Dealing with lack of aggregate demand

If many car factories find themselves running idle, or with surplus inventory it could be because there was over-investment in the sector. Owing to a rosy outlook and perhaps excessive exuberance a few years ago, many independent car companies decided to invest in new capacities, to take advantage of the strong demand that they anticipated.

But the collective independent and uncoordinated decisions of all investments, resulted in a glut of capacity. This caused all of them to slash prices to clear inventories.

This is a typical story of a downturn caused by excess investment, and is an inevitable part of market economies. Indeed, this may have been the story when huge investment was made in the steel sector in the mid-1990’s resulting in large capacity overhang, causing much distress.

But eventually such a downturn works itself out as inventories are cleared at lower prices, capacity utilisation of factories starts improving, and some pricing power returns to the producers.

The upswing of the cycle is inevitable because the underlying demand remains strong. It’s just that over-investment created a temporary glut. This is the way a typical business cycle downturn and upswing works, especially in market economies of the West. To some extent it may be true of India, too. 

But what if there is a lack of underlying demand? Then the business cycle does not start its upswing. Of course, one may say, that if there is lack of aggregate demand in the country, surely it can be offset by the global demand. But that works only for small open economies, and when the global demand is also strong.

For a large economy like India, with a slowing global economy it may not work. What we have is not a cyclical slowdown but largely a structural slowdown which needs deeper analysis, and long-term solutions to address the lack of demand. This may sound like a Keynesian approach, but alas, there is no escaping from Keynes!

Another example of a supply-side innovation which led to substantial growth is the sachet revolution. Technology made it possible to sell products and services in micro quantities without sacrificing quality. This was possible for shampoo, pickles, loans, talk-time or data for download.

This technological innovation from the supply-side made it possible to tap into hitherto untapped demand and led to output growth in several sectors.

This approach was glorified further by the “fortune at the bottom of the pyramid” approach of people like the late C K Prahlad and others. This too does not address the problem of lack of aggregate demand. This is an example of supply-side innovation.

So presently all those who just call for supply-side interventions like reduce cost of production, improve the ease of doing business, remove licensing or inspector raj, are missing the bigger problem.

Of course, the above supply side measures are necessary and should not be ignored. But we have to tackle the problem of lack of aggregate demand in the current context.

It may seem odd, given India’s demography and relatively high savings rate to highlight an “aggregate demand” problem. Also, should not Indian producers cater to global demand too, if domestic demand is inadequate?

After all India’s share in the global exports of merchandise is barely 2 per cent, which surely can be doubled, no matter how slow the global growth? Yes, but still, we must acknowledge that we need to boost domestic demand. 

Which immediately calls for fiscal action, for whatever is done, it will ultimately have a fiscal cost. During the rule of the UPA-1 government, there was a distinct move towards a rights-based approach away from a fiscal spending-based approach.

But each one of those landmark rights, whether right to work (NREGA), right to food or right to education eventually had a fiscal implication. And to this day we are still debating the efficacy of those legislations, although the right to work undoubtedly had significant impact in some parts of India.

So, whether we adopt a modified rights-based approach or straightforward fiscally supported boost of aggregate demand, that’s the only way to get out of the structural slowdown. Let’s examine a few of the structural problems with the economy.

Firstly, the low participation of women in the labour force. At 22 per cent it is lowest among peer countries. Can we think of radical measures? Like zero income tax for women workers for the next ten years? Extra incentive for factories who have women-only workers (or above a high threshold)? Or some government procurement reserved from women entrepreneurs only?

Secondly, the fall in households’ financial savings rate. Can we sell demat gold i.e. sovereign gold bonds more aggressively, and continuously? More tax sops for long term savings? Thirdly, the stagnation in exports for the past five or six years.

Thankfully this has the attention at the highest level, including a very recent panel formed under NITI Aayog’s Vice Chairman. We need to focus strongly on labour intensive manufacturing sectors like textiles and garments, leather and footwear, agro-processing, and services like tourism and construction.

Of course, there is the additional factor of proactively grabbing manufacturing activity which is moving out of China, especially in low-cost labour as mentioned above, and also electronic assembly.

This China opportunity of course depends on private sector initiatives, but the government can certainly push and nudge. There may be many other ideas to address the lack of aggregate demand.

Of course while we create a fiscally-powered demand push, we must not forget other supply-side reform measures such as simplification of GST (ideally to one or two rates), substantially less inspector raj (but with harsh penalties for breaches discovered in statistical sampling), lower income tax rates with minimal exemptions, less coercive tax collections and so on.

The recent announcement to immediately clear all pending dues from the government to vendors is welcome too. The journey to a healthy aggregate demand, and livelier animal spirits of entrepreneurs has hopefully begun.

Ajit Ranade is an economist and Senior Fellow, Takshashila Institution. Syndicate: The Billion Press

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