India experiencing artificial boom

'India Shining' has been the hotbed of numerous editorials and debates in the past few months. With India's landmark victory against Pakistan in the recent cricket series, the supporters of the 'India Shining' slogan will find themselves in a favourable position and voice their conviction with even more vigour.

Yet most of the global rating agencies have placed India's sovereign rating on junk status. For example, Standard & Poor's and Fitch have put India's debt at junk status, with ratings of 'BB' and 'BB-plus', respectively, primarily because of its burgeoning fiscal deficit.

Although Moody's investor service has given India a 'Baa3' investment grade for its growth and robust external health, Moody's has contended that India's 8.1 per cent growth is not sustainable and that it will eventually slow down to 6.5 per cent.

Now, whether India achieves a 8.1 per cent or a 6.5 per cent GDP growth is not the focus of this article.

In fact, it is irrelevant to the current discussion. We should not be bogged down by such esoteric statistics, which are anyway subjective indicators.

What we should try to understand instead is the process and the economic principles through which an economy becomes prosperous.

The process through which India has achieved this 'remarkable feat' is inherently unstable in nature and hence India Shining, which I believe to be a mere hype before the general elections, will crumble under its own weight in the near future.

What the Indian economy is experiencing today is an artificial boom and is the result of what is commonly known in economic parlance as the Political Business Cycle Theory.

So, what exactly is PBCT? What implications does it have in the long-term structural growth of the economy? The objective of this article is to throw some light on these litigious issues.

PBCT tries to establish a link between political elections and business cycles. This theory was first extended by the famous Yale economist William D Nordhaus in 1975.

His theory was that presidents, to the extent that they can influence the private economy, would manipulate the key macroeconomic variables in an attempt to achieve political popularity.

Hence, they would have a strong incentive to boost total economic output just prior to an election. By cutting taxes or increasing spending just before the election, their chances of re-election are improved, and the full negative consequences of the policy would not be felt until after the election.

The result, according to Nordhaus's theory, is a "political business cycle" where in every four years, the economy goes through a boom and bust cycle where the booms come just prior to the election, and busts come just after the election.

The tools applied by the incumbent politicians to manipulate the economic macro-variables  in their favour are expansionary fiscal and monetary policies. These policies are popular in the short run and take the form of tax cuts, falling unemployment, falling interest rates, new government spending on services for special interests and so on.

Unfortunately, these very policies, especially if pursued to excess, can also have unpleasant consequences in the longer term (like accelerating inflation, an unsustainably low rate of savings to support future investment, damage to the foreign trade balance, long-term expansion of the government's share of GNP at the expense of people's disposable incomes and so on).

So immediately after the election (and the next election is far away), politicians tend to reverse their strategy by raising taxes, cutting spending, slowing the growth of money supply, and allowing interest rates to rise.

Once this theory is clearly understood, it is not difficult to decipher the perverse nexus between the incumbent politicians and the central bank governors -- resulting in a promiscuous relationship between politics and macroeconomics.

So, despite the common assertion by economists that the Federal Reserve is an "independent" institution, in reality, it has never been independent of politics. According to Congressman Ron Paul (R-Tex): "The Fed is a political institution that is used to manipulate the economy for the benefit of White House incumbents at the expense of the rest of society."

The bottom line is that the actions taken by the central banking authorities, especially during a crisis or severe economic downturn, cannot be separated from the political needs of those who are in power. Currently, Alan Greenspan runs the Fed after accommodating the US president's political preferences.

If we take a look at history, it is not difficult to find similar examples. Let us consider the US as a case study.

In an April 1978 article, in the Journal of Monetary Economics, the late Robert Weintraub showed how the Fed fundamentally shifted its monetary policy course in 1953, 1961, 1969, 1974 and 1977 -- the years in which the presidency changed hands.

For example, Eisenhower wanted slower monetary growth; the money supply grew by 1.73 per cent during his first administration -- the slowest rate in a decade.

President Kennedy, on the other hand, wanted faster money creation; so from January 1961 to November 1963 the money supply grew by 2.31 per cent. Lyndon Johnson desired even faster monetary growth to finance the Vietnam war; money supply growth more than doubled during his presidential term to 5 per cent. These erratic fluctuations of monetary growth all occurred under the same Fed chairman, William McChesney Martin.

Economist Edward Kane describes this lucidly: "Whenever monetary policies are popular, incumbents can claim that their influence was crucial in their adaptation. On the other hand, when monetary policies prove unpopular, they can blame everything on a stubborn Federal Reserve."

In return for this favour, the Federal Reserve is allowed to accrue a gargantuan fund by earning interest income from government securities it purchases through open market operations.

Coming back to the Indian scenario, it is no wonder that the economy is flushed with excess liquidity and a mounting fiscal deficit (10 per cent of GDP, Central and state combined), right before the year of the election.

Some might attribute this to being a mere coincidence but past evidence seems to point towards the existence of a political business cycle. In fact, the consolidated fiscal deficit in India has been 7.5 per cent to 9.5 per cent for every consecutive three-year period since 1980.

With the election just round the corner, the incumbent government with the help of the Reserve Bank of India has embarked on an expansionary fiscal and monetary policy.

The result is a seemingly booming economy at the cost of excess liquidity and a burgeoning fiscal deficit in the economy that will surely have negative repercussions in the coming years.

The forecast growth rate in GDP of 8.1 per cent in FY 2004-05 could not have come at a better time. This has not only helped to usher in a 'feel-good factor' in the economy, but may also play an instrumental role in the re-election of the incumbent government.

But sadly, people have failed to appreciate the fact that such growth rate is unsustainable because it is built on the edifice of the incumbent political coalition's manoeuvre of the key macro-variables of the economy by using the RBI as its pawn to improve the chances of its re-election.

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