Economics in the Time of Corona (COVID-19): Digging into the Past Can Help
The year 2020 has commenced on a very bad note. The novel Coronavirus, now COVID-19, emerged in mainland China around January and has spread to over 170 countries. In a world where the existing body of work on economics was struggling to explain prolonged economic headwinds since the 2008 crisis, the pandemic has ensured that this struggle continues for some more time as there is no settled link between models of economics and those in epidemiology.
 
The peculiarities of the post-2008 world were always visible and, yet, were conveniently ignored. The rate of interest remained low in most parts of the developed world, but economic growth never picked up to what was its potential. The unbated expansion of money supply did not deliver inflation and prices of commodities, manufactured goods continued to fall, while those of financial assets rose. However, the final link appears to be snapping with the conterminous fall of the Dow when the Federal Reserve of the US cutting the benchmark interest rate to near zero,.    
 
Then, financial markets saw something that was unheard off in standard textbooks of finance—sovereign bonds carrying a negative interest rate. The new trend has caught up and around a quarter of all bonds issued now have negative interest rates. A negative interest rate is a virtual deathknell for banks, unaccustomed to charging a fee for placing deposits with the bank. 
 
Back at home, just like COVID-19, the economy was showing asymptomatic signs of distress. Even though the savings rate was falling, the growth outlook continued to be optimistic. Then slowly, the decline in consumption, which was already visible in sticky GST (goods and services tax) revenue collection, also became pronounced. The price of capital goods fell dramatically relative to other prices in advanced and emerging markets and developing economies alike, notes the IMF (International Monetary Fund) in April 2019. Yet, investments continued to remain stagnant.  
 
In a bid to steer the economy to a higher growth path, the RBI (Reserve Bank of India) adopted an inflation targeting framework in 2016, when it was not delivering desired results anywhere in the world. Since the adoption of inflation targeting, the repo rate has been cut to 5.15%, but surprisingly, both the GDP growth and repo rate have moved in the same direction—southwards. The rate of transmission continues to be weak, and even when MCLR (marginal cost of fund-based lending rate) credit has not picked up. Now, RBI is reviewing the flexible inflation targeting framework internally! 
 
Since we live in the time of Corona, it may be useful for us to adopt a trick quite well known to doctors, but not to economists. Doctors, at times, treat antibiotic resistance by prescribing an older version of the medicine, which is no longer prescribed. Thus, going back in the annals of economic history may provide a good vantage point to revisit some of the naïve assumption we make today.
 
Apparently, there is one problem with this approach. It is not clear which lens of economic theory is best suited to view India—is it the new Keynesian lens, neo-classical or neo-liberal etc. But if we ignore this for the time being, then literature of the Austrian School provides some useful insights. 
 
In his work, the Theory of Money Credit & Interest Rate, Ludwig Von Miss investigated the theoretical possibility of reducing interest rates to zero. This, of course, is true only under the assumption that fiduciary media enjoy the confidence of the public. But if the time preference (that is willingness to postpone or prepone future consumption) becomes agnostic to changes in interest rates no amount of policy rate change will impact real activity. The present state of affairs is no different. Hence, at time of Corona, RBI must think twice whether it should reduce interest rates further in response to the COVID-19 crisis.
 
Another scholar from the same tradition, a son of the soil, BR Shenoy, wrote two important papers in 1932 and 1934 on how the price of consumer goods and capital goods interact to determine overall price level. He challenged the Keynesian notion that banks have the direct capacity to determine the price of capital goods.
 
He conclusively demonstrated that the “banking system in whatever way it may behave cannot directly influence the price of capital goods.” Mr Shenoy’s logic suggests that to emerge out of the slough of a credit cycle, savings must be promoted, which internally adjusts the current account. The policy must address the reasons for erosion of profitability in the domestic capital goods sector. A combination of the above will reverse the deflationary trend and expand the GST base.
 
Sadly, the entire range of policy responses is exactly in the opposite direction. The effort is not to promote household savings but consumption. As a result, deposit rates have been slashed across the board. A better option would have been to link deposits of the government sector, private corporate sector, financial sector and foreign sector (with respective shares in the total of 14%, 12%, 8% and 10%) to an external benchmark, say G-Sec, while leaving household deposits at fixed rate.
 
This would have brought 44% of the banking system’s liability to market-based pricing, enabling better transmission on the asset side. Measures like operation twist would have a better chance of success if the liability side of the banking system is linked to an external benchmark as explained above.  
 
In conclusion, there is a long way to go before an economic understanding of India, on its own terms, will develop both in RBI and in the government. The voices of those rare experts who understand India on its own terms never make it to the menu of options. Hopefully,  these voices will get seriously heard in the time of Corona which has opened a window of opportunity to initiate serious structural reforms. 
 
(The author is an economist in the banking system. The views expressed here are personal)
Comments
Ramesh Popat
2 years ago
will India's rating be the same as it is?
chandragupta
2 years ago
Such a pleasant surprise to see someone write about Austrian School of Economics, Ludwig von Mises and even B.R.Shenoy! You have hit the nail on the head - the entire mainstream economic thinking is wrong. Until the world gets rid of this, global economic problems will not be solved. But who wants them to be solved?
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