First fix inflation then expect India's IIP to improve

The index of industrial production (IIP), a measure of industrial activity in the country, fell by 2.1 percent during the month of November 2013. The median consensus of a Reuters survey of 20 economists was that the IIP would grow by 1 percent during the month.

Hence, the real number has come in way off the mark from what the economists estimated it would. Nothing surprising on that front. On the whole, economists are usually wrong about things. Manufacturing, which has nearly 75 percent weight in the index, fell by 3.5 percent during the month, in comparison to the same period last year.

[caption id=“attachment_1027423” align=“alignleft” width=“380”]  Representational image. Reuters[/caption]

So why has the IIP been falling over the last few months? In order to understand that we need to go back a little in history to the Great Depression of 1929.

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Conventional economic thinking then drew upon the Say’s Law (attributed to French economist and businessman Jean-Baptiste Say). The law essentially stated that the production of goods ensures that the workers and suppliers of these goods are paid enough for them to be able to buy all the other goods that are being produced. A pithier version of this law is that “supply creates its own demand.”

In a scenario where consumers decided to save more the money would land up in banks. Banks would suddenly have more money, leading to lower interest rates. Lower interest rates would mean that businesses would borrow and invest more. This would lead to a situation where consumers would have more money in their pockets, which they would spend.

Hence, come what may, people would have enough money to spend at any point of time. A big slowdown in the economy or a depression was not possible. As economist John Kenneth Galbraith wrote in A History of Economics-The Past as the Present, “There could not be a remedy for a depression, if depression had been ruled out by the theory. Physicians, even of the highest repute, do not have a treatment for an illness that cannot exist.”

This was the thinking that prevailed among economists at that point of time. Of course it was wrong, given that the Great Depression was on. Hence, depressions did happen. It is just that the economists at that point of time did not have a reasonable explanation for it.

One of the first explanations of the Great Depression was provided by the British economist John Maynard Keynes in his 1936 classic The General Theory of Employment, Interest and Money. He explained the Great Depression using the “paradox of thrift.”

After the stock market crash of October 1929, which started the Great Depression, commodity prices also fell big time. This started to impact the farmers, first in the United States and gradually all over the world, and they started to cut back on expenditure. If a single person cuts back on his expenditure, it makes tremendous sense, because he is saving more. But if a significant section of the population cuts back, there is a problem, the logic being that one person’s spending is another person’s income. Hence, if a substantial section of the population cuts spending, the income of another section of the population is impacted. And this was the paradox.

As people cut expenditure, this has an impact on consumer demand. If the demand for goods is falling, it is very logical for businesses to cut down on production as well. This starts to reflect in the index of industrial production, which is a measure of industrial activity in any country. By March 1933, the index of industrial production in the United States had fallen by more than half to 54, from 114 in August 1929.

As John Cassidy of the New Yorker magazine writes in How Markets Fail-The Logic of Economic Calamities,“Keynes was pointing out that market economies are subject to positive feedback: downturns have a tendency to feed on themselves and get amplified, with the level of spending spiralling down.” And ultimately, the lack of spending leads to a lack of demand and that starts to reflect in the index of industrial production.

A similar dynamic, though at a significantly lesser scale, is playing out in India right now.

People are fed up with a double digit consumer price inflation that has been prevalent over the last few years. Their incomes haven’t been able to keep up with the rate of inflation. Food inflation has been particularly high. A higher inflation also leads to the regular expenditure of people, as a proportion of income going up. Given this, they have had to cut down on expenditure on non essential items like consumer durables, cars etc, in order to ensure that they have enough money in their pockets to pay for food and other essentials.

This is reflected in the index of industrial production when seen from the use based point of view. The index number of consumer durables fell by 21.5 percent in comparison to November 2012. The index number of consumer goods, which have the highest weightage in the index, fell by 8.7 percent, in comparison to the same period last year.

What has also happened is that people are not confident about their financial future. As RC Bhargava, Chairman of Maruti Suzuki told Business Standard in a June 2013 interview “With the uncertainties prevalent today, a consumer does not know what his job would be like after a year - whether or not he will have an incremental income, or even a job.” This phenomenon is at play and has a huge impact on consumer demand and through that on industrial production.

People will start getting confident about their financial future only once the inflation is brought under some sort of control. But that hasn’t happened. Only if that happens will people start spending more, and that in turn will start reflecting in the index of industrial production.

Vivek Kaul is a writer. He tweets @kaul_vivek