Matthew Effect of Covid Pandemic: Rich Got Richer and Poor Got Poorer

In 1968, sociologists Robert K Merton and Harriet Zuckerman, came up with the concept of the Matthew Effect of accumulated advantage. The term takes its name from the Gospel of Matthew, which points out: “For to everyone who has will more be given, and he will have abundance; but from him who has not, even what he has will be taken away.”

In simpler terms, the Matthew Effect of accumulated advantage is stated as the rich become richer and the poor get poorer. This is precisely how things have played out over the last one year, as the covid pandemic has spread through India and large parts of the world.

Let’s take a look at the different ways in which this has happened.

1) Central banks in the rich world have printed a massive amount of money post covid. Just the Federal Reserve of the United States has printed more than $3.5 trillion between end February 2020 and now. Other big central banks like the Bank of England, the Bank of Japan and European Central Bank have also done the same.

This has been done in order to drive down interest rates. The hope is that at lower interest rates people will borrow and spend money, and businesses will borrow and expand. This will help the economy revive. Many rich countries have put money directly in the bank accounts of people, encouraging them to spend.

Some of this money has found its way into stock markets all around the world, including India, driving stock prices way beyond what the earnings of companies justify. The foreign institutional investors invested a whopping $37.03 billion in Indian stocks in 2020-21, the highest they have ever invested. The next best being $25.83 billion in 2012-13.

This sent stock prices soaring with the Sensex, India’s most famous stock market index, gaining 68% in 2020-21. In fact, the market capitalisation of all BSE listed stocks (not just the 30 Sensex stocks) went up by Rs 90.82 lakh crore in 2020-21.

The poor don’t buy stocks, the rich do. The rally in the stock market has benefitted them tremendously, making them richer. In 2019-20, investment in shares and debentures (which includes mutual funds), despite all the hype, formed a minuscule 3.39% of the overall Indian household financial savings. In 2020-21, this would have definitely gone up, but given its low base it would have still formed a very small part of the overall financial savings of Indian households.

As per the 10th Edition of Hurun Global Rich List 2021, India added 55 new dollar billionaires in 2020, with the total number of billionaires in the country going up to 177, a 45% jump in the number of billionaires in comparison to 2019. If one looks at the list of the richest Indian billionaires, most of their wealth is in the stock market. And with stock markets rallying big time in 2020-21, their wealth has gone up.

2) Like the central banks of the rich world, the Reserve Bank of India (RBI) also joined the money printing party and printed Rs 3.6 lakh crore between the beginning of March 2020 and the end of March 2021. This has primarily been done in order to drive down interest rates and help the government borrow at lower interest rates. The central government borrowed Rs 12.8 lakh crore last year and is expected to borrow Rs 12.06 lakh crore in 2021-22.

While money printing helps the central government borrow at lower rates, it hurts the middle class and the poor, who invest in fixed deposits and other forms of fixed income investments to save money. It needs to be remembered that most Indians save by investing in fixed deposits, small savings schemes, provident and pension funds and life insurance. In 2019-20, 84.24% of the household financial savings were made in these financial instruments. Low interest rates largely mean lower returns from these investments. 

In the last two years, the average interest rate on bank term deposits (fixed deposits, recurring deposits, etc.) of more than one year has come down dramatically. It was at 7.5% in March-April 2019. In March 2021, it stands at 5.5%. A bulk of this fall has happened from the beginning of 2020. Recently, the government had majorly cut the interest rates on small savings schemes for the period April to June. Nevertheless, it reversed the decision overnight, probably because of the assembly elections that were still on. It is now expected that the government will cut the interest rate on small savings schemes for the period July to September. 

Lower interest rates, hurt the middle class and the poor especially when the rate of inflation is as high as the interest rates on offer.

The money printing by the RBI to drive down interest rates is likely to continue in the months to come. The Indian central bank is expected to print Rs 1 lakh crore during April to June . This means that bank interest rates will continue to remain low, continuing to hurt the poor and the middle class.

3) While the Indian economy is expected to contract during 2020-21, data from Centre for Monitoring Indian Economy (CMIE) shows that the listed corporates (both financial and non-financial) have made their highest profits ever during the period July to September 2020 and October to December 2020.

As Mahesh Vyas of the Centre for Monitoring of Indian Economy pointed out in a recent piece: “In the December 2020 quarter, the net profit of listed companies exceeded…the record profits of September 2020.” The net profit during the quarters stood at Rs 1.51 lakh crore and Rs 1.53 lakh crore, respectively. These were the highest quarterly profits ever made by listed Indian corporates. 

This means that owners of these businesses have grown richer and so has the top management of these companies given that they own employee stock option plans and benefit from the dividends paid by the companies every year.  

But how did listed Indian corporates make their highest profits ever, while the economy was contracting? The net sales of the non-financial companies, which are a bulk of the listed corporates, fell by 10.4% in the quarter ending September and by 0.9% in the quarter ending December, in comparison to a year earlier, but the companies still made record profits. This happened primarily because the companies were able to drive down their operating expenses.

In the quarter ending March 2020, the operating expenses or the cost of running a business, made up 91.1% of their sales. In the quarters ending September 2020 and December 2020, the operating expenses amounted to 81.4% and 82.8% of the sales, respectively.

In simple English, the companies slashed employee expenses and they renegotiated their contracts with their suppliers and contractors, to drive down their costs. The larger businesses benefitted in the process  at the cost of the smaller ones.

Of course, if a small company gets paid a lower amount of money from a large company, it also has to renegotiate the money it is paying to its employees and suppliers. This also leads to job losses as smaller companies then need to fire employees in order to cut costs and continue to stay viable.

This has played out for the last one year and continues to play out now as well, with the second wave of covid spreading. It is not easy to put a number to this phenomenon, but that does not mean that this is not happening or is not important.

4) Data from the Centre of Monitoring Indian Economy shows that the size of the labour force between January 2020 and March 2021, has shrunk by 1.66 crore. This when the size of the working age population or the population greater than 15 years of age has increased by 2.88 crore during the same period.

What this means is that many individuals who can’t find jobs, have stopped looking and simply dropped out of the workforce. To be counted as a part of a labour force, an individual needs to be either employed or unemployed and be looking for a job.

The sheer size of numbers here tells us that it is the poor who are dropping out of the workforce, giving up on job search. Also as I have discussed in the past, women have faced the brunt of India’s unemployment problem.

5) The rise of the internet and the availability of cheap broadband has ensured that the need to have all hands on the deck is no longer there.

Of course, this does not mean that everyone can work from home. The working class has faced the brunt of the crisis. As Scott Galloway writes in Post Corona – From Crisis to Opportunity: “Most working-class people… can’t do their jobs at home, since they are tied to the store, warehouse, factory, or other place of work.”

People working in factories, hotels, bank branches, hospitals, real estate projects, mom and pop shops, emergency services, delivery services, etc., or driving cabs for that matter, need to turn up at their places of work and job sites every day.

Also, extended working from home, will end up having other major economic consequences. Other than permanent employees, every office has office maintenance jobs which are not on the rolls of the company. Most large offices have canteens run by a contractor. Some companies offer pick up and drop facilities to their employees.

This is how services companies create low-skilled and semi-skilled jobs. Around many large office complexes there are tapris (very small shops) selling tea, coffee and food. Further, the app cab drivers and normal taxi drivers, have already seen their business go down.

Working from home has already hit people in these professions hard. Again, while it is not easy to put a number to this phenomenon, that does not mean that this is not happening or is not important.

6) Given these factors, it is hardly surprising that many people have dropped out of the middle class. A Pew Research centre analysis found that “the middle class in India is estimated to have shrunk by 32 million in 2020 as a consequence of the downturn, compared with the number it may have reached absent the pandemic.”

This accounted for three-fifths of the global retreat in the number of people in the global middle class (defined as people with incomes of $10.01-$20 a day).

While the number of people dropping out of the middle class is high, the increase in the number of poor is shocking beyond belief. Their number is “estimated to have increased by 75 million because of the COVID-19 recession.” This also accounts for around three-fifths of the global increase in poverty.  

In fact, this is something that Nobel Prize winning economist Angus Deaton confirms in a recent research paper, where he points out:

“China did better than almost all other countries, while India did worse. China’s 1.4 billion people experienced few deaths and growth in per capita income, which took them closer to the richer countries of the world and decreased (weighted) global inequality. India’s 1.4 billion people experienced many more deaths, as well as a large drop in income, which increased (weighted) global inequality.”

Of course, with the second wave of covid starting, all this is likely to continue. One point that we need to consider here is the ability of individuals to make a living in the years to come. School and college students are being taught digitally since the last one year. It needs to be considered here that not every student has access to a computer. Further, even if there is access to a computer, it might have to be shared among multiple siblings. Then there is the question of internet speed, electricity and so on.

The quality of education being delivered digitally will impact the earning capacity of many middle class and poor students, in the years to come.

In short, like the disease itself, the negative economic effects of covid, especially among the poor and the middle class, will continue to be felt in the years to come. 

Only 1.7% of Central Govt Petrol Taxes Shared with States – Where Has Cooperative Federalism Gone?

Note: Detailed analysis takes time. Like this piece took three weeks to write. Hence, please continue supporting this effort. Every rupee helps. 

Chintan Patel and Vivek Kaul

The devil, as they say, is always in the detail.

Nevertheless, in an era of instant digital journalism, where you, dear reader, are constantly bombarded with information, the real story, or should we say stories, often get buried under numerous headlines, lazy journalism, government press releases and the false news that is the flavour of the day.

But if one is willing to do some basic number-crunching, like we are, some interesting details and narratives can emerge.

This is one such story of the central government taking both the states and the common man, for a ride and that too in broad day light. At the risk of stretching the metaphor a bit too far, the scene of the crime is the petrol pump and the motive, the dire state of the economy.

But to do this story full justice, we need to set up the background with some dry, academic points as well as digress into some adjacent details.

So, kindly bear with us. While sensational things might get you excited and help us get a few more clicks, but as we said at the beginning, the devil is in the detail.

And here’s presenting the detail.

What’s the point?

Over the years, the central government has been sharing less and less of the overall taxes that it collects, with the state governments. This is the main point we make in this piece. 

The annual budget of the central government is presented in February ever year. The budget is analysed by the media in minute detail.

However, amidst all the analyses, one subject that is often ignored is the financial relationship between the central government and the state governments. After all, much of the services that the government provides are in fact delivered by local and state governments.

It is worth remembering that while the central government collects the bulk of the taxes in the country, it’s the states that the taxes ultimately come from. And given that, this money in one way or another needs to go back to the states.

But does it? The short answer is no. And there is a longer answer which explains the reasons, has some nuance and which forms the heart of this piece.

This piece is divided into three sections. The first section provides a background on how tax revenue is transferred from the central government to the state governments and the role of the Finance Commission.

The second section focuses on a special tax category – cess and surcharge, their increased prominence in recent times, and how that raises prices of petrol and diesel.

The third and final section examines the trend of total transfer of funds from the central government to the state governments.

This is an opportune time for such an analysis, since this year’s Union budget was accompanied by the unveiling of the 15th Finance Commission’s report for the period 2021-22 to 2025-26.

So, read on, to find out.  

Who Gets How Much?

The Constitution stipulates how taxes are collected and split between the central government and the state governments. It empowers the central government as well as the state governments to raise revenues from different sources of taxation.

The central government gets to collect more taxes while the state governments end up with the bigger portion of the expenditure, leading to a mismatch. This mismatch of money that is earned through taxes and other routes and money that needs to be spent, is referred to as a “vertical imbalance”.

Take a look at Figure 1. In 2018-19, the Union Government raised 62.7 per cent of the aggregate resources raised by both the Union and states, whereas the states spent 62.4 per cent of the combined aggregate expenditure. While Figure 1 shares data for just one financial year, what’s true for 2018-19 has also been true for other financial years.


Figure 1: Vertical imbalance (2018-19)

           Source: 15th Finance Commission Report. 

To offset this imbalance, the Constitution provides mechanisms for intergovernmental transfers – the transfer of funds from the central government to the state governments. A key player of this setup is the Finance Commission.

The Finance Commission (FC) is an advisory body that is appointed by the President every five years and which evaluates the state of finances of the central as well as the state governments, and determines how taxes collected by the central government are to be distributed between the central government and the state governments, and among the state governments.

Over and above this, the FC also recommends grants to states based on revenue needs, grants for local governments and grants for specific purposes e.g. health sector grants etc. Thus, there are two broad channels of transfer of funds under the FC umbrella – i) devolution of taxes, and ii) grants. 

At the heart of the idea of intergovernmental transfers and tax devolution is the concept of ‘divisible pool’. The divisible pool is the portion of the taxes (technically referred to as the gross tax revenue) collected by the central government, which is distributed between it and the state governments. What this means is that all the taxes collected by the central government aren’t shareable with the state governments.

Till the tenth FC which tabled its report in 1995, only union excise duties and personal income taxes made up the divisible pool. Under this arrangement, 85% of the personal income taxes and 40-45% of excise duties were shared with the state governments.

In 2000, the tenth FC recommended a constitutional amendment to expand the divisible pool to all central taxes. The central government accepted this recommendation and the 80th Amendment was passed making a certain portion of  central government taxes shareable with the state governments, effective retrospectively from April 1, 1996.

Further, the portion of the divisible pool that is shared with the states is referred to as the devolution of taxes and is determined by the FC. Before the14th FC which came into effect from April 2015, 32% of the divisible pool was shared with the states.

The 14th FC increased the share of the state governments in the divisible pool to 42%. At the same time, the sector-specific grants were eliminated. This decision was primarily in response to grievances expressed by the state governments. State governments prefer funding through devolution since such transfers are unconditional.

Other transfers of money, whether they are through FC grants, or through channels outside the FC (like schemes from central government ministries) impose policy priorities set by the central government over the state governments, compromising the latter’s fiscal flexibility or the ability to spend money as the state government deems fit.

To give an example, a FC health-sector grant can only be used for health spending by the states, or funds transferred to the states under Pradhan Mantri Gram Sadak Yojana can only be used to make roads.

When state governments have more flexibility in allocating funds for various initiatives, they can craft policy that is more responsive to the needs on the ground than having to blindly follow policy that is framed in New Delhi.

The 14th FC recognised this and increased the state share of the divisible pool from 32% to 42%. The intent behind this increase was not to increase the amount of transfers but rather change the composition of the transfers – from diverting conditional funds to diverting unconditional funds, to state governments.

The 15th FC tabled in 2021 lowered the divisible pool marginally to 41%, from the earlier 42%. The is because Jammu and Kashmir is no longer a state and the money allocated to it has not been counted as transfer to a state government. Given this, the 15th FC has kept the divisible pool distribution unchanged.  

And now we come to the most important point of this write up. A key detail in this entire discussion is that the only tax revenue that is excluded from the shared divisible pool are different kinds of surcharges and cess.

As we shall see next, this exclusion has proved to be the back door that the central government has been using to divert funds from the states governments’ kitty to its own.

A Tale of Two Taxes

Before we get into the details, let’s first try and understand what surcharge and cess actually are.

A cess is tax on a tax imposed by the central government attached to a specific purpose. For example, an education cess collected should be utilised only for financing education and not for any other purpose. It is worth remembering here that the education cess is imposed on the total income tax and not on the total taxable income.

Hence, as explained earlier, it is a tax on a tax. Examples include infrastructure cess on petrol and diesel, krishi kalyan cess, health and education cess on Income Tax, etc.

In theory, money collected under a cess is to be spent on the specific purpose for which it is collected but that’s not always the case.

A Comptroller and Auditor General (CAG) report for 2018-19 indicates that only Rs 1.64 lakh crore of the Rs 2.74 lakh crore or around 60% of the amount collected from cess and surcharge during 2018-19 had been transferred to their respective funds. Around 40% was still retained in the Consolidated Fund of India, which is the general-purpose fund of the Indian government.

The provision of levying a cess was intended to be used for shorter specific purposes. So, the procedure for introducing a cess is comparatively simpler than introducing new taxes, which usually require change in the law.

Coming to surcharges, a surcharge is also a tax on a tax, but is not tied to a specific purpose like a cess is. Let’s take the example of the surcharge on income tax. It is an added tax on the taxpayers having a higher taxable income during a particular financial year. So, an individual having a taxable income  between Rs 50 Lakhs and Rs 1 crore pays an income tax surcharge of 10%.

Further, an individual with a taxable income between Rs 1 crore and Rs 2 crore, pays an income tax surcharge of 15%, and so on.

Note that this surcharge is only on the base income tax, not on the income itself. So, if an individual earning Rs 1 crore in a year needs to pay an income tax of Rs 20 lakhs, the applicable surcharge would be Rs 2 lakhs (10% of 20 lakhs).

A surcharge can be utilised for any purpose of the government, without having to bend the rules, like they do sometimes for cess collections.

In the last few years, these surcharges and cess, which do not need to be shared with the state governments, have become the central government’s go-to tools to address the tax revenue shortfall.

Take a look at Figure 2a, which basically plots the total amount of surcharges and cess collected by the central government over the years, along with the surcharge and cess it hopes to collect during 2021-22, the current financial year.

Figure 2a: Total cess and surcharge revenue (in Rs crore).

Source: Union budget documents.  

Figure 2a clearly shows that the general trend is upwards, with small blips in 2017-18 and 2018-19. The government expects to collect total surcharges and cess of Rs 4,45,822 crore (revised estimate) in 2020-21.

This is surprising given that overall tax collection during the year is expected to come down. In comparison to the years before 2020-21, the collections for 2021-22 are also expected to be at a very high Rs 4,48,821 crore.

The collections of cess and surcharge surged from Rs 2,53,540 crore in 2019-20 to Rs 4,48,822 crore (RE) in 2020-21, an increase of a whopping 77%. This huge increase is almost entirely due to increased cess and surcharge on petrol and diesel – in particular, the road and infrastructure cess and the additional duty of excise on motor spirit (which is a surcharge), which increased by Rs 1,92,792 crore. Motor spirit is the technical term for petrol.

The increased reliance on cess and surcharge is also seen in Figure 2b below, which plots the total cess and surcharge earned by the central government as a proportion of the Indian gross domestic product (GDP). This is done in order to take the size of the Indian economy into account as well.

Figure 2b: Cess and surcharge revenue expressed
as a proportion of the GDP (in %).

Source: Union budget documents.

The above figure makes for very interesting reading. The total amount of cess and surcharges earned by the central government went up from 1.25% of the GDP in 2019-20 to 2.29% of the GDP in 2020-21, a massive jump of 104 basis points. Some of this jump was obviously because the size of the economy or the GDP is expected to contract in 2020-21. Nevertheless, the fact that cess and surcharges collected by the government went up in a year when the economy contracted, does come as a surprise.

In Figure 3, let us look at the breakdown between cess and surcharges earned by the central government over the years. Looking at the below figure it is evident that cess collections form the bulk of the total revenue.

Figure 3: Cess and surcharge breakdown (in Rs crore).

Source: Union budget documents.

Clearly, cess is bringing in more money for the central government, though the contribution of surcharges has also jumped up since 2019-20.

Now let’s try and understand, why has the central government increasingly become more dependent on earning money through cess and surcharges, and in the process it is sharing lesser proportion of taxes with the state governments.

This increased reliance on cess and surcharges in the last two years can be understood when one looks at what is happening with the total tax revenue. Figure 4 plots the total taxes earned by the central government or gross tax revenue as a proportion of the GDP.

Figure 4: Gross tax revenue as a proportion of GDP (in %).

Source: Union budget documents 

While the negative economic impact of the covid pandemic has been a telling blow, the downward trajectory in tax collections of the central government had started as far as back as 2018-19. The twin economic debacles of PM Modi’s first term – demonetisation and a shaky GST implementation – meant the economy was already tottering before the covid pandemic hit.

An obvious casualty of this slowdown has been a declining tax revenue as a proportion of the GDP. In the normal scheme of things, this would have meant that the central government would have ended up with lesser taxes for itself, after sharing with the state governments.

But this fall has been cushioned with the central government earning a higher amount of taxes through cess and surcharges (as can be seen from Figure 5).

Figure 5: Cess and surcharge as a proportion of total central government taxes. 

Source: Union budget Documents
RE = Revised Estimate
BE = Budget Estimate

 In 2019-20, the total taxes earned by the government or the gross tax revenue had stood at Rs 20.1 lakh crore. In 2020-21, it is expected to fall by 5.5% to Rs 19 lakh crore. The net tax revenue of the central government (what remains after sharing taxes with the state governments) in 2019-20 was at Rs 13.59 lakh core.

This is expected to fall to Rs 13.45 lakh crore in 2020-21, a fall of 0.9%, which is much lower than the 5.5% fall in gross tax revenue. While, the total gross tax revenue is expected to fall by Rs 1.1 lakh crore (Rs 20.1 lakh crore minus Rs 19 lakh crore), the net tax revenue is expected to fall by just Rs 14,000 crore (Rs 13.59 lakh crore minus Rs 13.45 lakh crore). 

In percentage terms, in 2019-20, the central government kept 67.6% of the taxes for itself in 2019-20. This shot up to 70.8% in 2020-21. 

Clearly, the state governments have been short-changed here, with their share of taxes falling from Rs 6.51 lakh crore in 2019-20 to Rs 5.5 lakh crore in 2020-21, a fall of a little over Rs 1 lakh crore or 15.5%, in such economically difficult times.

This is primarily because the share of cess and surcharge in total taxes collected by the central government has jumped from 12.67% in 2019-20 to 23.46% in 2020-21. Do remember that cess and surcharges are outside the divisible pool.

So, when the inflow of these taxes increases, the central government gets to keep all the revenue, as opposed to sharing 41% (15th FC guideline) with the state governments. So, it is far more efficient for the central government to increase cess and surcharge when it needs to increase tax collection. 

This overuse of cess and surcharges by the central government has not gone unnoticed. In fact, the chairman of the 15th FC, NK Singh has talked about introducing a constitutional amendment to include them in the divisible pool.

As he said

“I see no viable solution except a constitutional amendment. If that constitutional amendment is introduced, recognizing some proportion of cess and surcharge to the divisible pool, it will certainly allow greater flexibility to the successive Finance Commissions subsequently to be able to calibrate a framework.”

Ultimately, as we said at the very beginning, whatever might be the term used, a tax, or a cess or a surcharge for that matter, it is being paid by people. And hence, the money thus collected should be shared with the state governments.

How does all this affect you, dear reader?

If you have managed to make it thus far, many of you by now would be like how much gyan are these guys going to give. Why can’t they tell me straightaway how does all this impact me or the world at large or the aam aadmi?

Well, sometimes it is important to take a look at the bigger picture first and then arrive at how it impacts all of us.

The government’s increased reliance primarily on cess actually has had a direct impact on most citizens – in the form of increased prices at the petrol pump.

The biggest contributor to the spike in cess collection over the last two years has been cess collected on the sale of petroleum products. The figure below charts the total cess collected on petroleum products (crude oil, petrol and diesel) over the last five years. While the cess on petrol formed at least 50% of total cess each year, it was as high as 69% of the total cess revenue in financial years 2019-20 and 2020-21. 

Figure 6 clearly shows that the government has resorted to taxing petrol and diesel to make up for revenue shortfalls. This conclusion is hardly a revelation to anyone paying attention to prices at the pump, but the numbers help understand the government’s motivation.

Figure 6: Total cess on petroleum products (in Rs crore).

Source: Union budget documents

There is another way of looking at the cess on petrol and diesel. Table 1 below gives a breakdown of the union taxes on petrol and diesel for 2020-21 and 2021-22. Note that the table below only analyses central excise tax and excludes customs duty. There are technical complications in figuring out the per litre customs duty.  

Table 1: Central government tax breakdown on petrol and diesel.

Source: https://www.ppac.gov.in/content/149_1_PricesPetroleum.aspx

 

The total union excise duty on petrol and diesel, in 2021-22 are Rs 32.90 per litre and Rs 31.80 per litre, respectively, which are marginally lower than the previous year. All taxes other than basic excise duty, including special additional excise duty, which is a surcharge, are exempt from the divisible pool.  

1) For 2021-22, only ~5% of the excise taxes on petrol and diesel will go to the divisible pool. The rest (~95%) will be kept by the central government. In 2020-21, this portion was at around 91% for petrol and 85% for diesel. Clearly, the government is keeping a greater share of petrol and diesel taxes for itself.

2) The above point does not clearly bring out the gravity of the situation. Let’s do a simple calculation to show that. In 2021-22, the total excise duty on petrol stands at Rs 32.90 per litre. Of this, the basic excise duty of Rs 1.4 per litre is the only part which is a part of the divisible pool and hence, will be shared with the states. It is worth remembering only 41% of this or around 57 paisa per litre needs to be shared with the state governments.

What this means is that just 1.7% of the total excise duty earned by the central government per litre of petrol will be shared with the state governments. It was at 3.8% in 2020-21.

3) Now let’s carry out the same exercise for diesel. The total excise duty earned by the central government on the sale of one litre of diesel will be Rs 31.80 during 2021-22. Of this only Rs 1.8 per litre will be shareable with state governments. 41% of this amounts to around 74 paisa per litre.

This amounts to around 2.3% of the total excise duty of Rs 31.8 per litre earned by the central government per litre of diesel. It was at 6.4% in 2020-21.

4) In 2021-22, a new agriculture infra cess has been introduced. It amounts to Rs 2.5 per litre on petrol and Rs 4 per litre on diesel. This has led to the reduction of basic excise duty on petrol from Rs 2.98 per litre to Rs 1.4 per litre and that on diesel from Rs 4.83 per litre to Rs 1.8 litre. As mentioned earlier, only the basic excise duty needs to be shared with the state governments.

Hence, by introducing a new agriculture infra cess, the central government has ensured that state governments get an even lower share of taxes from petrol and diesel in 2021-22.

The general public is quite sensitive to price rise at the petrol pump since it is a highly visible and recurrent cost. That the government has still resorted to this strategy for increasing revenue, speaks to the lack of better options – a fact that is a direct consequence of the tepid economic scenario even before the pandemic began. Of course, the covid pandemic has only made things more difficult for the government on tax front.

Nonetheless, things are even more difficult for state governments, which don’t have many avenues to raise tax. Clearly, this amounts to the centre shortchanging the state governments during difficult economic times.

Oh wait, there is more – Total intergovernmental transfers

Other than the divisible pool of taxes, there are other channels of intergovernmental transfers between the central government and the state governments. So, to get the complete picture on the flow of money from the central government to the state governments, it is instructive to examine the total intergovernmental funds transferred in more detail.

Before diving into those details, a brief overview of intergovernmental transfers would be useful. Figure 7 below is a good graphical representation of all the ways in which the central government can transfer funds to the state governments.

Figure 7:  Vertical fiscal transfer channels. 

Source : Asian Development Bank

Broadly speaking there are two instruments of fund transfers.

1) Finance Commission funds: As discussed earlier, this includes the 41% of the divisible pool revenue, general-purpose grants for states with weak revenue raising capacity and specific purpose grants for funding local governments (panchayats and municipalities) and funding certain specific initiatives (eg. health-sector grants by the 15th FC). Most of the funds provided via the FC channel are not conditional and don’t require state government contributions.

2) Funds from central ministries: In addition to the FC funds, the central government also gives specific purpose grants through the respective ministries. These funds are transferred either through centrally sponsored schemes or central sector schemes. Central sector schemes are entirely funded by the central government. Some examples include the free LPG connections provided to poor households, crop insurance scheme etc.

The centrally sponsored schemes require a matching component from the state governments i.e. they have to fund a portion of the scheme. Examples of this include the Pradhan Mantri Gram Sadak Yojana, the Swachh Bharat Mission etc.

As Figure 7 shows, the mechanism of intergovernmental transfer underwent a major transformation in 2015. Two things led to this. Firstly, the 14th FC gave its recommendations for increasing the devolution share of state governments from 32% to 42% and eliminating a host of specific purpose grants. The underlying rationale was to change the composition of state transfers to increase the “no-strings-attached” outlays and reduce conditional grants to give state governments more financial headroom.

Secondly, the newly elected NDA government disbanded the Planning Commission and replaced it with the NITI Aayog. While the NITI Aayog has some shades of resemblance with the Planning Commission, the five-year plans, which was the responsibility of the Planning Commission, were scrapped.

The five-year plans would have their own grants for states in the annual budget of the central government. The establishment of the NITI Aayog and the approval of the 14th FC recommendations were two initiatives that formed the basis the oft-cited “cooperative federalism” mantra of the NDA government, especially in the early years.

The argument put forth to claim this catchphrase was that the Modi-led administration was reversing the centralising tendencies of earlier governments and ushering in an environment where states had greater fiscal autonomy.

Does the data corroborate these claims? Let us examine. Figure 8 below charts the tax devolution to states as a portion of the gross tax revenue.

Figure 8: Tax Devolution vs Gross Tax Revenue (in %).

Source: Union budget documents

  

Some interesting observations can be made from Figure 8.

1) The first few years after the 14th FC came to effect (April 2015) saw a significant increase in the portion of taxes devolved to the states.

2) This increasing trend of devolution peaked in 2018-19 when the devolution was 36.6%. The last three years have seen this number come down, with the 2020-21 figure (~29%) close to the pre-2015 levels. So, all the talk about cooperative federalism has gone for a toss, in the last few years.

3) Note that these numbers don’t reflect the 32% (pre-2015) or 42% (post-2015) devolution share prescribed by the FC since cess and surcharge revenue is not devolved. This also explains why the devolution percentage has dipped sharply in the last two years, a period when cess revenue has had a corresponding increase (as shown earlier in Figure 5).

While the 14th FC may have been the catalyst, the Modi government can rightfully claim credit for strengthening fiscal federalism, at least in its first term. However, most of these gains have been reversed in their second term. This justifies N.K Singh’s lament

“ It should not be a cat and mouse game that every finance commission raises the devolution number and it then neutralised simultaneously by an increase in cess and surcharge leaving the states where they were, nor the opposite way.”

Next, in Figure 9, let us look at the total transfers made to state governments in recent years, not just tax devolution. The total transfers to states includes tax devolution, finance commission grants, centrally sponsored schemes, central sector schemes and other miscellaneous items listed as state transfers in the union budget.

The figure below charts the total transfers made to states as a percent of the total expenditure of the Union government.

Figure 9: Portion of total expenditure of central government
transferred to state governments (in %).

Source: Union budget documents

 There are two caveats on the chart above.

1) Starting 2014-15 there was a change in how expenditure for central schemes was routed to the states. The figures for 2013-14 have been adjusted to make the comparisons with the subsequent years correctly.

2) We have excluded loans made to states from the total transfer amounts and only included grants and devolution, since loans do need to be repaid.

That said, these figures also lead to similar observations made from Figure 8. The period from 2015-16 to 2018-19 (roughly co-incident with NDA’s first term) had a significant increase in funding to the state governments.

While the increased devolution of taxes could be attributed to the recommendations of the 14th FC, the increase in total transfer of funds was certainly government policy. The last two years (and the projections for the next year) show a steep decline in the intergovernmental transfers.  
The huge spike in cess and surcharge collections which are not shared with states and declining tax revenues during this period contributed to this effect.

There are two other conjectures one can make based on the trends seen above. First, when Narendra Modi won in May 2014, he was a sitting chief minister and his perspective on governance was heavily biased towards the challenges of governing a state.

Hence, financial outlays were perhaps favourable to the states. In the second term, he was well-entrenched as a national leader and the instincts were now honed favouring centralisation.

Second, the Bhartiya Janata Party has adopted an increasingly overt approach favouring homogenisation of the country. Whether it is the abrogation of Article 370, the passage of national farm laws, or flirtations with one-nation-one-language, it is evident that impulse is towards uniformity and centralisation. In this context, the trend of holding back funds from states, seems a natural accompaniment. 

Everybody Loves a Good Interest Rate Cut…Except the Savers

My main life lesson from investing: self-interest is the most powerful force on earth, and can get people to embrace and defend almost anything – Jesse Livermore.

Late in the evening of March 31, the department of economic affairs, ministry of finance, put out a press release saying that the interest rates on small savings schemes for the period April to June 2021, have been cut.

The social media got buzzing immediately. And almost everyone from journalists to economists to analysts praised the decision. It was seen as yet another effort by the government to push down interest rates further.

With the state of the economy being where it is, lower interest rates are expected to perk up economic growth. People are expected to borrow and spend more. Corporates are expected to borrow and expand. At lower interest rates individuals who have already taken on loans will see their EMIs go down, leaving more cash in hand, and they are likely to spend that money, helping the economy grow.

That’s how it is expected to work, at least in theory. Hence, everybody loves a good interest rate cut… except the savers.

On April 1, the social media woke up to the finance minister Nirmala Sitharaman’s tweet announcing that “interest rates of small savings schemes… shall continue to be at the rates which existed in the last quarter of 2020-2021.” She further said that the order had been issued by oversight and would be withdrawn.

Later in the day, the department of economic affairs put out a press release to that effect.

The fact that lower interest rates are good for the economy is only one side of the story. They also hurt the economy in different ways. People who are dependent on interest income for their expenditure (like the retired senior citizens) see their incomes fall and have to cut down on their expenditure. This impacts private consumption negatively. 

While this cannot be measured exactly, it does happen. Also, a bulk of India’s household savings (close to 84% in 2019-20) are made in fixed deposits, provident and pension funds, life insurance policies and small savings schemes. Lower interest rates bring down the returns of all these products and this negatively impacts many savers.

As the economist Michael Pettis writes about the relationship between interest rate and consumption in case of China, in The Great Rebalancing:

“Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

The same logic applies to India as well, with lower interest rates being associated with declining consumption, at least for a section of the population.

This is not to say that interest rates should be higher than they currently are (that is a topic for another day), nonetheless the fact that lower interest rates impact savers and consumption negatively is a point that needs to be made and it rarely gets made. I made this point in a piece I wrote for livemint.com, yesterday. 

Also, borrowing is not just about lower interest rates. It is more about the confidence that the borrower has in his economic future and the ability to keep paying the EMI over the years. I wrote about this in the context of home loans, a few days back.

This leaves us with the question that why doesn’t anyone talk about the negative side of low interest rates. The answer lies in the fact that they don’t have an incentive to do so. Let’s try and look at this in some detail.

1) Fund managers: Fund managers love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to mutual funds and portfolio management services which invest in stocks. In the process, their assets under management go up. More money coming into the stock market also tends to push up stock prices.

All in all, this ensures that fund managers increase their chances of making more money and hence, they love lower interest rates because their acche din continue.

2) Analysts: Analysts love lower interest rates because it leads a section of the savers, in the hope of earning a higher return, to move their savings from bank fixed deposits to stocks. In order to buy stocks, they need to open a demat account with a brokerage. When the new investors buy stocks, the brokerage earns commissions.

Further, it also means that the interest cost borne by corporates on their debt goes down, leading to higher profits. The stock market factors this in and stock prices go up. Given this, analysts have an incentive to love interest rate cuts.

3) Corporates: Do I need to explain this? Lower interest rates lead to a lower interest outflow on debt that a corporate has taken on and hence, higher profits or lower losses for that matter. This explains why corporate honchos are perpetually asking the Reserve Bank of India to cut the repo rate or the interest rate at which it lends to banks.

4) Banks: Banks love lower interest rates simply because at lower interest rates the value of the government bonds they hold goes up. Interest rates and bond prices are inversely related. Higher bond prices mean higher profits for banks or lower losses in case of a few public sector banks. This is why bankers almost always come out in support of interest rate cuts.

This also explains why the bankers hate the idea of small savings schemes offering higher returns than fixed deposits. Lower interest rates on small savings schemes pushes the overall interest rates in the financial system downwards. 

5) Economists: Most economists are employed by stock brokerages, mutual funds, banks, corporates or think tanks. As explained above, stock brokerages, mutual funds, banks and corporates, all benefit from lower interest rates. If your employer benefits from something, you also benefit in the process. Hence, your views are in line with that.

When it comes to think tanks, many are in the business of manufacturing consent for corporates. Their economists act accordingly. 

6) Journalists: With the media being dependent on corporate advertising as it is, it is hardly surprising that most journalists love interest rate cuts. Further, the main job of anchors on business news channels is to keep people interested in the stock market because that is what brings in advertising. And this can only happen, if stock prices keep going up. In this environment, anything, like interest rate cuts, that drives up stock prices, is welcomed.

Of course, some mainstream TV news channels also run propaganda for the government. So, in their case every government decision needs to be justified. That is their incentive to remain in the good books of the government.

7) Government: The central government will end up borrowing close to Rs 25 lakh crore during 2020-21 and 2021-22. Hence, even a 1% fall in the interest rate at which it borrows, will help it save Rs 25,000 crore. It clearly has an incentive in loving low interest rates. 

The point is everyone mentioned above tends to benefit if interest rates keep going down or continue to remain low. Further, they are organised special interests with direct access to the mainstream media. The savers though many more in number aren’t organised to put forward their point of view.

Also, it is easier to do the math around the benefits of interest rate cuts and low interest rates than its flip side. As economist Friedrich Hayek said in his Nobel Prize winning lecture, there is a tendency to simply disregard those factors which “cannot be confirmed by quantitative evidence” and after having done that to “thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.”

That’s the long and the short of it. 

Women Are Bearing the Brunt of India’s Unemployment Problem

This piece is an extension of a piece on unemployment I wrote sometime back. Nevertheless, you don’t have to read that piece in order to make sense of this.

Honestly, this is probably the most disturbing data driven piece that I have ever written, despite the fact that I started writing on the issue of unemployment more than half a decade back, when it wasn’t very fashionable to do so.

The brunt of India’s unemployment problem is being borne by women. This is not to say that the men are having an easy time. They aren’t, given that many more men enter the labour force than women.

Nevertheless, the proportion of women who are employed and get paid was low to start with, and it has become even lower over the years. This, at a time, when more and more women are going to school and college.

As the All India Survey of Higher Education for 2018-19 points out: “Total enrolment in higher education has been estimated to be 3.74 crore with 1.92 crore male and 1.82 crore female. Females constitute 48.6% of the total enrolment.” But all this education isn’t helping them find paid employment.

Let’s start with the unemployment rate for men and women. The following chart plots this data since January 2016.

Source: Centre for Monitoring Indian Economy.

The above chart tells us several interesting things.

1) The unemployment rate for women is significantly higher than that of men. In February 2021, the unemployment for women stood at 12.39% whereas for men it stood at 6.23%.

2) The unemployment rate for women in February 2021 is much lower than it was in January 2016, when Centre for Monitoring Indian Economy (CMIE) published the unemployment data for the first time. Have things improved? Keep reading to know the answer.

3) The peak unemployment rate for women during covid was 29.22% as of April 2020. The rate has fallen since to 12.39%, as of February 2021. Again, have things improved?

In order to answer the questions raised above, we need to understand how unemployment is defined. (For those who have read the earlier piece I wrote on unemployment, the next few paragraphs may seem like a repetition, which they are. I have repeated these paragraphs, simply because it is important for every piece to stand on its own, so that first time readers can also read and understand it easily).

A person is categorised as unemployed “because of a lack of job and where such a person is actively looking for a job”. The word to mark here is actively. Hence, a person can be categorised as unemployed only if he doesn’t have a job and is searching for one.

As the Centre for Monitoring Indian Economy (CMIE) puts it, a person categorised as unemployed, “should be unemployed on the date of the survey, should be actively looking for a job in the 100 hundred days (approximately three months) preceding the date of the survey and should be willing to take up the job if a job is found.”

They further point out: “A person is considered to be actively looking for a job if such a person has contacted potential employers for jobs, contacted employment agencies, placement agencies, appeared for job interviews, responded to job advertisements, online employment sites, made applications, submitted resumes to potential employers or reached out to family members, friends, teachers to look for jobs from them.”

To put it in short, waiting for a job offer to come, is not considered as actively looking for a job.

Let’s move on and plot the next two charts, the labour participation rate for men and women.

Source: Centre for Monitoring Indian Economy.

Source: Centre for Monitoring Indian Economy.

Before we interpret these charts, we first need to define what labour participation rate is. Labour participation rate is the ratio of the labour force to the population greater than 15 years of age. And what is the labour force? As per CMIE, labour force consists of persons who are of 15 years of age or more, and are employed, or are unemployed and are actively looking for a job.

Now we are in a position to interpret the above two charts. Let’s do that pointwise.

1) The labour participation rate for women is miniscule on the whole. In February 2021, it stood at 9.42%. What does this mean? It means that a very small proportion of women over the age of 15, are employed and get paid for it or are unemployed and are actively looking for. a job. And the tragic part is that this rate is falling. It was at 17.7% in May 2016. Since then it nearly halved.

2) The labour participation rate of men is considerably higher. It was 67.82% in February 2021, even though it has been falling. Hence, two in three men over the age of 15, are employed and are getting paid for it, or are unemployed and actively looking for a job. For women, this ratio is less than one in ten. That’s the difference between the two sexes and it’s huge. 

3) Urban women are in a much worse position on this front. The labour participation rate for urban women stood at 6.56% in February 2021. The rate had peaked at 16.58% in August 2016 and has been falling ever since. What does this mean? It means that it is more difficult for a woman to be employed and get paid, if she is in urban India than in comparison to rural India.

Also, the dramatic fall in the rate since August 2016, tells us that once a woman loses a job or a source of income, it is very difficult for her to get it back. And finally, very few women in urban India are stepping out of their homes to go to work and get paid for it. This has only increased post the spread of covid. The labour participation rate for women was 9.92% in January 2020. It’s not at 6.56%.

4) Now comes the worst part. Between January 2016 and February 2021, the number of women greater than 15 years of age has gone up by 5.41 crore to 49.49 crore. Hence, the number of women who have entered the working age population has gone up by 12.26% (5.41 crore expressed as a percentage of 49.49 crore). On the other hand, the female labour force, has shrunk by 2.75 crore to 4.66 crore. In January 2016, it was at 7.41 crore. This is a collapse of 37% (2.75 crore expressed as a percentage of 7.41 crore).

Let me just repeat this again. While the working age population for women over the last five years has gone up by 12.26%, the female labour force has collapsed by 37.11%. This also explains the fall in unemployment rate for women, given that much fewer women are actively looking for a job. Many women who haven’t been able to find jobs, have stopped actively looking and simply dropped out of the labour force.

Economists have struggled to come up with an explanation for this phenomenon. One possible explanation lies in the fact that the number of jobs available haven’t grown at the pace that could accommodate the new individuals, both men and women, entering the workforce. Hence, in a patriarchal society, men in deciding positions, have offered jobs to other men, forcing women who have searched and not found jobs to stop actively looking for a job and drop out of the labour force altogether.

5) Let’s take a look at the overall population. The working age population, between January 2016 and February 2021, has gone up from 93.85 crore to 105.8 crore, this implies an increase of 11.95 crore. Nevertheless, the number of people employed or unemployed and looking for a job, that is the total labour force, has fallen from 44.76 crore to 42.85 crore, or by 1.91 crore.

Sothe working age population has increased by 11.95 crore between May 2016 and February 2021, but the total labour force as such has fallen by 1.91 crore. What does this really mean?

While, the total labour force has shrunk by 1.91 crore, 2.75 crore women have dropped out of it. This basically means that the number of men in the labour force has gone up.

Hence, the brunt of India’s unemployment problem is being borne by women. Women who lose their jobs find it difficult to find a new one and over a period of time simply drop out of the labour force. Many women who enter the labour force and actively look for jobs, are unable to find one and eventually stop searching and drop out of the labour force.

Given that chances of men finding a job are higher, they continue to look for a job and the situation is not as bad as it is for women. Between January 2016 and February 2021, number of men who crossed the age of 15 and entered the working age population, increased by 6.54 crore to 56.30 crore.

During the same time, the number of men entering the labour force (that is either they were employed or were unemployed and actively looking for a job) increased by 83.62 lakh to 38.19 crore. Hence, in this case of men, the labour force at least hasn’t shrunk.

6) Given that more and more women are dropping out of the labour force, it makes it easier for the men who don’t drop out of the labour force to find a job, from the opportunities that come up. (I am using the word easier here and not easy. Kindly appreciate the difference between the two).

7) Urban women are likely to be more educated, but their labour participation rate is very low. Hence, what that means is that they are unable to utilise their education to work and earn money in the process.

8) Now let’s take a look at how things have been post-covid.  In January 2020, before covid had struck, the working age population had  stood at 103.13 crore. By February 2021, this had jumped to 105.8 crore, a jump of 2.67 crore. Meanwhile, the labour force as of January 2020 stood at 44.24 crore. It has since shrunk to 42.85 crore, by 1.39 crore. So, post-covid, the working age population has gone up by 2.67 crore, but the labour force has shrunk by 1.39 crore.

How have the women done on this front? The working age population post covid for women has gone up by 92.23 lakh whereas the labour force has shrunk by 78.03 lakh. Again, more women have dropped out of the labour force than men, given that the labour force has shrunk overall by 1.39 crore. Also, do keep in mind that the fact that a lower number and proportion of women enter the labour force in the first place.

To conclude, the world celebrated the international women’s day a few days back (on March 8). On that day, the corporates and the government institutions talked about the importance of the women who worked for them. The social media influencers talked about women. Many women talked about what it means for them to be a woman.

But almost none of them talked about one of the most important issues at hand, the fact that Indian women are bearing the brunt of India’s unemployment problem.

If you are reading this(man or woman) please share it with your friends and family. The first step towards solving any problem is knowing and acknowledging that it exists.

On Confidence

Around mid-November 2020, I spoke to a bunch of macroeconomics students at IIM Ahmedabad on data in economics. After I had spoken, one of the questions asked was how can we use data to say things with absolute certainty (or something along similar lines).

My simple straightforward answer to the question was that we can’t. Over the years, economists had ended up portraying their subject as a science simply because it has a lot of mathematical equations built into it. But macroeconomics was always more of an art. Hence, we could say things with a reasonable amount of confidence, but never with total confidence.

I don’t think the student was convinced about what I said. And I don’t blame him for it because in the world that he lives in, economists, investors, analysts, politicians and just about everyone speaking to the world at large, is saying things with total confidence.

Let’s take the case of economists. Their economic growth forecasts are made to the precision of a single decimal point.

If we talk about investors, they forecast a stock market index reaching a particular level in a certain amount of time, with total confidence.

Analysts forecast the price of a stock or a commodity reaching a certain level at a certain point of time.

And let’s leave politicians out of this. Untangling their confidence levels will take a book.

The trouble is all this confidence comes in a world that keeps rapidly changing, where if we stick to our ideas all the time, we will largely turn out to be wrong.

As Dan Gardner writes in Future Babble—Why Expert Predictions Fail and Why Believe Them Anyway:

“The simple truth is no one really knows, and no one will know until the future becomes the present. The only thing we can say with confidence is that when that time comes, there will be experts who are sure they know what the future holds and people who pay far too much attention to them.”

And people pay far too much attention to experts who predict/forecast/comment confidently simply because confidence convinces. The audience is looking for a buy in and nothing helps get that more than the confidence of the expert talking.

Also, in these days of the social media, many a time we are simply looking for a confirmation of something that we already believe in. If the expert ends up saying something along those lines, he tends to become our go to man. Our echo chambers are really small.

Let’s take the case of the investor Rakesh Jhunjhunwala, a man known to make confident bold statements when it comes to the Indian economy and the stock market. He recently forecast that India will overtake China in the next 25 years. As he put it: “You may call me a fool… but I can tell you one thing – India will overtake China in the next 25 years.”

The media and the investors as usual lapped it up, without putting that simple question to him: How?

The Indian gross domestic product (GDP) in 2019 was at $2.94 trillion. And that of China was at $11.54 trillion (World Bank data, 2010 constant US dollars). What this means is that if Chinese GDP stagnates at its current level for the next 25 years, India still needs to grow at 5.62% every year for the next 25 years to get where China currently is.

So, the chances of something like this happening are minimal, given the current state of things. But Mr Jhunjhunwala might know something that ordinary mortals like you and I, probably don’t.

The funny thing is that the Big Bull, as the media likes to call him, has made similar such forecasts in the past, which have gone horribly wrong. In October 2007, he had forecast that the Sensex will touch 50,000 points in the next six to seven years.

And he is not the only one making such forecasts. In June 2014, the domestic brokerage Karvy had forecast that the Sensex will touch 1,00,000 points by December 2020.

People making a living out of the stock market (or any other market for that matter) have an incentive in saying that future will be better than the present is. Many analysts make a living by simply doing this on the business news TV channels, on a regular basis.

The media looking for bold headlines to run, laps it up. And the investors who are more like sheep ready to be slaughtered, follow the sheep in front of them.

In fact, the trick is to make bold bigger forecasts and not small ones. I mean, if you currently forecast that Sensex is going to touch 55,000 points this year, no one is going to pay interest. But if you say Sensex is going to cross 1,00,000 points by 2023 or 2024, everyone is going to sit up and take interest.

An excellent example of this is Jhunjhunwala’s 2014 forecast on the stock market index Nifty touching 1,25,000 points by 2030.

Of course, if he turns out to be right, everyone will be dazzled by the forecast he had made. If he turns out to be wrong, no one will remember. Did you remember that Karvy had forecast the Sensex touching 1,00,000 points by December 2020? That’s how the game is played.

Big investors are trying to drive up stock prices, so that their investment portfolios can also gain in the process, which is why they publicly need to be seen as being confident.

A similar game is now played on the social media where traders claim to have generated a humongous amount of return in a short period of time. Of course, there is no way to verify this, except believing him or her.

This is accompanied by other confident predictions of how the future is going to be. The idea is to sell some training programme that they are offering. And no one is going to buy a training programme from a trader who doesn’t sound confident.

For the economists, the game is a little different. They tend to treat their pet theories as gospel. So, an economist who believes in free markets will keep parroting the free market line on everything.

As Scott Galloway writes in his excellent book Post Corona—From Crisis to Opportunity:

“The libertarian argument… is that…regulation and redistribution is inefficient, that left to its own devices the market will regulate itself. If people value clean rivers, the argument goes, they won’t buy cars from companies that pollute. But history and human nature shows that this does not work.”

An excellent example of this is the river Ganga in India, which people keep polluting despite the fact that at the same time they look it as a holy river.

Galloway offers a few more examples. “Nobody wants to see children working eighteen hours a day in a clothing factory, but at the H&M outlet, the $10 T-shirt is an unmissable bargain… Nobody wants to die in a hotel fire, but after a long day of meetings, we aren’t going to inspect the sprinkler system before checking in.” The point being that some sort of regulation is necessary.

There is economic theory and then there is how things play out in real life. As Adam Grant writes in Think Again—The Power of Knowing What You Don’t Know: “In theory confidence and competence go hand in hand. In practice, they often diverge.”

Other than continuing to believe in their pet theories, there is one more reason for economists to portray confidence. Over the years, they have sold their subject as a science, if not to others, at least to themselves in their heads. I mean the first step before convincing anyone else is to convince oneself first.

Hence, the economic growth figure is forecast to the precision of one decimal point. I have always wondered about how economic growth, which is something very complex and is impacted by so many factors, can be forecast in such a precise way.

Now, this is not to say that the forecasting economic growth is not important. It is very important, simply because without that governments and corporations won’t be able to plan for the future.

Without knowing the economic growth number for the next year, a government wouldn’t be able to forecast its fiscal deficit or the difference between what it earns and what it spends expressed as a percentage of the country’s GDP. Without forecasting the fiscal deficit, the government wouldn’t know what kind of money it has to borrow in order to meet this gap. Without the government knowing the government’s borrowing target, the country’s central bank won’t be able to set the country’s monetary policy. And so on.

Nevertheless, the world would be a much better place if the economists started forecasting in ranges. Like, in 2020-21, the Indian economy is likely to contract by 8-10% or even 8-9%, rather than saying something as specific like the Indian economy is likely to contract by 8.3%.  In this scenario, the governments could also forecast a range when it comes to their fiscal deficit.

As John Maynard Keynes is said to have supposedly remarked: “It is better to be roughly right than precisely wrong.”

Hence, forecasting ranges and pointing towards the right direction is more important than being extremely precise about the economic growth.

As Tom Bergin writes in Free Lunch Thinking—How Economics Ruins the Economy:

“If economic models or theories can point us in the right direction and give us a reasonable estimate of the scale of a force or impact, they’re helpful. For example, if consumers are building up levels of personal debt that will require ever-rising house prices and wages to sustain – think the United States in 2006 –economists don’t need to tell us exactly how much a drop in GDP this situation will likely result in. If they can simply show the risks are unsustainable and material, this can prompt and inform government action and protect society.”

I learnt this the hard way. In 2013, when I first started writing about real estate, looking at the situation at hand, I started predicting a real estate bust very confidently. In the years to come, I turned out to be partly right, with parts of the country seeing a substantial fall in prices.

But the deep state of Indian real estate (the bankers, the builders and the politicians) essentially ensured that a real bust never really came. Of course, having learnt from this, now I point out more towards the perils of owning real estate at a price you cannot really afford because that is point people looking to buy a house to live in, essentially need to understand.

Also, one can more confidently say that the real estate sector will continue to remain moribund in the days to come, than confidently predict a bust. As far as investors are concerned, the real estate story has been over for a while.

Sometimes the confidence of economists comes from the prevailing narrative. As Daniel Acemoglu and James A Robinson write in Why Nations Fail – The Origins of Power, Prosperity and Poverty:  

“The most widely used university textbook in economics, written by Nobel Prize-winner Paul Samuelson, repeatedly predicted the coming economic dominance of the Soviet Union. In the 1961 edition, Samuelson predicted that Soviet national income would overtake that of the United States possibly by 1984, but probably by 1997. In the 1980 edition, there was little change in the analysis, though the two dates were delayed to 2002 and 2012.”

Of course nothing of this sort happened, and the Soviet Union broke up in December 1991. But those were the days, and the narrative framed around the success of the Soviet style of economics, driven by its Five-Year Plans, was very popular. Samuelson was not the only one to be seduced by it. In fact, an entire generation was.

Interestingly, the economist Phillip Tetlock has carried out extensive research on experts and their predictions. Gardner, from whose book I have quoted above, documents this in Future Babble.

As he writes:

“Tetlock recruited 284 experts— political scientists, economists, and journalists—whose jobs involve commenting or giving advice on political or economic trends…Over many years, Tetlock and his team peppered the experts with questions. In all, they collected an astonishing 27,450 judgments about the future.”

It turned out that the expert predictions were no more accurate than random guesses. As Gardner writes: “Experts who did particularly badly… were not comfortable with complexity and uncertainty. They sought to “reduce the problem to some core theoretical theme.” This means that they had this one big idea and they stuck to it, without trying to realign their view to the new information coming in.

An excellent example of this is all the gold bulls who came out of the woodwork post the financial crisis of 2008. They talked about gold reaching very high price levels (The highest I encountered was $55,000 per ounce).

As a journalist I interviewed many such individuals and the confidence they had in their forecasts was amazing. In that round, gold didn’t even touch $2,000 per ounce. But the audience lapped the interviews I did. Why? Because these experts exuded confidence in their interviews, even though they eventually turned out to be wrong.

In 2012, when I turned into a freelance writer, I exuded the same confidence on gold while writing about it. And when the prices actually started to fall, it sort of struck at a core belief I had developed over the years and it took me a couple of years to get around to the whole thing.

As Grant writes: “When a core belief is questioned… we tend to shut down rather than open up. It’s as if there’s a miniature dictator living inside our heads, controlling the flow of facts to our minds.” This is referred to as totalitarian ego and a decade later I can see this ego among many bitcoin experts, whenever one questions the entire idea of bitcoin as money, and that has me worried.

Now getting back to Gardner and Tetlcok. Experts who did better than the average of the group that Tetlock had recruited had no template or no big idea. They tried to synthesise information from multiple sources.

As Tetlock writes: “Most of all, these experts were comfortable seeing the world as complex and uncertain—so comfortable that they tended to doubt the ability of anyone to predict the future. That resulted in a paradox: The experts who were more accurate than others tended to be much less confident that they were right.”

This explains why most business TV news anchors, podcasters, YouTuber, social media influencers, etc., who are popular, sound very confident. They believe in this one big idea, which sounds sensible to people, irrespective of whether it is right in the real world or not, and they keep hammering it over and over again, to their audience.

It also explains why guys who are normally right about things aren’t really popular with the media or the public at large. This is simply because they are not totally confident about what they are saying. They have their ifs and buts built into what they say and are constantly revising the information in their heads. And as and when they feel like it, they are ready to revise their views as well. This constant revision comes across as lack of confidence to the world at large. Tetlock called such experts foxes and experts who believed in that one big thing as hedgehogs.

The categorisations were from an essay written by political philosopher Isaiah Berlin, in which Berlin had recalled a small part of an ancient Greek poem. “The fox knows many things… but the hedgehog knows one big thing.” After knowing this, it is easy to figure out who is a fox and who is a hedgehog.

As Gardner writes:

“If you hear a hedgehog make a long-term prediction, it is almost certainly wrong. Treat it with great skepticism. That may seem like obscure advice, but take a look at the television panels, magazines, books, newspapers, and blogs where predictions flourish. The sort of expert typically found there is the sort who is confident, clear, and dramatic. The sort who delivers quality sound bites and compelling stories. The sort who doesn’t bother with complications, caveats, and uncertainties. The sort who has One Big Idea.”

Hence, the kind of expert found in the media is the kind of expert who is more likely to be wrong. One of the key findings that emerged from Tetlock’s data was: “The bigger the media profile of an expert, the less accurate his predictions are.”

In a world filled with confident forecasts, this is a very important point that needs to be kept in mind. If we really need to make sense of the world we are in, we need to figure out who the foxes are and follow them, however mentally disconcerting it might be. The hedgehogs need to be discarded.