COLUMN: Why we should welcome a recession

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Finance Minister Nirmala Sitharaman | PIB

Subramanian Swamy is often accused of propagating outlandish ideas and suggestions, but at least on the issue of addressing a slowdown in India’s GDP growth, he seems to be closer to the truth than India’s ruling establishment.

Both Sitharaman and Swamy are united in recognizing the need for a ‘stimulus’ to nudge the economy from the sluggishness that seems to have got hold of it of late, but differ on the details.

While Swamy’s plans seem to emphasize putting cash in the hands of the consumers, the government’s measures have so far focused on putting more money at the disposal of the producers (companies).

It is, by now, considered almost a religion among central bankers and finance ministries the world over that when an economy starts to slow, an artificial boost must be provided in the form of cheap credit and/or tax cuts.

The biggest stimulus move so far this season has been the corporate tax cuts announced last week. Government expects that the tax cuts would make available an extra Rs 1.45 lakh cr, or about $20.50 bln.

What if we are rushing down the wrong path? Going by the evidence of countries like USA and China, it seems more and more likely that some of the medicine that Sitharaman is delivering will eroding our economic competitiveness in the long-term and return us to the days of the ‘Hindu growth rate’.

REPEATING THE MISTAKES?

The measures being delivered as ‘economic stimulus’ are modeled on what the US and Chinese governments did in the aftermath of the 2008 financial crisis.

While the US tried to stimulate private sector activity by slashing interest rates to almost zero — essentially giving ‘free money’ to corporates to spend– the Chinese kicked off a massive investment-driven stimulus via cheap credit to government-controlled companies and local governments.

The theory behind these cash infusions was simple: When companies get so much money ‘free of cost’, they would start spending it on new projects and investments, and this would create new jobs, which would create income, which would create spending, which would create demand for the companies and so on. Spending, in this theory, refers to building new factories, opening new retail outlets and so on, all of which create new jobs and permanent livelihoods.

However, there was just one problem with the whole theory — it simply didn’t match up with what really happened on the ground.

For example, in the US, companies took the money, but did not see the logic of using that money to put up a new factory or open a new outlet when their existing factories and outlets were running at half capacity, much like India’s car factories.

And they were running at half capacity not because companies lacked funds, but because consumers were scared of making new purchases, especially of big ticket items like cars and real estate, because they were uncertain of their future.

So, what did these companies do with the cash?

They could hardly put it in the bank, because interest rates were close to zero.

So they did the next best thing — they invested it in stocks; their own stocks, to be precise.

In other words, they channeled this money to their shareholders via what are called share buybacks.

It is estimated that US companies have returned over $3.5 trillion (Rs 250 lakh cr) to their shareholders via share-buybacks since Jan, 2011.

This money, originally meant for investments into business development activities, ultimately ended up as fuel for speculation on various asset classes, including stocks, real estate and even art.

While this may sound like a harmless outlet for excess funds, it actually had the opposite impact to what the government intended. Since the money reached only those who held shares in these companies, it only made investors richer.

These investors started investing their funds across assets — including real estate, stocks, art and even bitcoin.

So, instead of making lives better for those whose jobs were taken away by the recession, the stimulus helped to take many assets, particularly real estate, more and more out of reach of these people, making them feel even poorer.

The working class people, whose their incomes and quality of life continue to remain in the dumps, tried to rectify the situation by electing Donald Trump, who at least seemed to be cognizant of their condition and even promised to return them their jobs. That promise is yet to be delivered, despite attempts such as the annulment of job-depleting free trade agreements and the institution of punitive tariffs against China.

It therefore remains to be seen if the dissatisfied US voter continues to look for a more radical option in 2020 or gives Trump’s policies another chance.

The situation was somewhat different in China, given that the companies that received massive amounts of low-cost credit are owned and controlled by the Chinese Government. As such, returning the cash to investors or depositing it in the bank was not an option.

Chinese companies and local governments were forced to spend, and spend they did. They created new roads and bridges and even put up entire new cities of steel and glass.

The problem with the Chinese approach was that companies and local governments were often forced to spend the money on projects that they would otherwise not have touched because of concerns over economic viability.

So, roads were built to nowhere and bridges were even built on solid ground with nothing underneath them. Spanking new ‘ghost cities’ sprung up with not a soul in sight.

Given that many of these projects are economically ‘pointless’ and yield no return, the huge investment-based stimulus from 2009 to 2016 has created a new question of how the debt will be serviced, if not repaid.

And just like the ill-designed US stimulus package contributed to the overthrow of traditional politics and the rise of a ‘radical personality’ like Trump, it is quite possible that an economic crisis arising of out of all the bad loans in China could have severe consequences for the Chinese Communist Party.

LESSONS FOR INDIA

The US and Chinese attempts to counter a cyclical, and corrective, downturn by forcing cheap money into the economy holds valuable lessons for India as well.

India has so far been ‘collateral damage’ for the policies of the US Federal Reserve as a chunk of the ‘free money’ ended up in Indian asset markets. However, the latest attempts by Nirmala Sitharaman suggests that the government is trying to ape what the US Fed did in the wake of the 2008 recession.

And it’s not just the US model — of providing cheap money to private companies — that Sitharaman seems to have zeroed in on.

The Finance Ministry is also trying to copy the Chinese model, and has asked public sector companies to accelerate their investments. Like in the Chinese case, this has the potential for creating financially unviable and unsound investments that would turn into ticking time bombs later.

What Sitharaman can do is learn from the experience of other countries who have tried to control this natural cycle of any market-driven economy. Periods of exuberance and hyper growth are followed by periods of caution and slow growth.

Like forest fires, downturns serve a cleansing function, purging companies that are careless with their investments and growth plans, and leaving only the healthy, robust ones to grow in their place.

Trying to keep bad businesses afloat via cheap, inflation-funded credit will only serve to make the entire economy sick. However, allowing the cyclical downturn to do its cleansing function will re-invigorate the economy and help it grow much faster in coming years, despite some short-term pain.

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