Harish Damodaran

Killing growth through savings fundamentalism

HARISH DAMODARAN | Updated on November 20, 2017

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The Government’s primary job is to promote investment, not austerity.

Savings determines investment; the less you spend on current consumption, the more resources there are to undertake productive endeavours.

There is a certain simplicity and obviousness to this proposition, which holds very well at an individual household or firm level.

The problem comes when it is extrapolated to the economy as a whole, which many economists nowadays tend to do. One can see this even in the Finance Ministry’s latest Economic Survey, especially its analysis of the current growth slowdown.

The Survey is right in linking GDP growth with investment levels in the economy. The strong correlation between the two is clear from the accompanying graph: The years that recorded high GDP growth rates — 2003-04 to 2007-08 and also 2009-10 and 2010-11— posted even higher increases in gross fixed capital formation.

As against this, the years when GDP growth was low or fell — 2002-03, 2008-09, 2011-12 and 2012-13 — witnessed even lower or sharper declines in additions to fixed capital stock.

A slowdown of investments

The defining characteristic of a boom or a slowdown, in other words, is not growth in real incomes as much as the pace of capital accumulation. The ongoing India Slowdown Story is essentially one of a drying-up of investments.

It raises the question: Why have investments fallen?

The standard macroeconomic explanation, offered by the Survey too, blames it on falling savings, which, in turn, is the result of rising government deficits or public dis-savings. A corollary of this is that an investment revival cannot happen without raising domestic savings. And that has to necessarily come from fiscal consolidation, leading to increased public savings.

The above argument — that generating more savings internally is a prerequisite for an investment/growth recovery — has intrinsic appeal, partly because it conforms to our own sense of seeing virtue in thrift. Surely, if we need to save in order to invest, the same principle ought to apply to the national economy.

Moreover, it also seems consistent with official data.

Between 2001-02 and 2007-08, gross domestic capital formation (GDCF) rose from 24.3 to 38.1 per cent of GDP, alongside an increase in the rate of gross domestic savings (GDS) from 24.9 to 36.8 per cent. This was accompanied by a sharp reduction in the Centre’s revenue deficit ( see Table). Subsequently though, the savings rate has dropped by more than seven percentage points, along with deteriorating public finances. The GDCF-GDP ratio may have declined less, but only due to falling internal savings being partially made up through foreign capital flows or savings supplied from outside.

These external flows, besides a drawdown of official forex reserves, have enabled the country to import much in excess of its exports — translating into higher current account deficits (CAD) — and sustain an investment rate beyond what domestic savings alone can finance.

But this cannot obviously be sustained for long — which only re-establishes the case for according primacy to domestic savings and fiscal consolidation.

Counterintuitive logic

Where is the flaw in this entire analysis? Well, it lies not in the GDCF=GDS+CAD equation per se, but in assuming savings to be the determining variable and everything to flow from it. What, if we were to reverse the direction of causality? In this case, it amounts to saying that growth and investment is what matters, and everything else (savings included) follows from there.

Does that sound farfetched? It shouldn’t really. People, firms and governments, after all, save only from their incomes. And that can come only when there is growth and all-round spending, creating new investment and job opportunities. These, then, lead to more incomes and savings as well as further spending.

Savings, by this logic, are a mere byproduct of the growth process. So are public deficits; they contract or widen when growth picks up or falters.

Counterintuitive as this may be, this is precisely what happened between 2003-04 and 2007-08. At some point – for whatever may have been the reasons – the India Growth Story just took off, igniting the ‘animal spirits’ of businessmen. Their investments generated jobs and incomes. As people spent from these, they created incomes for others as well – including governments whose revenue collections soared.

To cut it short, domestic savings rose and public deficit shrank during 2003-08 only because of growing incomes, underpinned by investments. What we have been since then is a reversal of this process, with investments evaporating along with the ‘animal spirits’ of entrepreneurs. The reasons for that, again, need not detain us here. What we know for certain is that falling savings is not the cause.

Falling savings, if at all, is an effect of deceleration in household incomes, corporate profits and government revenues, consequent to an ongoing investment and growth slowdown.

Deficit myths

That leaves the question of the CAD. Hasn’t it gone up only because of a domestic savings drop and burgeoning public deficits in the recent period?

This explanation again is weak, if one looks at 2001-02 to 2003-04, which actually were years of current accounts surpluses, notwithstanding abysmal savings rates and runaway revenue deficits.

While the latter are clearly correlated with GDP/investment growth rates, the CAD seems linked more to the external economic environment, than having to do with rising or falling domestic savings.

A slowing world economy affects India’s exports more than its imports, which are significantly constituted by ‘inelastic’ items like oil and gold. The CAD, therefore, tends to rise whenever there is a global downturn. At the same time, a world economic slowdown, by impacting exports, also lowers the country’s growth and, thereby, domestic incomes and savings.

In this case, too, the causality runs in the reverse and not from lower savings to higher CADs.

The primary lesson from all this is that it is not savings but investment that matters – and ensuring a minimum level of investment in the economy is what should be the Government’s main concern as well.

This it can do by creating an atmosphere or ‘sentiment’ that induces businessmen to investment. But if that cannot be done – there is no magic formula to revive ‘animal spirits’ – it should invest itself.

While it is nobody’s case that the Government should splurge mindlessly, being austere cannot be its sole reason for existence. (Unless austerity itself is seen to stimulate business sentiment!) The deficits will take care of themselves, when growth returns. Unfortunately, those sitting in North Block and Mint Street believe otherwise.

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Published on March 03, 2013
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