Chief Economist K Subramanian has exhorted Indian businessmen to increase investment to break the present recession. We need to understand the connection between investment and consumption to place his comment in perspective. Their story is like that of the chicken and the egg—which came first? For a moment, let us begin with investment. Let us say an industrialist made an investment in a textile mill. This would lead to an increase in production of cloth. A number of workers would get wages. They will buy goods from the market for consumption, which on a larger scale augments consumption in the economy. Framed in this way, the driver of growth is investment.
The same process can be written in another way beginning with consumption. Let us say, the people of the country increased their consumption. This would lead to an increase in demand in the market, and businesspersons will make investments to profit from that opportunity. Framed this way, the driver of growth is consumption. It is clear that investment and consumption are connected to each other in a circle. We can “start” the cycle at any of these two points of the circle just like the chicken and the egg.
As said above, irrespective of whether we begin with investment or consumption, an increase in one soon begets increase in the other. If we choose to start with investment, it is soon followed by increased consumption and a ratio is established, and vice versa. We can temporarily increase one or the other, but a ratio will necessarily soon be reestablished. We can also think of them as two cars tied to each other with an elastic string. Either one can pull the other.
The ratio is determined by technology. For example, the consumption will be more and investment less if we are farming with bullocks because the labour involved is more. On the other hand, investment will be more and consumption less if we are farming with tractors because the labour is less.
The economy enters into recession if increased consumption does not follow increased investment i.e., the elastic string snaps. This is the situation of our economy today. Businesspersons have made investments, they are producing goods and paying wages but the consumption is not picking up. It seems that the people do not have confidence in the future and are in a comatose state holding their incomes back.
The present scenario indicates that consumption is the driver of economic growth rather than investment. Shops are full of goods. A further increase in investment would only add to the inventories since the car of consumption has its hand brake on and is holding back the other car.
A study done by the SDM Institute of Management Development, Mysore has examined whether consumption or investment has added to economic growth in India between 1992 and 2015. It concluded: “26 per cent is contributed to private consumption spending, whereas, investment spending causes only 4 per cent variability in the GDP.” Thus, the statement of K Subramanian does not hold true.
He concedes that consumption drives growth in the developed countries where the income levels are high. I believe reality may be the exact opposite. The poor use 90 paise out of every rupee of income for consumption.
They are willing to buy chappals, buckets and milk from the market but they do not have the incomes to do so. An increase in their incomes will immediately allow them to consume more, driving investment. On the other hand, the rich use only 10 paise out of their rupee of income to buy goods. The larger portion of it is invested in gold or in Time Deposits.
It may be that he is encouraging businesspersons to invest which is certainly welcome. The route to breaking the present recession, therefore, is to increase incomes of the poor that will the pull of the car of consumption, and the other car will follow.
Former Chief of the NITI Ayog, Arvind Panagariya, has said that the Government should implement more economic reforms to jumpstart the economy instead of giving tax exemptions or other stimulus packages to stressed businesses like the automobile sector. I agree. The reduction price of a car from Rs 5 lakhs to Rs 4 lakhs will scarcely lead to increased sales as the consumer rests.
Repeated reduction in the interest rates last year did not lead to increase in sales, that is correct. However his suggestion to implement more economic reforms is dicey because our experience tells us that the very thing has led to the present recession. Might we be giving more poison in the name of medicine? The much touted reforms of demonetisation and GST, implemented during the stint of Panagariya, have created immense trouble for small businesses, led to reduced employment generation, reduced consumption by the workers and thus led to recession.
The Government will have to take two steps to break the recession. One, protection will have to be given to small businesses. They use more labour and less automatic machines and the share of wages in the goods produced by them is more.
This will place more income in the hands of the poor. Two, the Government must focus on exports of services instead of manufactured goods. The global market for services such as software, mobile apps, translations and online tuitions is continually increasing. We must empower our youth to supply these services to the global market. This will definitely lead to a rise in consumption and investment.
The writer is former professor of Economics at IIM Bangalore.