Aren’t Rajan and Jaitley on the same side?

Rumour had it that there was a split between the RBI and the Finance Ministry till January 15 when the RBI decided to announce a cut in the interest rates. Well, not rumours quite as they were fuelled publicly by the finance minister himself by blaming the RBI for the slowdown in the Indian economy. Early on there was also talk of removal of Rajan who was a Congress appointee. Let’s see if they actually were (are) at loggerheads?

Let’s first lay down the basis for the news of conflict. According to this view, the RBI controls the flow of credit (broadly speaking) in the economy. In this, it has the twin objective of controlling inflation and inducing growth in the economy. It can control inflation (created by demand exceeding what can be supplied) by reducing credit availability to those who spend, thereby, bringing demand for goods in balance with what can be supplied. It can induce growth by relaxing credit availability again to those who can spend, thereby, creating market for goods. With the lull in GDP growth continuing with the current dispensation, the Finance Minster (FM) shifted the blame on the RBI for it. He argued that the ‘acche din’ (read high growth) were around the corner if only the RBI could make credit available for this purpose. This, it was argued, is specially true given that inflation had abated and was not showing signs of rising any time soon.

In its defence, the RBI had said that they will wait for a rate cut till not just inflation comes down but there are visible signs of it staying low in the future as well. In addition, they wanted a commitment from the FM towards fiscal consolidation (i.e. keeping its deficit under control). Both these reasons have been quoted by the RBI governor during the announcement made yesterday.

To those outside the (boring) world of Economics but politically interested, this seems either like a deep-seated conflict or a subject not worth a discussion (latter more likely). My attempt here is to draw the latter into this discussion as it has important ramifications for the people and the former to see through the smokescreen created in the process.

Let’s look at whether credit availability (through the interest rate cut) will usher in ‘acche din’. The operative word here is availability. While the RBI can influence its availability (potential credit supply), credit will actually come into being only once it is demanded in the economy. The assumption, therefore, is that with the fall in the cost of loans, there will be an increase in spending by the corporations on their unfulfilled investment plans as well as consumers on durables (like cars) and housing. With the increase in such spending, other things remaining the same, there will be an increase in growth and consequently in employment.

However, these spendings might not increase.

For the corporations, it is not just the cost of loan but the expectations about sales (in most cases it’s primarily the latter that matters) that determine their decision to increase spending. An automobile or software corporation will not increase spending if its existing plants, offices are under-utilised. And in a depressed economy, the expectations about sales are likely not to be high.

For the consumers, it depends on their current and expected income streams (which itself will depend on the level of overall past spending in the economy) and not just how cheap are the home or consumer loans. If I don’t have a job or a poorly paying job as a result of a depressed economy in the past, any amount of cheapening of loans is not going to induce higher spending. Also spending particularly on realty depends on speculative gains associated with the purchase of a property which is likely to be low in an economy where such purchases in the recent past have not been high.

What is possibly true of a rate cut in an economy where the spending is anyway high might not hold true generally. It will not take a genius to see that this is a chicken-and-egg problem. This vicious circle cannot be broken unless there is some exogenous intervention through direct spending rather than an indirect signals through rate cuts.

Such direct spending, which is not a victim of this vicious circle (i.e. it does not depend on the past level of spending itself) can only be the expenditure by external agents, external to this circle, i.e. the State or foreigners (export demand). The growth regime followed by the current dispensation which believes in the State withdrawing from spending (fiscal consolidation) has hardly any scope on the first count. On this, both Rajan and Jaitley are unequivocal but their concerns could not have been more misplaced as discussed here. As for the latter I have discussed the limitations in my last post.

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