#39 Dispelling The Many Myths of Our (Mythical) Readers Part #1

Everything you always wanted to know about the economy* (*but were afraid to ask)

This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?

Welcome to the mid-week edition in which we write essays on a public policy theme. The usual public policy review comes out on weekends.

— Raghu Sanjaylal Jaitley & Pranay Kotasthane

As many might have helpfully reminded you a million times recently, these are unprecedented times. We, at this newsletter, laugh it off because we don’t believe in the arrow of time. There is no past, so, where is the question of a precedent? But you have to admit things are a tad unusual. When you see Trump holding a bible in front of a church and priests baptising babies with water guns in scenes even Tarantino’s mind would have struggled to imagine, you can’t simply shrug your shoulders and say whatever.

There are other ominous signs around as well. Whatsapp messages exhort us to boycott videshi products with helpful sectoral desi-videshi segmentation charts, TV news anchors shake our conscience with questions on why do we import diyas and agarbattis from China, the PM gently nudges the industry towards import substitution and the DGCA insists the middle seat passengers of airlines must wear ‘wraparound gowns’ that meet the diligently approved gown standards proactively set by the ministry of textiles.

Such events raise many questions in the minds of our readers. So, we thought it is best to wheel out our parampujya guru of economic reasoning, Prof. Arthananda Ilyich Smith-Hayek (AISH), to help us with answers. Prof AISH is a home-grown economist without a single videshi bone or cartilage in him. He is a veritable sangam of three key economic streams – Neoclassical, Marxist and Austrian – whose advice can be safely consumed in these low trust times of lateral surveillance. Over to our readers and their questions.

Q1. Dear Prof, we are a big country with so many talented people. NASA, Google, Microsoft, Whatsapp, Pornhub – all these great institutions will collapse if we Indians decide to boycott them. Why shouldn’t we make everything in India and become a world leader? Why shouldn’t we substitute all these with Indian products? (ok, except Pornhub).

                                                                                                Yours etc

                                                                                                Bharat Jayjaykar

Prof. AISH: Dear Bharat, there’s no reason why we shouldn’t aim to be more self-reliant by making more products domestically. But like most things in life, we should be careful about how far we go with this philosophy. Taken to an extreme, this will lead to autarky. Not a good outcome. Let’s first look at what happens if we stretch self-reliance beyond economic reason.

Consider your family as an economic unit. Maybe you run a company that manufactures solar panels and your spouse works for an IT services company as an engineer. You have school-going kids who are dependent on you for their needs. You employ a cook and domestic help at home. You and your spouse like spending time at your kitchen garden during your leisure. As your garden blooms with herbs, vegetables and flowers, you realise the price you pay for them in the market is exorbitant compared to what it takes to grow them at home. You are soon questioning everything you buy from the market – milk, juices, clothes, soaps, food grains, your kids’ tuition and entertainment. Everything would be cheaper and safer if you made them at home. You can see where this is going. Would you start making all of them at home?

You find the question absurd. The obvious answer is no. Why? First, you don’t have time to make all of them at home even if you devote all your spare time and consider putting your kids to work on them too. Also, you won’t be good at raising cows, tailoring or at growing paddy in your garden. Lastly, you and your spouse are good at your jobs. If you spend your time learning more about your work, you will get richer rewards. So, it just doesn’t make sense for you to make everything at your home. Sure, you will still do a few things predominantly at home. For instance, you can’t imagine eating restaurant food every day. So, you will cook food at home on most occasions. Or, maybe you will always use herbs from your garden than buying it from outside. But these will be limited based on your priorities.

It is actually not a huge leap of imagination to extend this model to a country. There are natural resources, climate, land, technology and people that any country is endowed with for it to use productively. A country gets better at producing a few goods or services over time while it either doesn’t have resources or expertise in making others. So, it buys them from other countries who are good at making them. Now, it is possible that the country has spare resources (people or otherwise) that it can put to use to make a whole lot of things within its boundary. The question is which of these things the country should start making at home than buying from outside? The country can’t indiscriminately decide to make every single product at home. The criteria to decide this could include – what it might be good at making based on its assessment of our capabilities, what it could make in large volumes so it might even sell it to others and profit, and what could be high on priority for it like safety and security of its citizens.

If you follow the above, you will realise we have to carefully choose our bets in areas we want to be self-reliant. This will yield a smaller basket of products and services that we can target in being world-class producers.

We must not forget if we start closing our doors to others indiscriminately, they will start doing the same to us. This will be a zero-sum game. Specialisation and comparative advantage are real constructs. They help everyone gain. It is obvious to us when we apply that to our daily lives at homes. It can seem a bit non-obvious when we think of it for a country as large as ours. But, trust me, it is no different.

Also, there’s a paradox in pursuing the goal of self-reliance for any country. Let me explain how.

One can be self-reliant at multiple levels. The highest level (level 1) of self-reliance is when an economic unit can produce and consume everything by itself. No country in the world has reached this level.

The slightly relaxed condition of self-reliance (level 2) is when one can afford to buy what they want irrespective of who produces it. This level can be achieved by becoming rich. If you are rich, you can pay to buy any service you want. Even if the service provider asks for more, you have the wherewithal to buy that.

The lowest level of self-reliance (level 3) is when you cannot produce what you want and neither do you have the economic wherewithal to afford everything you wish. However, you do have enough diversified relationships with many producers of items that are really critical for you. So, you get what you want in your time of need from at least one of them.

India seems to aspire to reach level 2 – the slightly relaxed condition of self-reliance. Fair enough. To get there, we need to become rich. To get rich, we need investment and expertise from abroad. In other words, you need to rely on others. Just like Japan, China, and South Korea did on their journey to get rich. So, and this is important for you to understand, how we proceed towards becoming self-reliant is just as important as the goal. If we close our economy to the world in our search for level 1 self-reliance, we will not even achieve level 3 self-reliance.  

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Q2. Dear Prof, the GDP numbers for Q4 FY 19-20 were released a few days back. As usual, anti-nationals have started questioning the health of our economy and, this week, that mediocre, retired Aussie all-rounder, downgraded our sovereign rating from Baa2 to Baa3. Who really cares about a measure called GDP, tell me? Does it measure how our family bonds are growing stronger every day as we collectively delete Chinese apps? Or, the feel-good factor of being safely ensconced within our homes with our families during the lockdown? Our GDP would have grown by 100 per cent if you accounted for these vital goods. Should we really give such a flawed measure any importance?

                                                                                              Yours etc

                                                                                                Diya Bannerji

Prof. AISH: Dear Diya, there’s something right about your view but a whole lot wrong. There wasn’t a defined notion of GDP until the early part of the 20th century. The governments kept themselves distant from the economy and there wasn’t a need felt for a holistic national view of it. In the US, this changed with the Great Depression. As the government intervened to stimulate demand on the back of Keynesian principles, it became necessary for it to have a comprehensive view of the national income. The Department of Commerce called upon Nobel laureate Prof Kuznets to develop the first set of national accounts. By 1942, this estimation of national income became an annual affair, and this helped the US government plan their wartime efforts. Soon another Nobel Laureate, Wassily Leontief, was drafted into the team and he built the first input-output account for the economy.

It is widely acknowledged the development of national income account and its segmentation helped the US calibrate its response to the Great Depression and mobilise war efforts in a planned way. The subsequent post-war boom strengthened the need for greater details on the gross national product and, over time, as data gathering became scientific and the economy more formal, GDP and its details became important tools for economic policymaking. Other countries followed suit and soon GDP became a widely accepted measure for the health of a economy.

Like any measure, GDP has its failings. For instance, it makes no distinction on quality of growth. A government spending on war or investing in polluting industries will show an uptick in GDP though these may not be the right choices for its citizens. It also doesn’t factor non-market transactions like the food your dad makes for you or the happiness in your family Whatsapp groups because all of you have deleted TikTok. Also, GDP being a gross measure won’t tell us how the income is distributed among the citizens or if the equity in the society is improving. Lastly, there’s more to life than income; GDP doesn’t measure the health, education and well being of the society. It also says nothing about the environmental cost of growth.

However, here’s the rub. Despite all of the above, it tells us a lot and at a regular frequency. More than any other measure, it gives a comprehensive view of input-output across sectors and their trends over time. A specific policy intervention in any area can be made on these. The rate of growth in GDP is a shorthand for how the economy is faring and a useful way to compare different economies. GDP growth rate also helps the central bank in determining future interest rates based on what is called the Taylor rule instead of using the backward-looking rational expectations theory.

Also, the complaint that GDP doesn’t measure the environmental cost or equity or happiness is ill-informed. Do you measure Virat Kohli’s worth by counting the number of goals he can score? You don’t because that’s not the game he plays professionally. GDP is an approximation of national income, nothing more and nothing less. And I would argue, it is still the most important indicator to prioritise for a country like India where one in five are not able to earn enough to survive. That makes higher GDP a moral imperative for India, not just a good-to-have luxury that can be traded-off for something else.

In summary, the GDP measure is like the report card of a kid at school. You can always argue the report doesn’t measure her real knowledge, her potential and can’t be a good predictor of her future success. These aren’t always easy to measure objectively. Or, that it gives undue importance to tests and assessments. But you can’t dispute it measures something important that gives you a good sense of the child’s progress. Not having that measure would make things worse. GDP is somewhat like that.  

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Q3. Dear Prof, a few weeks back the PM announced a Rs. 20 lakh crores economic package that made us all so happy and proud. UN has already declared our package as the most impressive in the world. All of us are already feeling so good because of it. Stock market has zoomed too. My request is to have such packages announced every quarter, if not every month. Why can’t the RBI just print money and the government announce packages all the time? I am telling you, Prof, this will keep the josh of the nation high.

p.s: It is becoming tedious to rewatch ‘Uri: The Surgical Strike’ once every month.

                                                                                                Yours etc

                                                                                                Joshua Joseph

Prof. AISH: Dear Joshua, we are in a pandemic induced economic crisis. Demand has collapsed and supply chains have been severely dislocated. Everyone wants the government to help. How can it help? One simple way is to send a Rs. 1 lakh cheque to everyone in India. But how will the government fund this largesse? It doesn’t have money lying around in its bank (the RBI). In fact, the government runs a deficit every year where it ends up spending more than what it earns. For the year 2019-20, this deficit was about 4.6% of the GDP or about Rs. 9.35 lakh crores. That is the government ran losses by that amount during the year. How does the government manage then?

It issues bonds that guarantee a certain interest which banks, insurance companies and others buy. This funds the government. Of course, implicit in this is the belief that someday the government will turn a profit and be able to pay off its debt. But that’s in the future and we aren’t too bothered about our future generations holding the can. But remember, today’s deficits are tomorrow’s taxes. Every rupee overspent today is at the expense of future generations. For instance, out of every one rupee of the Union budget 2020-21, 18 paise is allocated to the interest on previous loans alone! We are already paying significantly for the sins of our past.

If the government bond market isn’t ready to absorb a huge amount of bonds issued, then the RBI can directly buy them (this isn’t allowed currently but we can change the rules). In simple terms, either RBI buys bonds indirectly through OMO (open market operations) or directly by printing money to fund the deficit of the government.

What if the RBI continues doing this every quarter based on the guidance from the government? Three things will happen.

One, there will be more money that will chase the same goods and services. This will increase the prices of those goods and services. This is inflation. It is more likely in a developing country like ours where the informal economy is still quite large, and the tax base is small. This means there is limited use of money for paying taxes by the citizens which could have cushioned the inflation. If there’s indiscriminate amount of money pumped in, the result will be hyperinflation where the prices go through the roof and the value of the savings of people turns to dust in quick times.

Two, let’s for a moment assume there is significant demand destruction that has happened because of the lockdown. So, when the government deposits Rs. 1 lakh into everyone’s bank account, people will want to buy things. The manufacturers who are running their plants at a much lower capacity than usual can step up their production and meet this demand without triggering inflation. What happens next? Well, eventually, the money spent by people moves into the bank accounts of others (retail stores, manufacturers etc). The banks will then have to find ways to use the money that’s come back to them. They will either lend it or, in a tough environment, they will park the money with RBI at what’s called the reverse repo rate. The RBI has been trying to discourage this over the last 2 months. It has cut this rate from 4.9 per cent to 3.35 per cent. But banks continue to park their funds in this since they are reluctant to lend. In effect, RBI prints money and a lot of it comes back for which it has to pay an interest. Printing money isn’t free. RBI pays 3.35 per cent for it.

Three, if the RBI is simply printing more money, what will foreign investors who hold assets in Indian rupees make of it? They will fear further value erosion of the stocks or bonds they hold, and they will sell them. Since US dollar is the reserve currency of the world, they will ask to be paid in it. The demand for dollar will go up and the value of rupee will depreciate in relation to it. A rapid fall in rupee over a period of time can trigger a currency crisis. There isn’t any immediate prospect of this since our foreign reserves are quite high. But a sustained fall of rupee can eventually get us there.    

On the balance, a one-time stimulus to revive the economy is fine but we can’t make it a habit. You can’t lift yourself by pulling at your own bootstraps.

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