2012, he kept insisting that a 7% economic growth rate for India was a given. Turns out it was not. The Indian economy grew by 4.5% in the three months ending December 31, 2012. Ahluwalia was way off the mark simply because he had the previous instances of 8-9% rate of economic growth in his mind. And he was projecting that into the future and saying worse come worse India will at least grow by 7%.
It is not only experts who become victims of the Sajid Khan syndrome taking into account events of only the recent past. In the aftermath of September 11, 2001, when aeroplanes collided into the two towers of the World Trade Centre, many Americans simply took to driving fairly long distances, fearing more terrorist attacks.
But driving is inherently more risky than flying. As Spyros Makridakis, Robin Hograth and Anil Gaba write in Dance with Chance – Making Your Luck Work for You “In 2001, there were 483 deaths among commercial airline passengers in the USA, about half of them on 9/11. Interestingly in 2002, there wasn’t a single one. And in 2003 and 2004 there were only nineteen and eleven fatalities respectively. This means that during these three years, a total of thirty airline passengers in America were killed in accidents. In the same period, however, 128,525 people died in US car accidents.” Estimates suggest that nearly 1600 deaths could have been avoided if people had taken the plane and not decided to drive,.
So what caused this? “Plane crashes are turned into video images of twisted wreckage and dead bodies, then beamed into every home on television screens,” write the authors. That is precisely what happened in the aftermath of 9/11. People saw and remembered planes crashing into the two towers of the World Trade Centre and decided that flying was risky.
They just remembered those two recent instances. What they did not take into account was the fact that thousands of planes continued to arrive at their destinations without any accident like they had before. So most people ended up concluding that chances of dying in an aeroplane accident was much higher than it really was.
The same logic did not apply to a car crash. As the authors write “Car crashes, on the other hand, rarely make the headlines…Smaller-scale road accidents occur in large numbers with horrifying regularity, killing hundreds and thousands of people each year worldwide…We just don’t hear about them.” And just because we don’t hear about things, doesn’t mean they have stopped happening or they won’t happen to us.
Another version of this is the probability of dying due to a terror attack. As Kahneman writes “Even in countries that have been targets of intensive terror campaigns, such as Israel, the weekly number of casualties almost never came close to the number of traffic deaths.”
A good comparison in an Indian context is the number of people who die falling off the overcrowded Mumbai local train network in comparison to the number of people who have been killed in the various terrorist attacks in Mumbai over the last few years. The first number is higher. But its just that people die falling off the local train network almost everyday and never make it to the news pages, which is not the case with any terrorist attack, which gets sustained media coverage sometimes running into months.
To conclude it is important to look beyond the recent past and ensure that like Sajid Khan and others, we do not fall victims to the Sajid Khan syndrome.
The article originally appeared on www.firstpost.com on April 4, 2013.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Hindi film songs have words of wisdom for almost all facets of life. Even inflation.
As the lines from a song in the 1974 superhit Roti, Kapda aur Makan go “Baaki jo bacha mehangai maar gayi(Of whatever was left inflation killed us).”
Inflation or the rise in prices of goods and services has been killing Indians over the last few years. What has hurt the common man even more is food inflation. Food prices have risen at a much faster pace than overall prices.
A discussion paper titled Taming Food Inflation in India released by the Commission for Agricultural Costs and Prices(CACP), Ministry of Agriculture, on April 1, 2013, points out to the same. “Food inflation in India has been a major challenge to policy makers, more so during recent years when it has averaged 10% during 2008-09 to December 2012. Given that an average household in India still spends almost half of its expenditure on food, and poor around 60 percent (NSSO, 2011), and that poor cannot easily hedge against inflation, high food inflation inflicts a strong ‘hidden tax’ on the poor…In the last five years, post 2008, food inflation contributed to over 41% to the overall inflation in the country,” write the authors Ashok Gulati and Shweta Saini. Gulati is the Chairman of the Commission and Saini is an independent researcher.
During the period 2008-2009 to December 2012, the wholesale price inflation, a measure of the overall rise in prices, averaged at 7.4%. In the same period the food inflation averaged at 10.13% per year.
So who is responsible for food inflation, which is now close to 11%? The short answer is the government. As Gulati and Saini write “The Economist in its February 2013 issue highlights that it was the increased borrowings by the Indian government which fuelled inflation…It categorically puts the responsibility on the government for having launched a pre-election spending spree in 2008, which continued even thereafter.”
Gulati and Saini build an econometric model which helps them conclude that “fiscal Deficit, rising farm wages, and transmission of the global food inflation; together they explain 98 percent of the variations in Indian food inflation over the period 1995-96 to December, 2012…These empirical results clearly indicate that it would not be incorrect to blame the ballooning fiscal deficit of the country today to be the prime reason for the stickiness in food inflation.”
Fiscal deficit is the difference between what a government earns and what it spends. In the Indian context, it has been growing in the last few years as the government has been spending substantially more than what it has been earning.
The fiscal deficit of the Indian government in 2007-2008 (the period between April 1, 2007 and March 31, 2008) stood at Rs 1,26,912 crore. This jumped by 230% to Rs 4,18,482 crore, in 2009-2010 (the period between April 1, 2009 and March 31, 2010). This was primarily because the expenditure of the Congress led UPA government went up at a much faster pace than the income.
The government of India had a total expenditure of Rs 7,12,671 crore, during the course of 2007-2008. This grew by nearly 44% to Rs 10,24,487 crore in 2009-2010. The income of the government went up at a substantially slower pace. Between 2007-2008 and 2009-2010, the revenue receipts (the income that the government hopes to earn every year) of the government grew by a minuscule 5.7% to Rs 5,72,811 crore.
And it is this increased expenditure(reflected in the burgeoning fiscal deficit) of the government that has led to inflation. As Gulati and Saini point out “Indian fiscal package largely comprised of boosting consumption through outright doles (like farm loan waivers) or liberal increases in pay to organised workers under Sixth Pay Commission and expanded MGNREGA(Mahatma Gandhi National Rural Employment Guarantee Act expenditures for rural workers. All this resulted in quickly boosting demand.”
So the increased expenditure of the government was on giving out doles rather than building infrastructure.
This meant that the money that landed up in the pockets of citizens was ready to be spent and was spent, sooner rather than later. “But with several supply bottlenecks in place, particularly power, water, roads and railways, etc, very soon, ‘too much money was chasing too few goods’. And no wonder, higher inflation in general and food inflation in particular, was a natural outcome,” write the authors.
So increased expenditure of the government led to increasing demand for goods and services. This increase in demand was primarily responsible for the economy growing by 8.6% in 2009-2010 and 9.3% in 2010-2011(the period between April 1, 2010 and March 31, 2011). But the increase in demand wasn’t met by an increase in supply, simply because India did not have the infrastructure required for increasing the supply of goods and services. And this led to too much money chasing too few goods.
No wonder this sent food prices spiralling. Food prices have continued to rise as the government expenditure has continued to go up. Also food prices have risen at a much faster pace than overall prices. This is primarily because agricultural prices respond much more to an increase in money supply vis a vis manufactured goods where prices tend to be stickier due to some prevalence of long term contracts. As Gulati and Saini put it “In fact, our analysis for the studied period shows that one percent increase in fiscal deficit increases money supply by more than 0.9 percent.”
The other major reason for a rising food prices is the rising cost of food production due to rising farm wages. This pushes inflation at two levels. First is the fact that an increase in farm wages drives up farm costs and that in turn pushes up prices of agricultural products. As the authors point out “During 2007-08 to 2011-12, nominal wages increased at much faster rate, by close to 17.5% per annum…The immediate impact of these increased farm wages is to drive-up the farm costs and thus push-up the farm prices, be it through the channel of MSP(minimum support price) or market forces.”
Rising farm wages also lead to a section of population eating better and which in turn pushes up price of protein food. As Gulati and Saini point out “This study finds that the pressure on prices is more on protein foods (pulses, milk and milk products, eggs, fish and meat) as well as fruits and vegetables, than on cereals and edible oils, especially during 2004-05 to December 2012. This normally happens with rising incomes, when people switch from cereal based diets to more protein based diets.”
In the recent past price of cereals like rice and wheat has also gone up substantially. This is primarily because the government is hoarding onto much more rice and wheat than it requires to distribute under its various social programmes.
If food inflation has to come down, the government has to control expenditure. The authors Gulati and Saini suggest several ways of doing it. The government can hope to earn Rs 80,000-100,000 crore if it can get around to selling the excessive grain stocks that it has. Other than help control its fiscal deficit, the government can also hope to control the price of cereals like rice and wheat which have been going up at a very fast rate by increasing their supply in the open market.
As the authors write “By liquidating(i.e selling) excessive grain stocks in the domestic market or through exports, massive savings of non-productive expenditures can be realized. For example, as against a buffer stock norm of 32 million tonnes of grains, India had 80 million tonnes of grains on July 1, 2012, and this may cross 90 million tonnes in July 2013. Even if one wants to keep 40 million tonnes of reserves in July, liquidating the remaining 50 million tonnes can bring approximately Rs 80,000-100,000 crore back to the exchequer. And with this much grain in the market food inflation will certainly come down. Else, the very cost of carrying this “extra” grain stocks alone will be more than Rs 10,000 crore each year, counting only their interest and storage costs.”
Of course this has its own challenges. More than half of this inventory of grain in India is concentrated in the states of Punjab and Haryana. Moving this inventory from Punjab and Haryana to other parts of the country will not be easy, assuming that the government opts to work on this suggestion. At the same time the government will have to do it in a way so as to ensure that the market prices of rice and wheat don’t collapse. And that is easier said than done.
The authors also recommend that the government can cut down on food and fertiliser subsidy by directly distributing it. “By going through cash transfers route (using Aadhar), one can plug in leakages in PDS(public distribution system) which, as per CACP calculations are around 40%, and save on high costs of storage and movement too, saving in all about Rs 40,000 crore on food subsidy bill,” write Gulati and Saini.
Something similar can be done on the fertiliser front as well. “Fertiliser subsidy, if given directly to farmers on per hectare basis (Rs 4000/ha to all small and marginal farmers which account for about 85 percent of farmers; and somewhat less (Rs 3500 and Rs 3000/ha) as one goes to medium and large farmers, and deregulating the fertiliser sector can bring in large savings of about Rs 20,000 crore along with greater efficiency in production and consumption of fertilisers.”
Whether the government takes these recommendations of the Commission for Agricultural Costs and Prices seriously, remains to be seen. Meanwhile here is another brilliant Hindi film song from the 2010 hit Peepli Live: “Sakhi saiyan khoobai kaamat hain, mehangai dayan khaye jaat hai(O friend, my beloved earns a lot, but the inflation demon keeps eating us up).”
The article originally appeared on www.firstpost.com on April 2, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Life is a great leveller. The Russians thought they had found an easy way to launder money by simply moving it to banks in Cyprus.
The Cyprian banks thought they had found an easy way to make more money on that money by investing it in Greece.
Trouble started once the Greeks decided that the borrowed money was as good as their own, and did not have to be returned. This left the Cyprian banks reeling with big holes in their balance sheets.
The Cyprian banks were too big to be rescued by the Cyprian government. Hence, they needed to be bailed out by an institution which was bigger than the Cyprian government. The International Monetary Fund(IMF) and the European Union(EU) moved in together and agreed to handover € 10 billion (or around $13billion) to the Cyprian government.
But there was the risk of the Cyprian government also deciding to behave like the Greeks had before them, and treat the € 10 billion bailout as their own money. So, the IMF and the EU demanded some sacrifices to be made by Cyprus as well.
A plan was made to forfeit a part of the deposits lying in Cyprian banks. A levy of 6.75% was proposed on deposits of less than €100,000 and 9.9% on deposits above that. Of course this did not go down well with the people of the country and they protested. So did its Parliament.
The plan was modified. And it was decided that the government will seize deposits greater than €100,000 lying in the Popular Bank of Cyprus (better known as Laiki Bank), the second largest bank in the country.
This move was accepted by Cyprus because deposits greater than €100,000 were largely held by the Russians. As The Huffington Post wrote “The country of about 800,000 people has a banking sector eight times larger than its gross domestic product, with nearly a third of the roughly 68 billion euros in the country’s banks believed to be held by Russians.” Hence, the move of seizing deposits greater than €100,000 did not impact citizens of Cyprus in a direct way. It ended up screwing the Russians. As I said at the beginning life is a great leveller.
But that does not mean that Cyprus would not have to bear any cost of such a move. Cyprus had positioned itself as a tax haven, to attract money from all over the world. And with the government moving to seize deposits greater than €100,000, it has lost its core industry of banking. Russians and other investors across the world who used Cyprian banks to launder money, will think twice before moving any money into the country. They will also move out the money they have in the country, once the capital controls are relaxed. As Ambrose Evans-Pritchard writes in The Telegraph “The country has just lost its core industry, a banking system with assets equal to eight times GDP, and has little to replace it with.”
What this means is that with its core industry gone, its economy is bound to slowdown in the days to come. The financial sector makes up for around 18% of the country’s gross domestic product (GDP). “I wouldn’t be surprised to see a 20% all in real GDP,” Noble Prize winning economist Paul Krugman told Pritchard.
There are other estimates of the Cyprian economy slowdown which are equally scary. As Matthew O’ Brien writes in The Atlantic “the International Institute of Finance thinks Cypriot real GDP could fall as much as 20 % over the next few years…And remember, unemployment is already 14.7% n Cyprus. It could easily climb to 25%.”
To cut a long story short, Cyprus is going to be in a much bad shape than it was in the past. So what is the way out for the country? It needs something to replace its banking and financial sector. The manufacturing sector forms just 7% of its GDP.
Tourism is the other big employer in Cyprus. But since Cyprus moved onto the euro as its currency, on January 1, 2008, tourism has become very expensive. “Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU(Economic and monetary union of the European union) membership has made it shockingly expensive. Turkey, Croatia or Egypt are all much cheaper….The IMF says the labour cost index has risen even faster than in Greece, Spain or Italy since the late 1990s,” writes Pritchard.
In the past countries which end up in such a mess have devalued their currency and exported their way out of trouble. When a country devalues its currency its exports become more competitive. Let me explain this in an Indian context. Let us say an Indian exporter exports a certain good at a price of $100 per unit. When one dollar is worth Rs 50, he gets Rs 5000 per unit. Lets say the value of the rupee against the dollar falls to Rs 60 per dollar. In this case the exporter gets Rs 6000 per unit. So with the value of the rupee falling against the dollar an exporter makes more money.
What the exporter can also do is cut his price in dollar terms. If he cuts his price to $90, he will end up with Rs 5400 ($90 x 60), which is greater than the Rs 5000 he was making in the past. At a lower price, his goods will become more competitive in the international market and thus he will be able to sell more.
Iceland is a very good example of the same. A country of 300,000 people which went financially bust a few years back has been able to get its exports going at some level because its currency the Icelandic Krona, fell in value against the other currencies. “What saved Iceland from mass unemployment after its banks blew up – was a currency devaluation that brought industries back from the dead. Iceland’s krona has fallen low enough to make it worthwhile growing tomatoes for sale in greenhouses near the Arctic Circle,” writes Pritchard.
As The Washington Post reports “Iceland experienced a banking collapse in 2008 during which its currency fell in half, from 60 krona to the dollar to 120. It was a horrible series of events for Iceland, but the collapse in the krona also led to surge in exports and tourism that kept unemployment contained.”
But Cyprus cannot do that given that it does not have a currency of its own. It is a part of a monetary union and euro is used as a currency by sixteen other nations . Cyprus can only devalue its way out of trouble if it chooses to move out of the euro and go back to the Cyprian pound which was its currency before it decided to move to the euro.
As O’Brien puts it “The euro isn’t terribly popular in Cyprus right now. Only 48 % of Cypriots were in favour of the common currency last November…compared to 67 % of Irish, 65 % of Greeks, 63 % of Spaniards, and 57 % of Italians. The euro is actually less popular in Cyprus than anywhere else in the euro zone — and it’s only going to get less so as their economy disintegrates.”
It makes great sense for Cyprus to leave the euro in the hope of getting its export going. Moving back to the Cyprian pound will also get its tourism sector up and running again. Let me explain this by extending the example used above. A tourist looking to visit India is more likely to come when one dollar is worth Rs 60, than when its worth Rs 50. At Rs 60 to a dollar, the tourist can consume goods and services worth Rs 6000 in India, whereas at Rs 50 to a dollar his consumption will be limited to Rs 5000. The same logic works for Cyprus as well if the country decides to leave the euro and move back to the Cyprian pound and devalue the pound against the international currencies.
One fear that has constantly been raised about leaving the euro is the fact that once people find out that there is a threat of a country is leaving the euro and moving on to its own currency, they will rapidly pull out money from the country. This argument works to some extent. In case of Cyprus though, international investors who have put their money in the country will pull out (and have already pulled out) their money irrespective of the fact whether the country remains on the euro or not. As O’ Brien puts it “Countries can’t leave the euro because its banks would collapse and there would be massive capital flight, and … wait. These things have already happened in Cyprus. Its banks just got restructured, and it just instituted capital controls. There’s not much left to lose from euro-exit. And plenty to gain.”
The danger of Cyprian citizens moving out their savings is not very strong. As Albert Edwards of Societe Generale writes in his recent report titled The eurozone is working just fine …as far as Germany is concerned “I know from first-hand experience the extreme difficulty for a European citizen to open an account in another European country it is nigh on impossible for the man in the street.” Given this its highly unlikely that people of Cyprus will be able to move their money out of the country. But that is no guarantee that money will continue to remain in Cyprian banks. As Edwards put it, people have the “choice of stuffing” their “money under the mattress or buying safe financial assets (maybe overseas mutual funds or gold?), or indeed spending the money on goods and services.” (For a more detailed argument on how a country should move out of the euro in a somewhat orderly manner click here).
The country has no plans of leaving the euro currently. Nicos Anastasiades , the President of Cyprus said on March 29, 2013 that “We have no intention of leaving the euro…In no way will we experiment with the future of our country.”
If Cyprus does decide to leave the euro that might encourage other countries to do so as well. There are several countries which could face a Cyprus type of bailout in the days to come. As Guy Verhoftstadt, a former prime minister of Belgium writes in The New York Times “Perhaps Malta, which has an even bigger banking sector than Cyprus relative to G.D.P., much of it highly reliant on offshore depositors. Or maybe Latvia, fast becoming the destination of choice for Russian funds flowing out of Cyprus and now on course to join the euro zone. Even Spain or Italy could be vulnerable to a similar bailout, now that the Dutch finance minister, Jeroen Dijsselbloem, who is president of the Euro Group of finance ministers, has hinted that Cyprus could provide a model for the resolution of future banking crises.”
Given this, the future of the euro looks very dicey. As Martin Wolf, one of the foremost economic commentators of the world, wrote in a recent column in the Financial Times “Old fears that the euro would undermine European unity rather than strengthen it seem more plausible.” Nobody could have put it better.
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Joseph Heller’s Catch 22 remains one of the literary classics of the twentieth century. Set during the course of the Second World War, the book gave a new phrase to the English language. As a paragraph from the book goes:
There was only one catch and that was Catch-22, which specified that a concern for one’s safety in the face of dangers that were real and immediate was the process of a rational mind. Orrwas crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn’t, but if he were sane he had to fly them. If he flew them he was crazy and didn’t have to; but if he didn’t want to he was sane and had to.
Orr is a bomber pilot who keeps getting shot down. He has been shot down seventeen times, which is more than anyone else in his unit. Given that he is deemed crazy to still be flying. All he has to do to be grounded is to ask. But the catch is that the moment he asks he would no longer be be deemed to be crazy. He would be sane and being sane he would have to fly more missions.
This catch was the Catch 22. Over a period of time such a hopeless no win situation that Orr was in, came to be referred in the English language as a Catch 22.
The Indian economy is currently in a Catch 22 situation. The government of India had a total expenditure of Rs 7,12,671 crore, during the course of 2007-2008 (i.e. the period between April 1, 2007 and March 31, 2008). This grew by nearly 44% over the next two years and during the course of 2009-2010 (i.e. The period between April 1, 2009 and March 31,2010), the total expenditure stood at Rs 10,24,487 crore.
Increasing expenditure is not a problem if its met by increasing income. But that wasn’t the case here. Between 2007-2008 and 2009-2010, the revenue receipts of the government (or the income that the government hopes to earn every year) grew by a minuscule 5.7% to Rs 5,72,811 crore.
Some part of the increase in expenditure was met by selling shares that the government held in public sector companies. But a major part of the increase was met by simply borrowing more. The borrowings and other liabilities of the government shot up from Rs 1,26,912 crore to Rs 4,18,482 crore, a massive jump of nearly 230%, during the period.
The good part of this massive increase in government expenditure was that the Indian economy continued to grow at very high rates, even though economic growth in large parts of the world was slowing down in the aftermath of the financial crisis that had erupted after the investment bank Lehman Brother went bust in September 2008.
The Indian economy grew by 8.6% in 2009-2010 and 9.3% in 2010-2011. And the Indian politicians opened their champagne bottles and told us that India had decoupled from the global economy. As Sajjid Chinoy of JP Morgan writes in the Business Standard “The charitable (but incorrect) interpretation is that India successfully decoupled from the global economy, returned to its nine per cent growth path post-Lehman.”
The formula seemed to be working and so the government continued with it. For 2012-2013 (the period between April 1, 2012 and March 31, 2013), the government expenditure was expected to come in at Rs 14,30,825 crore. This meant that the government expenditure more than doubled between 2007-2008 and 2012-2013. This when the revenue receipts of the government went up by around 61% to Rs 8,71,828 crore, during the same period.
The borrowings and other liabilities of the government during the same period went up by 310% to Rs 5,20,925 crore. The government borrows money to make up for the difference between what it earns and what it spends. This difference is referred to as the fiscal deficit.
If the economic growth rate of 2009-2010 and 2010-2011 was anything to go by the Indian economy should have continued to grow at the same pace, given that the government was spending more and more money.
But that did not turn out to be the case. Numbers released on February 28,2013, suggested that the Indian economy grew by 4.5% during the three month period ending on December 31,2012. This was the lowest in fifteen quarters.
So what happened that led to the economic growth rate falling by half? Initially increased government expenditure translated into economic growth. As the government spent more money those who got that money benefited. They spent that money by goods and services, and this translated into higher economic growth. But two other things happened as well.
As the government went around spending more it led to a higher inflation. More money chased the same amount of goods and services leading to higher prices. Food inflation rose at a much faster pace than overall inflation.
Higher prices meant that people were spending more to meet their regular expenditure. And this meant lower savings. In the year 2009-2010 the household savings stood at 25.2% of the GDP. In the year 2011-2012 the household savings had fallen to 22.3% of the GDP. Even within household savings, the amount of money coming into financial savings (i.e. bank deposits, life insurance funds, pension and provident funds, shares and debentures) fell at a faster rate. As the Economic Survey that came out before the budget pointed out “Within households, the share of financial savings vis-à-vis physical savings has been declining in recent years…Financial savings accounted for around 55 per cent of total household savings during the 1990s. Their share declined to 47 per cent in the 2000-10 decade and it was 36 per cent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis-à-vis 2010-11.”
So we have a situation were the government has been borrowing more and the overall household financial savings have also come down. When the government borrows more it “crowds out” and leaves a lower amount of savings for the banks and other financial institutions to borrow from. This leads to higher interest rates on deposits and hence higher interest rates on loans.
Higher interest rates to some extent have killed economic growth as people have bought fewer homes, cars, consumer durables etc. Corporates have also postponed their expansion plans. So increased government which drove economic growth between 2009-2011, has pulled it down since then as interest rates as well inflation have remained high.
So does this mean that the government expenditure needs to be cut? Yes and no. If interest rates and inflation have to come down, the government expenditure and hence borrowing need to come down. But with the private sector and households going slow on spending money, if the government expenditure is also cut, it will slowdown economic growth even further. So that’s the Catch 22 situation that the Indian economy has been put in.
As Chinoy puts it “A tightening fisc and slowing growth are seen as coincidental. Markets applaud fiscal discipline, but bemoan weak growth. But these are not independent phenomena. Instead, they are inextricably linked. Fiscal austerity impinges upon growth. A reduction in the deficit has a contractionary impact on activity.”
In fact this can already be seen in the Indian context. During the second half of 2012-2013, the government cut down on expenditure as it feared a downgrade by international rating agencies. The targeted expenditure for the year stood at Rs 14,90,925 crore. It was revised to a Rs 14,30,825 crore, which was 4% lower. And this has had an impact of economic growth. “On a cyclically adjusted basis, India’s deficit was reduced by a whopping 1.5 per cent of GDP in 2012-13 – largely by squeezing expenditures. No wonder the slowdown was accentuated further,” writes Chinoy.
Getting out of this Catch 22 situation is difficult. It makes immense sense for the government to cut down on expenditure. Only that can drive down interest rates and inflation and thus revive genuine economic growth. But that of course will take time to happen and meanwhile the economic growth will slowdown further. Given that Lok Sabha elections are due next year, it is not hard to figure out what the government is likely to do.
The government’s targeted expenditure for the year 2013-2014 (i.e. the period between April 1, 2013 and March 31, 2014) is at Rs 16,65,297 crore, which is 16.4% higher than the last financial year. Given this a scenario of high inflation and high interest rates is likely to continue in this financial year as well. And that is no April Fool’s joke.
The article originally appeared on www.firstpost.com on April 1, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)