Dear money policy compromises growth

Within policy circles in the last two decades, attention has been paid to endogenous growth. A robust theory explains long-run growth and prosperity as emanating from activities creating new capital assets, technology and knowledge.

Any country paying short shrift to capital investments and technological progress faces regress. Endogenous growth is long-run sustainable. Growth is determined by factors internal to a polity that provides opportunities for entrepreneurship, innovation and knowledge creation.

Endogenously influenced growth depends on productivity, which is a function of technological progress, and a continuing stream of capital investments and capital goods output. These capital-intensive facilities are vital, because they can be used for the purposes of building machines that build other machines. Without these other machines, making up the output of the important capital goods sector, downstream industries cannot be set up.

The above capital investments approach, in producing capital goods, represents a means for key entrepreneurs and government to influence the speed and direction of economic growth.

For India's future, production of capital goods is necessary. World-class scale and productivity are key drivers here, which are driven by capital goods production. In my recent book India's Late, Late Industrial Revolution: Democratizing Entrepreneurship , I have shown how India's industrial production constituents have grown.

In the first decade of the new millennium, overall industrial growth was 7.5 per cent, but capital goods and consumer durables output grew by 11.5 per cent and almost 10 per cent respectively. In 2009-10, overall industrial growth was 11 per cent, but capital goods output growth was 19 per cent. Consumer durables output growth too, representing production of long-lasting goods embodying new technologies and knowledge, was 26 per cent. The data show India's good performance. Till 2010!

Why Worry?

If the facts are positive, why worry? Well, in the last 20 months the trend in capital goods output has turned sharply negative. Official data for the 12 months till March show a year-on-year production decline taking place in seven of these months. The trend line in the accompanying chart is sharply negative.

Not only did the growth expected in capital goods output in 2011-12 not occur, even the growth that took place in 2010-11 was wiped out. As a result, the level of capital goods production reverted back to 2010 and earlier levels.

Stagnation in capital goods output growth is a clear policy failure outcome. What are the reasons?

Cost of Money

An important concern is how financing affects investment and capital goods output. Other than market demand, policies affecting firms' financing matter in generating output.

Many statements suggest that the current deceleration has been due to the Reserve Bank of India's (RBI) monetary tightening. A dear-money policy has been in place, with the cost of money showing a sharply rising trend.

I tracked the relationship between the cost of money, using as an indicator the base rate data released by the RBI, and the rate of change in capital goods production.

The correlation between the base rate level and decline in capital goods output works out to -0.51, denoting that the negative relation between the cost of money and slowdown is large. Additional analysis shows the relationship between base interest rate levels and output declines as sharply negative and statistically significant.

We know that in the last 20 months, dear money has severely compromised India's growth. By negatively impacting capital goods output, monetary policy has ensured that the real capital building blocks necessary for India's development are not to be put in place.

The dear-money policy may have not only applied a sharp, and sudden, brake on current capital goods output, but also led to economic regression. The output declines will now require considerable time to reverse and subsequently engender a return to status quo.

Thereafter, harnessing the growth engine, to generate sustainable and high growth, will require considerable effort on the part of India's entrepreneurs, professionals and workers, who will have seen past efforts nullified because of rising interest rates.

A Policy Fallacy

The RBI's approach from mid-2010 to keep interest rates high in order to control inflation only set growth expectations back and de-energised the economy. It rested on a simplistic assumption that money supply is all that mattered.

By raising interest rates, the liquidity in the system would dry up as borrowers opted out of fund-raising to complete projects.

This would also reduce overall demand in the economy, as households would save, attracted by higher interest rates, and reduce consumption expenditures.

The fatal flaw was apparent. Brakes on consumption and investment spending were sought to be applied, but while also slowing down economic growth. India's growth, which was about 9 per cent a year, has since dropped to 6-7 per cent..

Faulty monetary policy in India has created stagnation. It has led to declines in capital goods production putting back India by at least five years, if not a decade, and stymied attempts to engender innovation-driven endogenous growth.

Will We Never Learn?

This is what dear money was supposed to do. This is also what a dear-money policy did even a decade-and-a-half ago, when interest rates were sharply raised in the mid-1990s. As a result, India's growth plummeted. Thousands of crores in investments were abandoned and India's economy was set back by a decade.

It was the Y2K phenomenon that eventually enabled India's information technology firms to body-shop thousands of Indian white-collar labourers to the West, so that information systems could be re-programmed.

This brought substantial foreign exchange into India and re-ignited growth after 2000. A new generation of entrepreneurs subsequently emerged, whose expectation were moulded by a positivist liberal mindset, in place since the late 1990s and in the first years of the new millennium.

But now, their expectations, too, have been belied by the negative mindset that believes only money supply matters. The obvious conclusion is that making money cheaper is an urgent policy need for India.

(The author is professor of technology strategy in University of Texas at Dallas.)

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