Prime but don’t pump

It is well known that the government has tried many ways to improve infrastructure but has not been as successful as it desired. The reasons have to do with difficulties in contracting and follow-up action between the various entities involved in the government and private sectors. Systems that enable smooth interaction between the two are still somewhat weak in India.

Consequently, the only way the government will be able to pump-prime the economy very rapidly would be through public sector leadership and action. This is the first danger. Post-Independence we assigned to the public sector a similar task, and it delivered for a while; but it took us many decades to emerge from the deep hole of inefficiency that we let the pubic sector dig for us.

The second danger is related to financing these expenses. Where will the government get the money from? It won’t tax much more, and will borrow either internationally or domestically. Domestic borrowings will lead to the same set of problems that contributed to this mess — increased interest rates, the crowding out of stable but low-return investments in the private sector, and greater probability of high-risk, high-return investments. Given recent experience, the government would like to avoid this.

Consequently the government will need to increase its international borrowings. This is something that countries in Latin America are very familiar with — infrastructure investments by the government backed by large-scale international borrowings. This is not really a problem if the scales are limited. But if we want to “pump-prime”, then scales cannot be low. Large-scale international borrowings will be a natural outcome of pump-priming.

The third danger is related to timeliness. Infrastructure build-up takes many years, the gestation periods are high, and it is not clear how the downturn would be affected during the intervening period. Typically an infrastructure project takes one to two years to plan and two-four years to set up (the experts will say these are optimistic numbers); but during that period the regular business cycle would have run its course internationally.

In other words, “pump-priming” would require international borrowings, greater role of the public sector, and will yield fruits quite a few years from now.

Pump-priming is a bad idea. This is a typical World Bank and IMF solution and taken directly from discredited Keynesian texts (as the PM himself mentioned). But international institutions will love this idea, as it will once again allow them to affect India’s reform process. And the centre-left politicians will love this idea as that calls for increased government expenditures and meddling in the markets.

There is a consensus within and outside India on our long term potential, and within this envelope of opportunity and optimism is a short term crisis. No one can deny that there is a crisis. No one can also deny that infrastructure is required. But infrastructure investment is the wrong solution to this crisis. Trying to fit the two together will not benefit us, and may only harm. The solution to this crisis of confidence is somewhere else.

The current crisis happened because of improperly working financial markets, and the solution also lies there. A liquidity crisis arose in September abetted by government action (large amounts were withdrawn from the system to pay taxes and interest rates were high). The government has already taken corrective action, and is expected to take some more in coming weeks. Interest rates are also expected to go down. But despite this the pessimism continues, and stories of organisations holding cash and slashing expenditures continue.

To improve confidence and remove pessimism from the markets, the government needs to ensure that markets are strengthened, and it signals universally its faith in Indian private initiative and markets — just as we support a child who has failed a test. There are many possibilities within this larger framework. And pump-priming is not one of them.

First, high interest rates have made many projects unviable, so interest rates need to go down (inflationary expectations are also down). Second, there are a range of regulations that prevent smooth flow of funds within and between the financial and real sectors. Third, many companies have become undervalued; let the pubic sector resort to equity market purchases in the stock markets — other countries such as Taiwan have done it. Fourth, real estate overpricing is a real problem that needs to be corrected. A good quality real estate index is being developed and good information works wonders in introducing sanity in a market. The key is to ensure that government action does not help in sustaining a bubble, as that will only create a more serious problem later (and pump-priming can very easily create another bubble). Fifth, by all means improve infrastructure, as long as it is not based on ad hoc public sector action. Outsourcing IT infrastructure creation within the government is one such example, where our IT companies can compete.

A strong economy is characterised by low costs of production and economic efficiency. Only this leads to sustained and long term optimism and progress. Everything else leads to short term gains at best. Pump-priming will yield fruits when they are no longer required, adversely affect the fisc, weaken the growth and maturing of all kinds of markets (not just financial), and increase governments role in the economy. As a consequence it will increase pessimism in the economy. A better alternative is to take measures that remove pessimism directly by removing the factors that caused this short term pessimism in an era of 8 per cent growth.

The writer heads the economics research firm Indicus Analytics

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