Overheated economists

India is sui generis in details. Development Cassandras forget this

Is the economy overheating? For 2005-06, we now have revised figures that show real GDP growth of 9 per cent. This makes deficit targets easier to attain. The higher base implies lower growth in 2006-07 than what would have been attained with a smaller base. However, we will probably still achieve 9 per cent or thereabouts in 2006-07.

Now the question about overheating. Many don8217;t believe India is on a higher growth trajectory; 9 per cent growth is apparently not sustainable. The wholesale price index WPI shows an inflation rate of over 6 per cent, assorted consumer price indices show still higher inflation rates. Isn8217;t this evidence of over-heating? Look at India8217;s savings and investment rates and compare them with China. Look at the state of infrastructure. Look at the state of education and, more importantly, skills. In the history of developmental experience, no country has achieved such growth rates based on services alone. True, manufacturing has done well, but it is export driven. What if there is a global slowdown? There hasn8217;t been a structural change in the economy, the growth is cyclical. And we must slow things down by jacking up interest rates repo rate, reverse repo rate, cash reserve ratio.

Notice there are two separate, though related, arguments in this dire prognosis. First, there is over-heating. Second, present growth is unsustainable. Although advocates of non-sustainable growth won8217;t admit it, in the second proposition we are effectively saying we have no idea why the economy is chugging along merrily. Since we don8217;t understand what is happening, we jump to the conclusion that this can8217;t continue. We can also attempt to question the veracity of CSO8217;s GDP figures and even suggest the facts are doctored, but one shouldn8217;t take this very seriously. Notice there is a difference between over-heating in selected sectors real estate, capital market, some human resource segments and aggregate over-heating. Most proponents of over-heating base their arguments on what is happening in selected sectors. Notice also that a point-to-point WPI measure is hardly a good indicator of aggregate inflation. Any point-to-point indicator is a function of the base at that precise point in time last year. Ipso facto, as last year8217;s base goes up beyond March, WPI-based inflation will also decline. Are we to then conclude that over-heating has disappeared since April and supply-side adjustments magically taken place in two months?

While on WPI, should we base an over-heating argument on figures that include oil and commodity prices? True, the manufacturing component of WPI shows inflation just a shade below 6 per cent, but capacity expansion is in the pipeline. At the aggregate level, I therefore have five points. First, there8217;s no robust statistical evidence for over-heating. Second, increase in WPI-based inflation rate is transient. Third, these monetary policy-based measures will have little impact on over-heating, if it did exist. Fourth, knee-jerk reactions like hikes in interest rates will have the perverse effect of choking growth. Fifth, to the extent there is a trade-off between inflation and growth, it is better to have 9 per cent growth and 7 per cent inflation than 6 per cent growth and 4 per cent inflation.

The case for over-heating is more convincing in those sectors where there is clearly excess demand. But the question of an appropriate policy response remains. Alfred Marshall wrote that supply and demand are like the blades of a scissor. Why should we consider one blade demand and try to curb it, to the exclusion of the other supply? For real estate, the capital market, and even agro products, there are policy-induced distortions that create artificial scarcities, making supply inelastic. Not only is an interest rate hike unlikely to curb demand, the right response should be one of introducing reforms to end these rigidities. Instead, we ask RBI to solve a problem it has no control over.

Let us now turn to the other proposition about growth being unsustainable. India is sui generis. We do not always remember who first said this. It was Annie Besant, who was more Indian than many Indians, but was nevertheless a foreigner. And we now have a succession of other foreigners coming along to tell us India cannot be sui generis. There are certain lessons of development and India cannot buck the trend. This proposition is true up to a point. But also remember there are several countries that have registered growth rates of 8 per cent-plus over two decades and more and none of these have exactly replicated lessons of developmental economics. Indeed, economies that have faithfully followed the gospel truth of theory have typically failed to grow. No economist has ever predicted the miracle before it happened. The new school of institutional economics also emphasises specific structures of individual economies that make complete generalisations impossible. Stated differently, India cannot be sui generis in a broad brush sense, but is certainly sui generis in details.

Now notice the following. Indian savings and investment data are for 2004-05, not later. And even there, rates have been increasing and are higher now. Rarely does any model factor in the labour component, as opposed to capital alone. Arguments that there is little evidence of productivity increase that is, capital and labour growth netted out in India rely on data for the 1990s and earlier. If there has been a structural break around 2002, one shouldn8217;t extrapolate that finding to what has happened post-2002. Finally, with manufacturing performing well a function of export growth, we have broken away from the historical service sector dependence.

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In other words, India8217;s growth experience is veering around to the broad brush prescription. Though not entirely accurate, people have argued India8217;s growth is consumption-led, while China8217;s is investment-led. In this simplified framework, a proposition has been advanced that these paths are now converging, with China emphasising consumption and India, investment. That is another way of restating what I have just said. Cassandras notwithstanding, I still believe in 9 per cent and a structural change. Let us not forget what happened to Cassandra. No one believed her predictions and she was murdered.

The writer is an economist