Chapter 6: The Boom and Bust Phenomena PDF

Chapter 6 : The Boom and Bust Phenomena 4/23/24 11:47 PM Outline: 1. Business Cycle 2. THE BOTTOM LINE: UNEMPLOYMENT RATE 3. Fiscal and Monetary Poli...

Chapter 6 : The Boom and Bust Phenomena 4/23/24 11:47 PM Outline: 1. Business Cycle 2. THE BOTTOM LINE: UNEMPLOYMENT RATE 3. Fiscal and Monetary Policies Business Cycle Free market economies go through what is termed a business cycle. Figure 6.1 shows GDP growth rates for India from the fiscal year 1966–67 to the fiscal year 2011–12. The negative growth rate of about -0.04 percent in 1966–67 was preceded by the war with Pakistan on the western front. The very low growth rate of about 1.63 percent in 1971–72 and the negative growth rate of about -0.55 percent in 1972–73 can be attributed to the war that carved out a new nation— Bangladesh. War creates uncertainty and fear which makes businessmen wary of future prospects and makes them hold back on new investment plans. This lowers the demand for investment goods in the market. Consumers, too, defer any major purchases of consumer durables and real estate. This leads to a lowering of demand and an accumulation of inventories, which sends a signal to businesses that they should produce less which, in turn, leads to a negative GDP growth rate.War-related expenses increase the demand for some goods such as arms and ammunition, which however, add virtually nothing to the final goods and services consumed by households. The biggest trough in the fiscal year 1979–80—the year of the oil shock when the world experienced a shortage of crude oil due to the Iranian revolution and successive price hikes by OPEC. Beginning of economic reforms in India in 1991. Prospects were very bleak for the economy at that time—businesses refrained from major decisions in the expectation of a devaluation of the Indian rupee. As was feared, the rupee was devalued by about 20 percent in July 1991. The GDP growth rate came down to barely 1 percent that year. The World Trade Centre bombing on September 11, 2001 jolted the economic world. Air travel and global trade were substantially reduced in the wake of the event, bringing the GDP growth rate in 2002 down to 3.77 percent. The last full downturn in India was witnessed in 2008, immediately following the 2007 subprime crisis in the US, which caused a severe downturn and sharp fall in the US GDP by 2.67 percent. Figure 6.1: India’s Annual GDP Growth Rates (1966–67 to 2011–12) Recession as a phenomenon where the GDP falls (that is, the GDP growth rate is negative) at least for two consecutive quarters. Reasons behind the reduced output is caution exercised by firms due to accumulation of inventories. Inventories pile up when a sufficient demand is not coming through for goods and services. A lack of sufficient demand for goods and services is the main reason for a recession setting in. Output can also come down due to cost–push inflation (previous chapter). Only now has the world come to know that the debt crisis in Greece was partly due to fiscal deficits being under-reported. Keynes argued that ‘animal spirits’ are dimmed by such events which lead to a lowering of demand for goods and services, ultimately leading to a recession. Dimmed Animal Spirits and the Recession Keynes : positive activities of businesses depend on spontaneous optimism and an urge to action which he called ‘animal spirits’. He used this colourful term to describe one of the essential ingredients for economic prosperity— confidence. Animal spirits are a particular sort of confidence, a naïve optimism. When economic calculations are supported by animal spirits, the thought of making losses is put aside, just as a healthy man puts aside the expectation of death. This is substantially dependent on the socio-economic and political environment which should be congenial to the business community. During Jet airways downturn - The socio-economic and political environment was vitiated by various big- ticket corruption scams such as the 2G spectrum, the Radia phonetapping episode, and the hasty introduction and withdrawal of the bill to allow multi-brand FDI in the retail sector Important tasks for the government, therefore, is to engage in a dialogue with industry to reassure, provide good governance, create a congenial environment, and foster business confidence. Promote the proverbial animal spirits. THE BOTTOM LINE: UNEMPLOYMENT RATE A higher GDP and a higher output mean that there is more employment in the economy—more employment of factors of production in general, and of labour in particular. A workforce consists of those who are employed and those who are involuntarily unemployed. The unemployment rate is defined as a percentage of the workforce that is involuntarily unemployed. ‘Frictional’ unemployment: Unemployment that occurs when people happen to be between jobs or have just graduated from school. Structural unemployment: Unemployment caused by structural changes among various sub-sectors of the economy, leading to a mismatch between the vacancies and the skills in the labour force, until workers can be retrained or relocated. The unemployment rate associated with these two types of unemployment is described as the ‘natural rate’ of unemployment or the level of unemployment associated with full-employment of resources. Rule of thumb in the Western world is that 4 to 5 percent unemployment is natural and consistent with full-employment of resources. Demand–pull inflation - had addressed the issue of economy overheating— when the demand for goods and services keeps increasing (a rise in animal spirits at play), inventories may go down, prices may rise, and firms will try to produce more. This forces firms to overwork the factors of production. This applies to labour as well. During the upswing of the business cycle, the unemployment rate may temporarily go below the natural rate. Turnover is very high as people move from job to job looking for better prospects—quits are pro- cyclical. Cannot be sustained for long and eventually rapid inflation may result. In the long run, production capacities may expand, technology may improve, and therefore, inflation may come down. Policies which the government and RBI may adopt to curtail such demand–pull inflation. If animal spirits get dimmed and confidence levels are lowered because of a variety of socio-economic and political causes. This represents the downswing of the business cycle. Demand for goods and services falls and causes unemployment rate to increase beyond natural rate. Demand for goods and services is down, and firms accumulate inventories and plan to produce less, so lower amounts of factors of production, including labour, are required. Cyclical Unemployment: Unemployment associated with the business cycle or the boom and bust in the economy Thus, if (job) quits are pro-cyclical, (job) firing is countercyclical occurring on the downturn of the business cycle. The demand for higher education seems to be counter- cyclical. If graduates lose jobs in a recessionary period, the opportunity cost of their time is low and they go for skill-enhancement through higher education. This, perhaps, explains why applications for PhD programmes seem counter-cyclical! Unemployment seems to create a negative externality on society, and government intervention is called for in terms of what is called the fiscal policy of the government and the monetary policy of RBI. Unemployment Rate in India: Who Knows? The US Bureau of Labor Statistics has been calculating the US monthly unemployment rates since 1940. In contrast, Indian data becomes available only every five years. The data is collected using three approaches: Usual Principle Status (UPS); Current Weekly Status (CWS); and Current Daily Status (CDS). UPS is the most liberal, followed by CWS and CDS. NSSO unemployment rates were 2.5 percent, 3.6 percent, and 6.6 percent for UPS, CWS, and CDS, respectively. Fiscal and Monetary Policies In the long run—prices and wages could adjust themselves to reach full employment of labour once again. That is, if unemployment is high, then it is critical we do something about it in the short run itself. Fiscal and monetary policies of the government are, therefore, short-run remedies to bring the economy back to the full-employment level of GDP—a GDP that is consistent with the natural rate of unemployment. Fiscal Policy The policy adopted by the government of a country to alter its spending or taxes to bring changes to GDP, employment and inflation in the economy. During recession, government follows what is called an expansionary fiscal policy. This involves increasing government spending and/or cutting taxes. Essentially, the government tries to give a fillip to the demand for goods and services which has come down due to recession. Increase in GDP in multiples Govt Spending Let us suppose that the government hires people by paying them Rs 100 for constructing a dam. Assuming people save 30 percent of income, they spend Rs 70 on goods and services. This expenditure of Rs 70 becomes income for some other individuals, like, grocers and tailors. They, too, will save 30 percent of this amount and spend Rs 49. This chain of spending increases GDP in successive rounds by Rs 100, Rs 70, Rs 49, and so on. In all, the addition of this geometric series amounts to Rs 333.33. The original employment of workers, by spending Rs 100, generates employment in other sectors, and the total addition to GDP turns out to be 3.33 times original spending. This 3.33 is called the ‘income multiplier’. Tax reduction by the government. A reduction of tax by Rs 100 causes people to spend Rs 70 in the first round. This spending of Rs 70 becomes income for others and they, too, will save 30 percent of this amount (Rs 21) and spend Rs 49. When taxes are cut, income generation in successive rounds is Rs 70, Rs 49, Rs 34.3, and so on. The addition of this geometric series amounts to Rs 233.33, that is, 2.33 times the original reduction of Rs 100 in taxes. The income expansion through a tax cut is lower by Rs 100, for the government itself does not spend Rs 100 in the very first round. Expansionary fiscal policy raises GDP in multiples of the original spending or of the tax cut. Fiscal deficit for the Central government in India was 2.5 percent in the year 2007–08. The GDP growth rate that year was 9.82 percent. However, the very next year, the GDP growth rate fell to 4.93 percent. This sudden fall was triggered by the subprime crisis in the US which resulted in a recession. Indian Govt: fiscal spending on the MGNREGS, highway projects, and Sixth Pay Commission disbursements, importantly, over time, it reduced excise duties from a high of about 14 percent to 8 percent. Service tax, too, was cut from 12 percent to 10 percent. This expansionary fiscal policy resulted in a fiscal deficit amounting to 6 percent and 6.3 percent in the next two years, 2008–09 and 2009–10. But it had a salutary effect on growth: the GDP growth rate bounced back, averaging about 9 percent during the fiscal years 2009–10 and 2010–11. Expansionary fiscal policy was a revolutionary idea which Keynes propounded for reducing unemployment—a deficient demand in a recessionary period could be countered by an increase in government spending or by tax cuts which increase demand in multiples of the initial spending or of the tax cut. There are limits to how much the government can spend and how much taxes it can cut, for it could snowball into high fiscal deficits. High fiscal deficits cause a crowding-out of private investments, and may increase the trade deficit as well. Accumulated fiscal deficits could lead governments to high indebtedness. The European PIIGS (Portugal, Italy, Ireland, Greece, and Spain) countries today are having a hard time repaying their debts. Greece’s public debt had crossed 142 percent in 2010. Inability to repay is causing enormous economic hardship to the country and the rest of the world. Moreover, while it may be easier for governments to start incurring certain expenditures during recession, it is politically not easy to withdraw spending when the economy is booming. RBI, India’s central bank, also has an important role to play in preventing the extremities of the boom and the bust through its own independent policies of demand management. Monetary Policy Monetary Policy: The policy adopted by the central bank of a country to change money supply to bring changes to GDP, employment and inflation in the economy. Unbridled use of the central bank by a government to augment the money supply and to finance its Contractionary/ expenditures can lead to hyperinflation. Expansionary RBI follows an independent monetary policy to control inflation and to boost demand during Monetary recessionary periods. policy RBI’s stance for controlling the demand–pull inflation that typically occurs when the economy is overheated during a boom period is called the ‘contractionary monetary policy’. On the other hand, if the economy is in recession due to a deficient demand for goods and services, RBI may engage in an expansionary monetary policy. Recession -> high cyclical unemployment, To increase employment, RBI induces firms to start new investment projects by reducing cost of capital and interest on loans. Increased availability of loans in banking system happens through increase in money supply in the economy. Ways to do it: RBI Addressing RBI can decrease the CRR or the SLR so that banks are left with more cash on hand per deposit recession received. This would enable banks to initiate multiple credit/deposit creation (see Chapter 3). This would lead to a bigger money supply and an increased availability of loans in the market. RBI may engage in an OMO to buy government securities from the market. When RBI buys the securities, it is tantamount to cash or money flowing into the private sector which would get deposited in bank accounts. This increases cash on hand with banks with which they would be able to initiate multiple credit/deposit creation. OMO operations (Another perspective): RBI purchases government securities -> demand for government securities goes up -> raises the price of gov securities. Ex.initial price of security Rs 100 and 10 percent interest on it. This means that Rs 10 is paid every period as interest. Assume security price goes up to Rs 120 -> Any new buyer of would get Rs 10 from the government on a security bought for Rs 120. Rs 10 interest over purchase price of Rs 120 implies the new interest rate is (10/120) x 100 = 8.33%. OMO-purchase of government securities by RBI leads to a fall in the market interest rate. Repo rates RBI has created a new and popular window for commercial banks to borrow from RBI - LAF. Inverse with Commercial banks generally need funds for short-term purposes to on-lend to its customers, maintain Money supply CRR, SLR requirements, or fund any other temporary obligations. To facilitate this, RBI enters into an agreement with commercial banks, whereby the latter sell government securities to RBI and simultaneously place a repurchase order (Repo) with it for the same securities for a future date. The repurchase price is higher than the selling price. This effectively means that commercial banks borrow temporary funds from RBI. The difference in price—expressed as an annualized percentage of the selling price— represents the interest rate and is popularly known as the ‘repo rate’. The repo rate has been effectively used by RBI as a monetary policy tool. Lower the repo rate, higher will be the expansion in money supply and availability of loans. US interest rates were low in 2001 to 2005, in the eagerness to sell homes loans were granted to many subprime borrowers. Real estate prices were high, banks and customers used the very homes they were buying as collateral against the loans. These subprime loan assets were sold by banks to GSE such as Fannie Mae and Freddie Mac. The GSEs repackaged these loans as MBS with a much higher credit rating -> Foreign investors readily bought these. Housing bubble burst -> prices went down -> interest rates went up -> borrowers defaulted -> collateral could not cover loan -> foreclosures -> sellout of MBSs Lehman Bros - FI specialist went bankrupt Sept 2008 Subprime crisis Impact to India To recover financial losses in the US, investors started liquidating overseas portfolio investments including those in India. Therefore, stock prices plummeted globally. Increased demand for US dollar resulted in depreciation of rupee making exports difficult. India’s exports dwindled because of recession in US and Europe. Falling exports and falling stock prices dimmed the business confidence in India, and production and investments fell. The recession had been passed on to India. The result—the GDP growth dropped to 4.93 percent in 2008–09. Indian government -> expansionary fiscal policy -> cutting excise duty to 8 percent ,service tax to 10 percent. RBI -> expansionary monetary policy by lowering the repo rate -> boost to domestic investment projects. The economy bounced back in the next two years with an average GDP growth rate of about 9 percent. Monetary policy, therefore, can be summarized as the management of market interest rates, changing the stock of money supply in the economy, and changing the availability of credit in the market. Expansionary monetary policy -> ‘RBI has engaged in quantitative easing’; -> ‘RBI is pumping liquidity into the market.’ Ultimate objective, through this, is to increase the GDP growth rate and reduce unemployment. A RECENT EPISODE: STAGFLATION A price rise is not a concern in a recession which is caused by deficient demand. In fact, prices may go down. In such a situation, expansionary fiscal and monetary policies are adopted to revive the economy. If the economy is overheated, that is, there is a high growth rate in GDP, a low unemployment rate (perhaps lower than the natural rate), and high inflation, the contractionary fiscal and monetary policy will be followed. Aftermath of the subprime crisis, - US and the UK turned almost into a depression, India’s GDP growth rate fell from 9.82 to 4.93 in 2008– 09, pulled out of this recession through the stylized expansionary fiscal and monetary policies. German philosopher Johann von Goethe: ‘Everything in the world may be endured except continued prosperity.’ New problem: India was cruising at a 9+ GDP growth rate, double-digit inflation surfaced. Food and fuel inflation continued throughout 2011. Financial crises surfaced in many European countries around May 2010 dampening stock-market activity and international trade. Business confidence was weakened corruption allegations and scams such as the 2G spectrum. Slow progress on many of the fiscal reform promises also contributed to this loss of confidence. Stagflation On the one hand, cost–push inflation raised its head, and on the other, a deficient demand in the in India - 2011 economy slowed down the GDP growth rate. This meant that India in 2011 was suffering from stagflation, that is, the simultaneous existence of inflation and unemployment. Double-digit inflation - major concern - RBI increased the repo rate more than a dozen times -> hope that private spending would get halted -> inflation would be curtailed. This meant that the GDP growth rate would go down. This did happen, but India had high GDP and was able to absorb 2 point drop. Handling Stagflation Handling stagflation—promoting GDP growth and reducing inflation—is always difficult. Fiscal and monetary policies offer a trade-off between the two. Extinguish inflation at cost of growth or Growth at the cost of inflation. Therefore, the stylized fiscal and monetary policies have to be complemented by some tailor-made policies in right earnest. These policies should achieve two things: Ease the supply constraints, so that cost–push inflation comes down; Bolster the animal spirits in the minds of producers and consumers through economic reforms. Specifically, these involve: 1. Building up a consensus in Parliament and allowing multibrand FDI in the retail sector. Eliminate the cascading profit margins of middlemen in the supply chain. Price rise in check. Signal to private sector that economic reforms are on track. 2. Introducing a single GST so tax-on-tax is removed and dampening effect on the price rise. positive signal to industry. 3. Expediting the disinvestment of public sector undertakings—promote operational efficiency, give a one-time boost to lower budget deficits for few years. 4. Fast-track handling of the series of corruption and scam cases - reviving the animal spirits. 5. Publishing unemployment rates at regular intervals - help better assess economic situation frequently and to calibrate their policy initiatives. 6. Private competition against monopolistic APMC wholesale markets dealing in agricultural produce. Handling 7. RBI engages in selective credit control, charge higher interest rates on working capital loans for Staglation private food warehouses, to slow food price inflation and discouraging the hoarding of food supplies. 8. Improving the output delivery of MGNREGS so that quality construction of bunds, roads, and wells would increase not only employment but agricultural productivity as well. 9. Infusing new technology into agriculture in the form of GM (genetically modified) foods; building agricultural infrastructure; lowering customs duties. required to meet the future demand, for population growth has outstripped growth in food grain production for the past two decades. Definitions Animal Spirits: Spontaneous optimism and urge to action among businesses, which is conditioned by the socioeconomic and political environment. The term was used by John Maynard Keynes, the father of modern macroeconomics in his 1936 treatise, The General Theory of Employment, Interest and Money. Booms and Bust: A term used to describe business cycles. See Business Cycle. Business Cycle: A phenomenon in a free market economy where periods of high growth in GDP and employment are followed by a low or negative growth in GDP and employment. Cyclical Unemployment: Unemployment associated with the business cycle or the boom and bust in the economy. Depression: A severe form of recession. For example, GDP, employment, and prices fell by about 25 percent in the US during the period 1929 to 1933. This was referred to as the Great Depression. Fiscal Policy: The policy adopted by the government of a country to alter its spending or taxes to bring changes to GDP, employment and inflation in the economy. Frictional Unemployment: Unemployment that occurs when people happen to be between jobs or have just graduated from school. Involuntary Unemployment: An activity status where individuals actively seek jobs at given wage rates but do not find one. Labour Force: Those who are employed and involuntarily unemployed. Monetary Policy: The policy adopted by the central bank of a country to change money supply to bring changes to GDP, employment and inflation in the economy. Natural Unemployment: Unemployment that consists of the frictional and thestructural types. Overheating of economy: A phenomenon where business and consumer optimism lead to a higher demand for goods and services, resulting in a higher GDP growth rate, but, in which, the factors of production are overworked and this leads to inflation. Recession: An economic phenomenon where GDP falls for at least two consecutive quarters. Quite often, a sharp fall in the GDP growth rate also gets described as recession. Stagflation: An economic phenomenon characterized by high inflation and high unemployment. Structural Unemployment: Unemployment caused by structural changes among various sub-sectors of the economy, leading to a mismatch between the vacancies and the skills in the labour force, until workers can be retrained or relocated. Unemployment Rate: The percentage of labour force that is involuntarily unemployed. Voluntary Unemployment: An activity status where individuals choose not to seek employment at the given wage rates.