Remedy For Recession

T he full depth of the recession has not yet unraveled. The authorities continue to follow unwise policies by borrowing heavily from the markets thereby keeping the structure of interest rates at too high a level. The finance minister has cottoned on to the point that a single minded preoccupation with inflation led to an excessively restrictive policy. But judging from his explanations in the Lok Sabha, he is a devotee of the quantity theory of money. So much so that he offered a mechanistic formula which claimed the rate of inflation was directly and causally linked to the money supply. So far so good that is standard monetarism. But then he went and borrowed something from a speech by the governor of RBI and misunderstood it to the point of making the ludicruously precise suggestion that an x amount of increase in M3 leads to a y per cent rate of inflation. Economics is not half as simple as that as he will discover.

 

However the state of monetarism is not important. Much worse is happening in the real economy than is apparent on the surface. We are rapidly moving into a frightening state where interest rates are falling too slowly to keep up with the fall in the rate of profits. First class borrowers are still paying 13 per cent on commercial deposit when the inflation rate is below 6 per cent. This cannot go on for long. These high rates are only obtainable because companies are desperately shoring up their balance sheets. It is one thing to show profits by an optimistic valuation of inventors; but valuations do not provide liquidity. To get cash you need to sell goods. On todays balance sheets bankers would be fools to lend money. They are made up of receivables and stocks not income and cash.

So what should be done? The finance minister, like Eliza Doolittle, must be sick of words from economic commentators. We have nothing better to do than talk and write while he has to take the risks. Yet this division of labour has one advantage; we can allow our imaginations to range over a wider spectrum than officialdom can. If we say something outlandish it can safely be ignored and discarded with the morning cup of tea. He can then proceed to his office and think of weightier matters in a ponderous manner. Like Pagliaccis buffoons, we convey serious messages behind our clownish masks. We suffer or live the same gladness or sorrow as our weightier and more responsible colleagues.

But all this is a diversion. I must return to my question What should be done? There are of course many tentative solutions. There are those who will recommend an immediate revival of public sector capital investment. I imagine that are those who blame all our difficulties on infrastructural bottlenecks. Set up a few power projects and all will be well; unfortunately the malaise in the economy is much wider.

It seems to me that the only solution is a sharp reduction in long term interest rates; again nothing particularly startling about that. The government is fully alive to the need for a lower interest rate. But the startling piece of my conclusion is that you need to literally halve the nominal interest rate from the present 12 per cent or 13 per cent on five year paper down to 6 per cent or 7 per cent. A cut of 1 per cent or 2 per cent will do little good as we can see from the cut that has already been affected. The difference in perception between the establishment view and mine is that the orthodox measure the cut in interest rates from what they were previously while I look only to the real interest rates prevailing and compare it to the expected rate of return on capital in the real economy.

The wide fall in inflation rates has raised the level of real interest rates to unsustainable heights. In no economy since the beginning of time have new projects been able to achieve a return of 7 or 8 per cent in real terms. These things at the arithmetical level are very easy to work out by the familiar techniques of discounting and compounding. In a fanciful exercise Keynes once calculated that the entire wealth of England was equal to the forty thousand pounds that Drake had brought home on the Golden Hind invested at 3 or 4 per cent. Working backwards we can surely conclude that if the economy could earn 7 or 8 per cent in real terms on a sustained basis, we would already be far ahead with the few investments made in the last century.

The truth is that the return to investment over long periods is unlikely to be more than 2 or 3 per cent. The expected rate of return that businessmen calculate after making allowances for risk and uncertainty is even lower. In such an environment a high interest rate regime is disastrous. However once it is introduced you need a very sharp fall in interest rates to reverse perceptions. The simple way of doing this is to allow inflation to creep back in again, but that is probably throwing away all the good that an anti-inflationary regime has done. For there is no doubt that during the present recession industrial productivity has improved through a severe exercise in cost cutting. If therefore we are set on an anti-inflationary policy the only logical corollary is to introduce a low interest rate regime.

The painless first step to such a regime is to scrap all controls on borrowing from abroad. Those who have the knowledge and skills can then reduce their interest costs somewhat by taking exchange risks. But the better solution that would have a much wider impact would be for the Reserve Bank to slash the rate on long dated bonds down to 6 per cent or lower.

Sadly there is no prospect of such a dramatic turn in the interest rate regime. So equally there is no prospect of an end to the recession. Every second day we shall read about absurd actions like that of the Prime Minister holding a meeting on exports, as if that can increase exports, or the finance minister undertaking a padayatra to persuade industrialists to invest as if that will change the expected return on investments.

What we need is not exhortations but a very much more flexible regime of economic administration. We need men in authority who have the capacity to observe and re-act to the changes taking place in the economy. It was in fact self-evident that the present recession was heralded by the very tight monetary regime last year. Some of us wrote about that but we were dismissed as mad Keynesians. However continuing in a Keynesian manner, the finance minister should beware from believing that reversing the present policy will reverse the consequences. The tightening effected the real markets dramatically and he may have to do a lot more to put that right, but cutting interest rates would be a good beginning.