The Hindu Business Line : How ‘rational’ behaviour begets recession

Savings — contrary to common logic — can be a curse for an economy in recession. Since one man’s spending is another’s income, the cumulative effect of rational individual caution is a collective contractionary spiral.

One man’s spending is another’s income.

Harish Damodaran

Much of the economic theory in textbooks implicitly rests on two mutually reinforcing propositions. The first of these is Say’s Law — “supply creates its own demand”. When an entrepreneur produces a good, he expends money that goes to pay workers, raw material suppliers, interest on working capital, rent on hired premises, taxes, etc. Every cost adding up to the sale price of the product becomes someone’s income — including the profit ac cruing to the entrepreneur after deducting all expenses.

When this postulate is extended to the broader economy, it means the very act of producing (supply) generates incomes (demand). The households, firms or governments receiving these, then, have all the money to buy what is produced. Of course, there could be too much or too little of certain products. But in this case, the second law — of flexible prices — comes into play. When a thing is supplied in excess of demand, its prices are driven down.

The resultant dip in profits (or losses) would force units to pare supplies till they are brought into balance with demand. Likewise, consumers bid up the prices of goods in short supply, stimulating production.

Gluts

Thus, even if “partial gluts” specific to individual commodities occur, “general gluts” are ruled out. As John Stuart Mill wrote: “Could we… double the supply of commodities… we should, by the same stroke, double the purchasing power. Everybody would bring a double demand as well as supply; everybody would be able to buy twice as much, because everyone would have twice as much to offer in exchange.”

The one obstacle to this smooth cyclical flow from producers to consumers, though, is that people do not spend all their incomes. A part of what they earn is saved. Will that not lead to “general gluts” as there would be a surplus of unsold goods to the extent of income leaked out?

To this, too, the economists had an answer. When individuals save, they do not tuck the savings into their mattresses. Instead, they are deposited in banks or invested in stocks and other capital market instruments. The saved monies, therefore, also get “spent” — the buyers being firms that deploy them in new plant and equipment.

What if people spend less and save more? According to the flexible prices doctrine, when the supply of savings exceeds demand, its “price” (the interest rate) falls, making it attractive for companies to borrow and set up factories. Ergo, any reduced demand for consumption goods is offset by higher offtake of steel, cement and other investment goods, which, in turn, manifests as someone’s profit or salary and sustains the cyclical flow.

Textbook wisdom

The long and short of it is that recessions — if at all they happen — are short and self-correcting. If prices, wages and interest rates are flexible as per proposition No. 2, Say’s Law would prevail, so that the incomes from whatever is produced will get spent either directly by households or indirectly by businesses (on investment goods). Even if there are supply disruptions or gluts in individual industries, the economy’s natural course is towards full employment.

The above textbook wisdom received a rude jolt with the Great Depression of 1929-33 and the publication of John Maynard Keynes’ General Theory of Employment, Interest, and Money.

Keynes took off from the point that people consume only one portion of their income and save the remaining. If Say’s Law holds, there would always be sufficient investment to absorb the surplus of the community’s income over its consumption. But what, Keynes asked, if the desired investment did not materialise? The only way to establish balance in the event is through a contraction of incomes, which would squeeze out savings. The savings glut vanishes simply because there is no scope to save at the bottom of the trough.

‘Optical illusion’

Keynes was, in effect, saying that instead of supply creating demand, it was demand that actually regulated supply. His prime target was the assumption of an in-built mechanism that united savings with investment. People save and invest for different reasons. To presume they are two sides of the same coin — an act of saving by A will inevitably engender a parallel act of investment by B — was an “optical illusion”.

By inverting Say’s Law, Keynes shifted the spotlight to demand, recognising it as the key variable governing economic activity. And demand, by its nature, is a fickle thing, a function of confidence and sentiment. When people have stable jobs and expect salary jumps, they spend beyond the daily necessities. If they foresee hard times, the natural tendency is to defer big-ticket purchases.

What is true for consumption demand applies equally, if not more, to investment. If the business outlook is bleak — for whatever the stated reasons are — even interest rate cuts may not induce companies to come out of their shell. During the Depression, US commercial paper rates fell from over 5 per cent in 1929 to below 1 per cent by 1933; yet private business investment plunged from $15 billion to less than a billion. Japan experienced a slump all through the 1990s despite money market rates consistently ruling below one per cent. The same is happening on a global scale today, where slashing of policy rates to near-zero in the US and Japan has failed to boost entrepreneurial expectations.

Savings curse

In the Keynesian scheme, the fundamental constraint was not savings, but willingness to invest. If investors are bullish — as they were till recently about India — savings will automatically come from rising domestic incomes or from outside. Current account deficits and government dis-savings do not matter; what counts is the “animal spirit” of the capitalists. To quote Keynes: “If Enterprise is afoot, wealth accumulates, whatever may be happening to Thrift; and if Enterprise in asleep, wealth decays, whatever Thrift may be doing”.

In fact, savings — contrary to common logic — can be a curse for an economy in recession. There might be nothing irrational about households cutting back on spending in times of uncertainty, just as companies are nowadays retrenching workers and hoarding cash. But since one man’s spending is another’s income — which translates into further rounds of spending and income generation — the cumulative effect of rational individual caution is a collective contractionary spiral.

In Keynes’ language, “private virtue” becomes “public vice”, as opposed to Adam Smith’s “what is prudence in the conduct of every private family can scarce be folly in that of a great nation”. Moreover, as the recession bites, savings start drying up. During 1929-33, the national income of US shrank from $87 billion to $39 billion and, as unemployment soared to 25 per cent, household savings declined from $3.7 billion to nil.

Spending big

What’s the way out? The policymakers here have so far responded by lowering interest rates and excise duties, injecting liquidity into banks and allowing firms greater access to external borrowings — the underlying assumption being these would revive spending by households and businesses.

But that brings back the question: If you or I feel our jobs are on the line, will we buy a flat just because home loan rates are down? In the present scenario, only somebody who is relatively impervious to risk and, unlike you or I, is not solely guided by rational calculation can afford to spend big.

That “somebody” is the government. But does the government really have the capacity to spend effectively? Are there enough public sector managers today of the calibre of K. L. Rao, V. Krishnamurthy, Verghese Kurien, E. Sreedharan and Sam Pitroda who can conceive of and execute large projects cutting through the bureaucratic red tape?

And do we have a political leadership that will empower these professionals? The issue, in short, is not about Government-Why but Government-How.

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