Why the 2019 economic slowdown is different from 2012-13 | Analysis

Inflation was very high during the earlier slowdown compared to what it is now. This is the case even if one excludes food and fuel inflation, which plots GDP growth and core inflation (inflation excluding food and fuel).

India’s GDP growth slowed to 5% in the first quarter of the current fiscal year. Since June 2012, the earliest period for which we have quarterly GDP statistics for the current series, GDP growth has only been slower than 5% twice. It was 4.3% in March 2013 and 4.9% in June 2012. There is a crucial difference between then and now. Inflation was very high during the earlier slowdown compared to what it is now. This is the case even if one excludes food and fuel inflation, which plots GDP growth and core inflation (inflation excluding food and fuel).

Why should inflation matter while analysing an economic slowdown? It matters because it tells us whether the slowdown is driven by supply- or demand-side factors.

A small digression is useful here. Let us assume that an economy has 10 workers and only one factory, which produces shirts. Five workers are employed in the shirt factory while the other five work in the tourism industry and they need new shirts every month. Everything else remaining the same, if the machine producing shirts were to suffer a breakdown leading to a decline in the number of shirts produced everyday, the GDP growth of the economy would go down. However, because the other five workers are continuing to earn what they were earning from the tourism sector, this will also lead to a scarcity of shirts. This will result in a rise in shirt prices, and hence inflation as the tourism industry workers will try and outbid each other to get shirts. This is a supply-side growth shock.

 

Let us consider a different scenario now, where tourist inflows come down drastically and tourism workers actually do not want shirts every month anymore. This will lead to a decline in shirt prices, as supply overtakes demand. The shirt factory will realise this sooner or later and cut production, which will lead to a decline in the GDP growth rate. This is a demand-side growth shock.

While a real economy is infinitely more complex, the thumb rule holds. A low-growth, low-inflation situation is more likely to reflect a demand-side problem while a low-growth, high-inflation situation is likely to be the result of a supply-side problem.

There is more evidence to support this thesis in the case of the Indian economy. The Indian economy was administered a demand shock via the monetary policy route beginning 2012. The policy rate, or the rate at which the Reserve Bank of India (RBI) lends money to commercial banks, had been at 6% in all quarters between 2004 and 2011. It was at 9% or more in the four quarters beginning March 2012. Just as the RBI expects rate cuts to boost growth, rate hikes are expected to bring down the growth rate in an economy.

 

Another set of statistics supports this line of argument. RBI’s consumer confidence surveys (CCS) ask respondents about their perception on current incomes. The net perception –difference between those who think incomes have increased and those who think they have decreased – was much higher in 2012-13 than what it is now. This suggests that the current economic slowdown is a result of lower demand due to lower incomes. To be sure, the CCS only covers urban areas. However, inflation-adjusted rural wage data also shows a similar trend, with wage growth during 2012-13 being much higher than what it is now (see https://bit.ly/2lwye2z for details).

What is the takeaway from the discussion above? Going back to the example given above, the current economic problems are more due to a slowdown in the earnings of tourism industry workers rather than a machinery breakdown in the shirt factory. This is exactly why rate cuts, which were supposed to revive investment (help buy machines for the shirt factory), have not improved matters.