Why the Indian economy is in a Catch-22 situation

Joseph Heller's Catch-22 remains one of the literary classics of the 20th century. Set during the course of the Second World War, the book gave a new phrase to the English language. As a paragraph from the book goes:

There was only one catch and that was Catch-22, which specified that a concern for one's safety in the face of dangers that were real and immediate was the process of a rational mind. Orr was crazy and could be grounded. All he had to do was ask; and as soon as he did, he would no longer be crazy and would have to fly more missions. Orr would be crazy to fly more missions and sane if he didn't, but if he were sane he had to fly them. If he flew them he was crazy and didn't have to; but if he didn't want to he was sane and had to.

The Indian economy is currently in a Catch-22 situation. Reuters

Orr is a bomber pilot who keeps getting shot down. He has been shot down 17 times, which is more than anyone else in his unit. Given that, he is deemed crazy to still be flying. All he has to do to be grounded is to ask. But the catch is that the moment he asks he would no longer be deemed to be crazy. He would be sane and being sane he would have to fly more missions.

This catch was the Catch-22. Over a period of time such a hopeless no-win situation of the kind Orr was in came to be referred in the English language as a Catch-22.

The Indian economy is currently in a Catch-22 situation. The government of India had a total expenditure of Rs 7,12,671 crore, during the course of 2007-08. This grew by nearly 44 percent over the next two years and during the course of 2009-10, the total expenditure of the government stood at Rs 10,24,487 crore.

Increasing expenditure is not a problem if its met by increasing income. But that wasn't the case here. Between 2007-08 and 2009-10, the revenue receipts of the government (or the income that the government hopes to earn every year) grew by a minuscule 5.7 percent to Rs 5,72,811 crore.

Some part of the increase in expenditure was met by selling shares that the government held in public sector companies. But a major part of the increase was met by simply borrowing more. The borrowings and other liabilities of the government shot up from Rs 1,26,912 crore to Rs 4,18,482 crore, a massive jump of nearly 230 percent, during the period.

The good part of this massive increase in government expenditure was that the Indian economy continued to grow at very high rates, even though economic growth in large parts of the world was slowing down in the aftermath of the financial crisis that had erupted after the investment bank Lehman Brothers went bust in September 2008.

The Indian economy grew by 8.6 percent in 2009-10 and 9.3 percent in 2010-11. And Indian politicians opened their champagne bottles and told us that India had decoupled from the global economy. As Sajjid Chinoy of JP Morgan writes in Business Standard: "The charitable (but incorrect) interpretation is that India successfully decoupled from the global economy, returned to its nine percent growth path post-Lehman."

The formula seemed to be working and so the government continued with it. For 2012-13, government expenditure was expected to come in at Rs 14,30,825 crore. This meant that expenditure more than doubled between 2007-08 and 2012-13. This, when revenue receipts of the government went up by around 61 percent to Rs 8,71,828 crore, during the same period.

The borrowings and other liabilities of the government during the same period went up by 310 percent to Rs 5,20,925 crore. The government borrows money to make up for the difference between what it earns and what it spends. This difference is referred to as the fiscal deficit.

If the economic growth rate of 2009-10 and 2010-11 was anything to go by the Indian economy should have continued to grow at the same pace, given that the government was spending more and more money.

But that did not turn out to be the case. Numbers released on 28 February 013 suggested that the Indian economy grew by 4.5 percent during the three-month period ending on 31 December 2012. This was the lowest in 15 quarters.

So what happened that led to the economic growth rate falling by half? Initially, the increased government expenditure translated into economic growth. As the government spent more money, those who got that money benefited. They spent that money on goods and services, and this translated into higher economic growth. But two other things happened as well.

As the government went around spending more it led to higher inflation. More money chased the same amount of goods and services leading to higher prices. Food inflation rose at a much faster pace than overall inflation.

Higher prices meant that people were spending more to meet their regular expenditure. And this meant lower savings. In the year 2009-10 the household savings stood at 25.2 percent of GDP. In 2011-201, household savings had fallen to 22.3 percent of GDP. Even within household savings, the amount of money coming into financial savings (i.e. bank deposits, life insurance funds, pension and provident funds, shares and debentures) fell at a faster rate.

As the Economic Survey 2012-13 pointed out: "Within households, the share of financial savings vis--vis physical savings has been declining in recent years...Financial savings accounted for around 55 percent of total household savings during the 1990s. Their share declined to 47 percent in the 2000-10 decade and it was 36 percent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis--vis 2010-11."

So we have a situation were the government has been borrowing more and the overall household financial savings have come down. When the government borrows more it "crowds out" and leaves a lower amount of savings for banks and other financial institutions to borrow from. This leads to higher interest rates on deposits and hence higher interest rates on loans.

Higher interest rates, to some extent, have killed economic growth as people have bought fewer homes, cars, consumer durables, etc. Corporates have also postponed their expansion plans. So increased government spending, which drove economic growth between 2009-11, has now pulled it down, as interest rates as well inflation have remained high.

So does this mean that government expenditure needs to be cut? Yes and no. If interest rates and inflation have to come down, government expenditure and hence borrowing need to come down. But with the private sector and households going slow on spending money, if government expenditure is also cut, it will slow down economic growth even further. So that's the Catch-22 situation that the Indian economy has been put in.

As Chinoy puts it,"A tightening fiscal and slowing growth are seen as coincidental. Markets applaud fiscal discipline, but bemoan weak growth. But these are not independent phenomena. Instead, they are inextricably linked. Fiscal austerity impinges upon growth. A reduction in the deficit has a contractionary impact on activity."

In fact this can already be seen in the Indian context. During the second half of 2012-13, the government cut down on expenditure as it feared a downgrade by international rating agencies. The targeted expenditure for the year stood at Rs 14,90,925 crore. It was revised to Rs 14,30,825 crore, which was 4 percent lower. And this has had an impact on economic growth. "On a cyclically adjusted basis, India's deficit was reduced by a whopping 1.5 percent of GDP in 2012-13 - largely by squeezing expenditures. No wonder the slowdown was accentuated further," writes Chinoy.

Getting out of this Catch-22 situation is difficult. It makes immense sense for the government to cut down on expenditure. Only that can drive down interest rates and inflation and thus revive 'genuine' economic growth. But that, of course, will take time to happen and meanwhile economic growth will slow down further. Given that Lok Sabha elections are due next year, it is not hard to figure out what the government is likely to do.

The government's targeted expenditure for 2013-14 is at Rs 16,65,297 crore, which is 16.4 percent higher than the last financial year. Given this a scenario of high inflation and high interest rates is likely to continue in this financial year as well. And that is no April Fool's joke.

Vivek Kaul is a writer. He tweets @kaul_vivek