“ The economy, stupid” was an election message crafted by James Carville for Bill Clinton’s successful campaign in 1992. The US economy was then facing recessionary conditions. As Nirmala Sitharaman rises to present her maiden budget a few days from now,” the economy ,stupid” will loom large in her calculations and her approach. India will look forward anxiously to what the renewed Modi Government will offer, because the situation, by all accounts, will need skilful salvaging. My memory goes back to the Great Recession of 2008, the adroit handling of which was one of the important factors leading to Dr. Manmohan Singh’s re-election in 2009.
The crisis started in the United States In 2006–2007. It started in the sub-prime mortgage market and grew into a full-fledged global phenomenon that engulfed India among other countries. The prelude to the crisis was a prolonged period of calm, stability, sustained growth and low inflation in the global economy over many years. A mild recession in 2011 sparked off a series of interest rate cuts by the Federal Reserve, as many as 11 times from 6.5% in May 2000 to 1.75% in December 2001 thus substantially injecting liquidity into the market. With so much of cheap money sloshing around, there was a tendency on the part of banks and financing institutions to seek more avenues for lending. Housing mortgages became the favoured channel for funnelling credit, particularly since affordable housing had become a prime policy objective of the Federal Government ever since the founding of “Fannie Mae” by Roosevelt in 1938 and “Freddie Mac” in 1970.”
In the US, benign macroeconomic conditions sparked off a housing boom through an increase in mortgages originated by banks and non-banking financial institutions. This also induced speculative activity as real home prices rose by 85 per cent from 1997 to 2006.The underlying expectation was that real prices will continue to rise and rise enabling an upward growth spiral. It was also expected that if at all the bubble burst, the bits and pieces would be picked up by Fannie Mae, Freddie Mac and the Federal Reserve.
This seemed to be too good an opportunity for big finance to pass up. Housing debts were repackaged with other high risk debts and sold to eager financial investors creating financial instruments called CDOs or Collateralised Debt Obligations, a form of mortgage backed derivative. The risk was thus passed on manifold through derivatives trade. The entry of big finance into the mortgage market was on the back of high leveraging. Derivatives trade in financial markets, supported by low interest debt of a high order, replaced genuine house buying and selling activity, thus making the bubble grow and grow, until inevitably it burst. As Alan Greenspan, former Governor of Federal Reserve and a votary of animal spirits in the economy put it, “The very nature of finance is that it cannot be profitable unless it is significantly leveraged….and as long as there is debt, there can be failure and contagion.”
In early 2008, a major US investment bank, Bear Stearns, was sold on an emergency basis. The second largest US investment bank, Lehmann Brothers went bankrupt. Another big investment bank, Merrill Lynch merged with a commercial bank. The capital adequacy of Fannie Mae and Freddie Mac came under increasing pressure. The financial markets were in turmoil and the contagion spread worldwide, affecting global capital flows, global trade and global growth severely. As credit became increasingly vulnerable, deleveraging took place almost in panic mode and a huge credit crunch enveloped the world. National stimulus packages became the order of the day in all major economies.
The years before the crisis had been great years for India. India became a US$ 1 trillion economy in 2007-8. The rate of growth of per capita income had accelerated to more than 7% in the previous five year period as compared to 3% to 4% in the preceding two decades. Despite the conservative stance of Indian monetary policy for years, the malaise was sure to affect a large and growing economy like India, whose global interface had been increasing steadily since the sweeping economic reforms of 1991. Liquidity seemed to disappear overnight from the market. The call money rate rose dramatically from 9% on 8 September 2008 to about 20% a month later.
“ In responding to the crisis, it is essential for public policy to resist the temptation to excessively focus on measures recommended by the global fora and ignore the unique features of the Indian economy” ( Adarsh Kishore et al, referring to Reddy 2009. P. 143). To me, the experience of the economic crisis was a refreshing exercise of the Government of India and the Reserve Bank, then led by D. Subbarao, acting in sync with one another, of complete harmony and cohesion between fiscal policy and monetary policy, of mutual coordination and support between two great arms of policy in the economic sphere. As in later years, I watched with consternation a developing conflict between the Reserve Bank and Government, as Reserve Bank Governors engaged in an immature battle for “autonomy” with the Government, regardless of the needs of the economy and the people of India, I could not but reflect on the unity of action displayed in those difficult days.
Montek Ahluwalia, then Deputy Chairman of the Planning Commission, prepared the first stimulus package, aimed at revving up the economy and stimulating certain affected sectors like automobiles. I worked with him to add a few elements like an across-the-board cut in excise duties. Dr. Manmohan Singh , who was also finance minister at the time, asked me to discuss the package also with Pranab Mukherjee and with Chidambaram, then Home Minister, former Finance Minister. I recall that Chidambaram asked me in particular whether overall cuts in excise duty were necessary. I told him that a clean cut across all products is better than sectoral cuts, as otherwise we will be battling with problems of duty inversion for long. The package contained a slew of measures aimed at stimulating consumption, promoting investment and exports and specific measures to support hard-hit sectors like housing, automobiles, textiles and small and medium industries.
The first stimulus package was announced in the evening of 7th December at a Press Conference, taken by Montek jointly with Ashok Chawla, then Secretary (Economic Affairs) and me. Before the Press Conference, Montek requested me to call Subbarao and see if Reserve Bank could come out with a supportive package on the same day. Sure enough, an hour after the fiscal policy package was announced, Subbarao announced further measures to ease liquidity. The combined effect was electric.
The Reserve Bank played a major role in containing the crisis in India. The Bank rates were reduced significantly, the Statutory Liquidity Ratio and the Cash Reserve Ratio were cut, financial markets were given confidence and many other measures taken to infuse liquidity. In the meanwhile, I encouraged commercial banks to convert the easing of liquidity announced by the Reserve Bank into more investment and more consumption through greater outflow of credit. Along with Montek, I also endeavoured to make statements intended to revive confidence in the market.
Another fiscal stimulus package was announced a few weeks later. The net result, as stated by Stephen S. Roach, Chairman, Morgan Stanley India (Economic Times, June 2,2010), was that” India sailed through the Great Crisis of 2008 without barely missing a beat.“
A somewhat similar global and national situation prevails now. The situation is summed up with clarity in the Minutes of the June meeting of the RBI’s Monetary Policy Committee. As the Governor, Dr.Shakti Kanta Das, candidly admitted,”There is clear evidence of economic activity, losing traction, with the GDP growth in A4:2018-19 slowing down to 5.8 per cent”, down from 6.6 per cent in the preceding quarter. The global economy has been slowing down, the emerging economies have been sluggish, the US-China trade dispute has been simmering, Brexit has brought in its wake its own set of problems. There has been a decline in rabi production and uncertainty on El Niño conditions in the current monsoon. Growth in eight core industries decelerated sharply in April. The service sector shows no great signs of growth and the automobile sector, railway freight traffic and domestic airline capacity utilisation all showed a downward trend. The GDP growth rate for the current year, originally estimated by RBI as 7.2 per cent has now been reset at 7 per cent. Gross fixed capital formation declined from about 200 billion USD in December 2018 to 198 billion USD in March 2019. Private consumption expenditure declined from 61 per cent of GDP to 59 per cent, while investment as per cent of GDP fell from 32 per cent to 28 per cent. Business confidence too showed a downward trend. Official data show unemployment rate at 6.1 per cent, the highest in 45 years.
While the facts present a gloomy picture, there are some encouraging signs. First, no one in authority is trying to pretend that the situation is better than it is. The first step towards resolution of a problem is its recognition. Second, the solid majority which the people have given this government gives it more space to take firm decisions. Third, the Reserve Bank has moved away from pure inflation targeting to an accommodative stance. More liquidity has been pumped into the financial system, and repo and reverse repo rates have been cut. The excessively hawkish monetary policy stance has obviously been softened.
The ball is now in the Finance Minister’s court. Will she supplement the accommodative monetary policy stance with a fiscal stimulus to kick start the economy on both the supply side and the demand side? Or will she adhere to conservative fiscal deficit norms? In his statement at the recent RBI Monetary Policy Committee meeting, Dr. Ravindra Dholakia said, “The concern about first, the fiscal slippage at this stage and second, its adverse impact on inflation in my opinion is both misconceived and misplaced.” The fiscal deficit ratio, absolute fiscal deficit divided by GDP expressed as a percentage, is a function both of its numerator and its denominator. The numerator and the denominator are also interconnected, as more investment, more public consumption, which will inflate the numerator, can lead to a higher GDP, the denominator ,thus automatically correcting the ratio at a higher level in the medium term.
These are the questions before the Finance Minister. The answers will be known shortly.
Former Union Cabinet Secretary, presently, Chairman, Centre for Development Studies, Trivandrum
(The facts and views expressed in the article are those of the writer.)