The Hindu Business Line : Triggering the right growth impulses

Estimating potential output is helpful for both policymakers and the markets. Though difficult to arrive at, especially in an interdependent world where uncertainties are far too many, it should be pursued, says A. VASUDEVAN.

An important aspect of the current growth story that has been largely overlooked by economists is psychology. Lord Keynes, in response to the helplessness expressed by the great quantum physicist Max Planck in understanding economics, said that good economists have to understand well a combination of subjects, namely, the principles of, mathematics, philosophy and history, and have command over the language as well. However, Lord Keynes, despite his recognition of the animal spirits that rule the markets and influence investment, did not mention psychology. Perhaps he believed in the state having a critical role in shaping economic development.

The situation has changed somewhat since then in that the markets are no longer limited to national boundaries and they play a dominant role in determining the destinies of countries, with the state having largely a regulatory role.

More than mere numbers

Call it confidence, sentiment, expectations, growth impulses will not be triggered unless people are willing to invest, innovate and improve the rate of output per unit of input, be it labour or any other factor. In other words, growth is not merely a technical product of investment rate and productivity of investment. Behind the technical factors lie the psychology of investors.

The final product — the growth number — is therefore not simply an economic fundamental. It reflects so many `potentials'— of output and employment situation, the price competitiveness and fiscal turnaround. A GDP growth of 8.4 per cent in 2005-06 on top of 7.5 per cent in 2004-05 is important in one respect. It shows a better balance in the rates of growth in all the three sectors — agriculture (primary) , industrial (secondary) and services (tertiary).

Agriculture growth of 3.4 per cent in 2005-06 may not seem impressive but it gives a good base for demand for industrial goods and services. Within the industrial sector, manufacturing growth at 10.7 per cent is robust.

The sectoral growth consistency exercises of the mid-1960s, by Ashok Rudra, and the early 1980s, by Dr C. Rangarajan, have shown how a desirable `x' per cent of growth in the manufacturing sector would be rendered feasible when there is `y' per cent growth in agriculture. Such an exercise would have to be extended to cover the services sector too for benchmarking the critical minimum growth rates of each sector that should be achieved to derive the targeted growth of the economy.

Potential output

The Planning Commission would, one expects, attempt such an exercise for the Eleventh Plan. The Commission, however, would have to guard against the fact that internally consistent exercises can be severely constrained by the growing openness and globalisation of the economy. As a result, the targeted growth of the economy during the five-year period could turn out to be tricky.

Ideally, the target growth should be close to potential growth, estimating which is not easy in the context of globalisation. For, potential output by definition is equal to the product that is attainable when the economy operates at a high rate of resource use. The estimated potential output is not a ceiling; it can, in fact, be exceeded. It is essentially a measure of sustainable output in the sense that the intensity of use of resources should not fuel inflation.

Potential output estimation in the case of India has been done only by a few economists. Officially, there is perhaps no potential output estimate. The few publications on the subject tended to look at the problem as a technical or statistical one. Tools such as statistical filters (Hodrick-Prescott filter is the most widely used) yielded 6.5-7 per cent, depending on the period covered. Use of the production function approach yielded higher figures of 8-9 per cent. This approach however suffers from many limitations, including those related to data deficiency.

Other methods of measuring potential output are mainly econometric in nature, such as simultaneous equation systems and plain and structural vector auto regressions. Like all econometric tools, they suffer from restrictions with regard to the structure and relationships among the economic variables. In addition, there are serious data problems. In the circumstances, the rule-of-the-thumb approach of policymakers seems to have received wide recognition. The approach considers the average of the attained growth rates in the last 3-5 years, which is about 8 per cent, as the feasible potential rate.

Attaining 8 per cent growth should be easily possible given the share structure of the sectors in GDP, the impressive performance of the services sector and the optimism about the manufacturing sector's potential. If this is correct, then one need not be a teleologist with bias towards the vitalist philosophy to place the potential growth estimate at a relatively higher level of, say, 10 per cent over the next 10-year period. This estimate can turn out to be a reality if investor confidence is high and if the macroeconomic and institutional policy path is clearly laid down. The problem, however, is with the current knowledge about market expectations and optimism. In an interdependent world, the psychology of investors is influenced as much by external factors as by the domestic policy framework.

Where uncertainties are far too many and where domestic policies are under the influence of political coalitions, estimation of potential output and laying down policies for its attainment on a sustained basis would be a difficult task.

A useful estimate

Yet, estimating potential output is helpful for both policymakers and the markets. It would, for example, help the fiscal authorities make better projections of revenues and improve expenditure and domestic debt management. Monetary authorities, on their part, could use the estimated potential output to work out the influences, in particular, the interest and exchange rate positions that work on domestic financial and external flows. Since the estimate is expected to be a sustainable one with no inflationary implications, the objectives of both fiscal and monetary policies would be well served. Market expectations would be better formed by the communicated estimate of potential output and the medium term policy trajectory.

In view of the need for enhanced private sector dynamism in agriculture, services and manufacturing, it would be ideal if the fiscal and monetary authorities and the Planning Commission, in consultation with experts and market persons, provide the best estimate of potential output for a somewhat longer period of, say, 10 years along with a provision for revisits to the subject after every three years. The longer period projection could be collapsed into two five-year periods for planning.

The policy path that is expected to help attain the estimated potential output would be useful for coalition politics as well, as that would signal the intention of the authorities, irrespective of their ideological preferences, to foster sound and stable policies and reduce volatilities in the markets.

(The author, a former Executive Director of the Reserve Bank of India, can be reached at asurivasudevan@hotmail.com)