Income volatility: The new gorilla in the room

As the economy begins to recover, the government has to decide on a stable medium-term investment and consumption policy. So far it has been focusing on reviving output. That approach may now have reached its limits. There isn’t much more to be done, except by way of new investment.

But, along with production and investment, consumption, too, needs to be revived. This is a much more difficult proposition, made all the more so by the absence of a theoretical underpinning or framework.

All we have now is the plain vanilla Keynesianism of the “let them have money”. But that’s the equivalent of “lazy banking”. It is in this context that I draw attention to a now long forgotten theory.

A little while ago, Niranjan Rajadhyaksha, research director at the IDFC Institute, drew attention to a tweet from a student somewhere. The tweet reminded us of Milton Friedman’s Permanent Income Hypothesis, formulated in the mid-1950s.

The hypothesis is that in deciding their consumption people take a view on what they think their lifetime income will be, and adjust, or space out, their consumption accordingly. Thus artificial boosts to income — like cheap credit, tax cuts, and out-of-turn increments — will only have a temporary effect.

For a more permanent and lasting effect, you have to look at income expectations over a lifetime. This is a crucial insight for future policy.

A new kind of volatility

I had written last September about the new sociology of consumption in India. My proposition was that urbanisation has created a hybrid between a joint family and completely nuclear family.

The end result of this is that while income is now being earned largely by one member of the family, or at best two, costs that had been spread over many more income earners were now concentrated in just the one or two income earners.

Not just this. There has also been a massive increase in inelastic overheads imposed by health, education, communication, and entertainment. This has meant a new pattern of savings and expenditure, both declining.

This, in my view, has acquired a new salience post-2020 because income earned from jobs in the formal economy will now gradually form a smaller proportion than income earned from non-jobs, i.e. shall we say, consultancies. The Americans call it the gig economy where between 80 and 90 per cent of the income is earned from fees and not salaries.

Given the level of competition in the labour markets, this exerts a downward pressure on incomes. This is what we have seen since 2011. This is what, in my perhaps limited understanding, explains the decline in the rate of GDP growth.

Just think about it. If your family income was not steady but depended on how many consultancies you got, what sort of view of lifetime income expectation would you form?

An income issue

This is not as bizarre a question as it sounds. In fact, it is the norm in the informal sector. Thus, of India’s 600 million income earners, as many as 550 million don’t earn a steady monthly income. They earn alright but only intermittently.

Some highly skilled people like doctors, lawyers, architects, sports persons, and other professionals earn a lot. But most others, including, say, small shopkeepers, earn very little.

And not just that: They are being joined daily by others whose incomes have plummeted. We are thus in a low-income, high-volatility trap. That is, we are back to the pre-Second World War era in the labour market.

In other words, the consumption problem is one of high volatility in incomes. Let me emphasise: It is not one of total income or its distribution. It is one of volatility.

This is the sea change that the virus and new technologies like artificial intelligence have — and will have — wrought in the next five years. This is the problem that policy has to tackle — how consumption can be increased on a secular basis when income is so volatile?

This leads to an even more fundamental question: Is it possible to eliminate or hugely dampen volatility? India’s political class has tried to do this by becoming the largest employer of low-productivity jobs. But the fiscal limits to that were reached long ago.

The correct answer may well lie in recognising that with the massive dilution or total absence of consumption-led growth, we are in for a prolonged or even permanent period of less than 7 per cent growth. If a third as usual comes from agriculture, what does it mean for the other two sectors?