From UPSC perspective, the following things are important :
Prelims level : Minsky moment
Mains level : Paper 3- Policy intervention needed for recovery of economy
In recent times, several economists have been arguing that the Government does not need to do anything with the economy. They argue that like after the Great Depression, the economy rebounded worldwide, and so will it with us. The argument is fallacious on four accounts:
Four factors that make recovery different from the recovery after the Great Depression
1) Demand destruction
- In the case of the Great Depression, demand was created by the Second World War effort, especially in the United States.
- Demand destruction: In the current scenario, the COVID-19 pandemic has resulted in demand destruction.
- This is because many jobs have been lost, and even where jobs were retained, there have been pay cuts.
- Both of these trends were confirmed in the Centre for Monitoring Indian Economy and other surveys.
Bright spot on export front
- The only bright spot in this dismal scenario is that the western world has spent a lot of money stimulating the economy.
- However, the Indian exporter face the challenge of rising freight costs and structural issues such as a strong rupee relative to major competitors.
- Only the Indian IT sector is placed well to capitalise on rising demand in the world markets.
2) Inflation and factors driving it
- India is suffering from stagnant growth to low growth in the last two quarters.
- As in the low initial base set by last year, almost any growth this year is seen as a significant growth percentage.
- Commodity prices and monetary policy: Inflation in India is being imported through a combination of high commodity prices and high asset price inflation caused by ultra-loose monetary policy followed across the globe.
- Liquidity infusion: RBI is infusing massive liquidity into the system by following an expansionary monetary policy through the G-SAP, or Government Securities Acquisition Programme.
- Foreign portfolio investors have directed a portion of the liquidity towards our markets.
- India has a relatively low market capitalisation, therefore, India cannot absorb the enormous capital inflow without asset prices inflating.
- Supply chain issues: Additionally, supply chain bottlenecks have contributed to the inflation we see in India today.
- Rising fuel prices: India’s usurious taxation policy on fuel has made things worse.
- Rising fuel prices percolate into the economy by increasing costs for transport.
Impact of inflation
- The middle and lower-middle-class get destitute due to regressive indirect taxes and high inflation, with their wealth eroding due to said inflation.
- Especially in the case of the lower middle class, inflation is lethal as they do not have access to any hard assets, including the most fundamental hard asset, gold.
- The increase in fuel prices will also lead to a rise in wages demanded as the monthly expense of the general public increases.
- This leads to the dangerous cycle of inflation and depleting growth.
3) Interest Rate
- The only solution for any central banker once he realises that inflation is entrenched is tightening liquidity and further pushing the cost of money.
- If this does not dampen inflation, repo rates will need to go up later this year or early next year.
- Tightening the money supply is a painful act that will threaten to decimate what is left of our economy.
- Rising interest rates lead to a decrease in aggregate demand in a country, which affects the GDP.
- There is less spending by consumers and investments by corporates.
4) Rising NPA and its impact on credit growth
- Rising interest rates, lack of liquidity, and offering credit to leveraged companies instead of direct subsidies to support small and medium-sized enterprises (SMEs) and micro, small and medium enterprises (MSMEs) to counter the COVID-19 pandemic and its effects will result in NPAs of public sector banks climbing faster.
- Our small and medium scale sector is facing a Minsky moment.
- The Minsky moment marks the decline of asset prices, causing mass panic and the inability of debtors to pay their interest and principal.
- India has reached its Minsky moment.
- This means that the public sector unit and several other banks will need capital in copious amounts to make up for bad debt.
- The Union government’s Budget is in no position to infuse large amounts of capital.
- As a result of the above causes, credit growth is at a multi-year low of 5.6%.
- Indian economy is in a vicious cycle of low growth and higher inflation unless policy action ensures higher demand and growth.
In the absence of policy interventions, India will continue on the path of a K-shaped recovery where large corporates with low debt will prosper at the cost of small and medium sectors. This means lower employment as most of the jobs are created by the latter.