Memo to Modi and Rajan: 'Achche din' can be a self-defeating prophecy

The scary numbers of the October Index of Industrial Production (IIP), where the overall index was a negative 4.2 percent and consumer durables nosedived 35.2 percent, may have a different underlying story to tell. We need a better explanation simply because almost all the outward signs are one of optimism.

Why are consumers not buying and businesses not investing? What could be the reason for the sharp divergence between what we see all around (hope and expectations of political and economic change for the better) and what we get in the official numbers?

I believe it has to do a lot with expectations.The devil is not in the data, but in expectations. This is why a falling IIP is compatible with a falling CPI (down to 4.38 percent in November from 5.52 percent). The real issue may be that people believe the “achche din” promise a bit too much, effectively making it a self-defeating belief. And right now there are two people promising “achche din” - RBI Governor Raghuram Rajan on lower inflation and Narendra Modi on economic policies.

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Economists know that expectations about the future are as important as actual reality in terms of driving demand or prices. What one expects will happen in future impacts what we do (or don’t do) now.

For example, micro-economic theory tells us that if prices rise, demand should fall. But real markets and prices don’t always behave this way because of expectations about the future. If consumers expect inflation to keep rising, they may buy more even though prices are high, in the belief that prices may go higher in future. In acting out their beliefs they make higher inflation a self-fulfilling promise. This is the main reason why RBI Governor Raghuram Rajan is keeping interest rates higher than needed: in order to kill expectations of continued inflation.

If you apply common sense expectations theory to Narendra Modi’s promise of “achche din”, where does it leave us?

My answer would be: in the dumps.

As long as Modi’s promise of “achche din” continues to be believed substantially by business, consumers and economic players in general, they will wait for it and not act. Businesses will wait some more time before investing, consumers will wait to see if the prices of that plasma TV they want to buy will fall further, etc, etc. Why would you do today what appears a good thing to do if you believe tomorrow will be even better? No one wants just a good deal; we all want a better deal. No one wants to be an early bird only to see others walking away with even more later.

A corollary to this theory is this: you will get “achche din” only if you stop believing things will get even better.

If industrial data are still pathetic, our problem may be the overdose of “achche din” promises simultaneously from the Reserve Bank and the central government.

It is possible that Rajan has actually succeeded in convincing the markets that he will kill inflation. His “achche din” are round the corner. This is why government and corporate bond yields are crashing.

A corollary to Rajan’s success in making his anti-inflation stance believable is that business and consumers will wait before borrowing. If you believe rates and prices will come down, why would you borrow at higher rates today? The same applies to consumers who are holding back on purchases expecting both rates and prices to weaken. Why will you buy that car today if you think auto EMIs will fall tomorrow?

Everybody is waiting for “achche din”. In the process they are ensuring that it does not happen too soon.

The essential problem is that people believe both Rajan’s implied “achche din” promises on inflation and Modi’s on fiscal and economic policy. They are thus ensuring their own defeat.

The way out is actually simple: for Modi, despite his preference for incremental reforms, the way out is to go for quick big-bang reforms in two or three areas and say: “This is it. In future, there will be only incremental tweaks to make continuous ease of doing business the policy goal.”

Once he says ’this is it’, businesses could move into decision mode. They will decide whether to invest and where. In terms of monetary policy, Rajan has more or less come to the point where he has said “this is it” - rates are expected to fall by around March-April.

It is time for Modi to get to that point where he can say ‘This is it’ by doing the big bits of reform in one go. To revive the economy, he has to kill the growth-slaying expectation that there is lots more to come. He has to overcome his incrementalist instincts and do the big number now.

If the 1991 reforms succeeded, it was believe it was not incremental in nature. Modi does not have the advantage of a world economy that will respond readily to incremental reforms. When the world is going down the tubes, only eye-catching reforms will work. He must go for it. Good economics will enable good politics in the second half of his five-year tenure.

The Indian economy is like the proverbial frog that refuses to jump out of slowly warming water because it does not feel the change. Heat it quickly and it will jump out.

Modi has to convince people that “achche din is now”, not some time in the future. This is the best way to make the economy jump out of its skin and come alive.