There is a little doubt that we are on the downward slope of a business cycle. There is a little doubt that we are on the downward slope of a business cycle.

Now that the euphoria over the projected $5-trillion GDP number has calmed down, let us look at some ground realities. These could not be better summed up than by Harish Damodaran (‘Death of enterprise’, IE, June 29). To quote: “Since around October, even the big guns have been feeling the heat, with sales of everything — from cars, two-wheelers and trucks to consumer staples — slowing down. Worse, nobody knows when growth is returning. The slowdown, now clearly visible, could be the cumulative result of an extended investment famine, which, together with demonetisation, GST, agrarian distress and high real interest rates, has taken a toll on incomes and spending.”

There is a little doubt that we are on the downward slope of a business cycle. While no two business cycles are identical in terms of their cause and duration, there are important lessons to be learnt from how they began and how they were tackled. The Great Depression of the 1930s began with the collapse of the stock market on the New York Stock Exchange in 1929 and well over a decade. Since then we thought we had learnt to tame such a depression thanks to the General Theory of John Maynard Keynes, who propagated that the basic cause of a downturn was the absence of aggregate effective demand. This was a consequence of people’s preference to hold on to money at a time of uncertainty. It followed that there would be a fall in the rate of saving and investment.

After the start of World War II, which presaged the recovery on account of the massive demand for armaments, Keynesian theory became the accepted wisdom in the developed world. There was, however, this rider: Fiscal conservatism is not desirable during a downturn in the economy and some deficit financing may be required even if it leads to a little temporary inflation. This was ridiculed specially by the Chicago monetarists, who claimed that a little inflation is like a little pregnancy which cannot remain “little”.

Keynesian wisdom prevailed well into the Seventies with a further rider that there is a trade off between inflation and full employment. In other words, if full employment is the goal of policy makers, they should tolerate some inflation in the interim. If zero inflation is the goal, then full employment is unlikely. There was empirical evidence for this.

Keynesian theory was jolted during the Seventies. The first oil shock with a 400 per cent rise in oil prices halted growth in the industrial world, which gave rise to a phenomenon known as stagflation. Keynesian wisdom was in question, although Paul Samuelsson vigorously defended Keynes saying that stagflation — a combination of stagnation and inflation — was the consequence of a supply shock and quite consistent with Keynesian theory. However, the tide turned against Keynes with the second oil shock of 1978.

In the meantime, redemption came to Friedrich von Hayek, Keynes’s lifelong rival, who was dead set against monetary measures to tame the business cycle. He gained traction in the Eighties when Margaret Thatcher in the UK and Ronald Reagan in the US adopted his ideas, which led to prosperity. Milton Friedman, Hayek’s protégé, became the leading light of the monetarist school at the University of Chicago. Consequently, the economics profession got divided between the salt water (those economists associated with the universities on the eastern or western sea board of the US) and the fresh water ones (associated with Chicago and the universities around Lake Michigan). The former called themselves the New Keynesians and the latter, the New Classicals. The New Classicals, who had their say from 1978 onwards, faced the Great Recession in 2008.

The Great Recession was unquestionably a financial crisis beginning with irresponsible housing loans in America, which spread to the entire banking system in the Western world. So, comparing the two downturns, what lessons can we learn for India? One important point brought out by Thomas Piketty’s numbers is that high growth and low-income inequality prevailed during the Keynesian years (1945-75) compared to the periods before and after that.

In India, income uncertainty and the desire to hold on to the money was in all probability triggered by demonetisation and later, by initial hiccups of the GST plan. Macroeconomic policy, however, was more in tune with the Chicago school. That is, zero tolerance for inflation without concern for the possible impact on employment. The consequences are before us. India has managed low levels of inflation and achieved targeted budget deficits, but look at the state of employment. Never have we had such high levels of joblessness. And with no concern about Piketty’s numbers, we are trying to control the disparity between the rich and the poor through taxing the upper layer without a care about declining growth numbers.

What we need is low real interest rates and greater liquidity in the system to revive the animal spirits of businessmen. Only then can greater investment follow. This is a time to take some lessons from Keynes and possibly retain some advisors from the “salt water” school of thought.

This article first appeared in the print edition on August 28, 2019 under the title ‘Learning from Keynes’. Bharat-Ram is the author of Evolution of Economic Ideas.

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