Union Budget 2024-25: Three macro puzzles and policy implications

Why is consumption soft, employment growth weak, and core inflation low, when the economy is apparently growing strongly?

As July 23 draws near, all eyes have turned to the Union Budget, as the nation waits to see the course the new government has charted for the country. This course will be informed by the government’s explanation for three macroeconomic puzzles that have emerged in the last year.  Namely: Why is consumption so soft, employment growth so weak, and core inflation so low, when the economy is apparently growing so strongly?
 

Analysts have sought to explain each of these puzzles by recourse to all manner of intellectual contortions. Wielding Occam’s Razor, we can suggest a simple and unifying answer to all three puzzles: Growth is actually modest. If true, this answer has profound implications for policy going forward.
 

Start with some of the intellectual contortions. During the last Monetary Policy Committee (MPC) meeting, two economists dissented from the decision to maintain Reserve Bank of India (RBI) interest rates at their current level. They argued that interest rates instead should be reduced, right away.
 

Why were they so unhappy with the status quo, when India has apparently been growing at gangbuster rates of 9.7 per cent, 7.2 per cent and 8.6 per cent over the past three years? Normally, such a sterling growth performance should lead to discussions of tightening, not easing.  
 

‘Output gap’
 

This awkward advocacy of monetary easing was justified by saying that even though Indian growth has been gangbuster, and even though the forecast for next year is 7.2 per cent, it was “only” 7.2 per cent because India’s potential growth is even higher at 8 per cent. There is an “output gap” that can be filled with lower rates.
 

But how does anyone know what potential growth is? It is not an observable number; it is estimated using any number of fallible tools, based on any number of underlying assumptions; it is most commonly estimated by extrapolating the past trend rate; and even on the government’s own numbers, trend growth over a longer period before Covid was closer to 4.5-5 per cent well short of the claimed rate of 8 per cent. Policy cannot possibly be based on such shaky foundations and must be derived from other considerations.
 

The other main argument for stimulating aggregate demand is that consumption has been remarkably sluggish, growing at just 4 per cent last year in real terms, half the rate of overall GDP growth. This number also needs to be treated with some scepticism, as the infirmities of the national income accounts are well known.
 

But it is supported by other, more reliable data, such as those on industrial capacity utilisation, corporate sales and especially sales of fast-moving consumer goods (FMCG) and two wheelers. Even so, before one jumps to policy conclusions, one must first ask why consumption is weak when growth is apparently so strong.
 

In principle, the answer could be that households were curbing their spending so they could save more. But, in fact, household saving has been declining sharply in recent years, with Nikhil Gupta estimating that household net financial saving was only 5.7 per cent of GDP in 2023-24, well below the 7.6 per cent of GDP average in the years before Covid.
 

In part, this reflects households’ extremely rapid pace of borrowing from banks to the point where their stock of debt has reached unusually high levels relative to GDP. In other words, households are not saving more; they are actually borrowing more, just so they can sustain a feeble rate of consumption.
 

This is indeed worrying. As a matter of accounting, if both household consumption and saving are both weak, then household incomes must be very weak. But this is difficult to reconcile with strong GDP growth, because that normally leads to high incomes and employment. It’s much more logical to conclude that that weak consumption is a symptom of weak growth (and not its underlying cause).
 

Frail demand
 

Take the other two puzzles. Employment growth also appears to be problematic, notwithstanding the encouraging official numbers. And core inflation (excluding food and fuel prices, which the RBI cannot control) has fallen to exceptionally low levels of around 3 per cent, which suggests that aggregate demand is frail. Just like weak consumption, these features of the Indian economy are difficult to reconcile with booming growth. 

They instead suggest that growth is actually modest.
 

If this assessment is correct — if growth is indeed weak — it has profound implications for macro policy.
 

For a start, we consider as misguided calls for the government to try to spur consumption by reducing tax rates. For a start, tax cuts would be ineffective, since they would affect only a small portion of the population, the top 10-20 per cent who are part of the income tax net. They would also be unfair in the context of the K-shaped recovery and the damage suffered by the informal sector.
 

For these reasons, we believe the growth problem should be attacked directly, with structural solutions that we have discussed elsewhere.
 

Moreover, tax cuts are bad policy for many other reasons. Tinkering with tax policy on cyclical grounds is bad policy. Tax regimes should remain stable. In addition, with the GST revenues just recovering to pre-GST levels, tax cuts would jeopardise the public finances. 
 

Instead, to spur investment and growth the government could finally embark on a programme of privatisation. After all, this government had earlier developed a detailed divestment strategy, so all that remains is implementation, the timing of which now seems right, since share prices are extraordinarily high, including for PSU firms. And if these firms were shifted into the private sector, this could spark a burst of investment, since surely the new owners will want to modernise them, as the Tatas have been doing with Air India.

Most of all, it would be irresponsible and absolute folly for the government to pump more public money into the black holes of PSUs such as MTNL.
 

Finally, monetary policy. If the economy is indeed weak and core inflation low, it makes sense to begin to reduce interest rates. The case for monetary easing is straightforward. One collateral benefit of lower rates is that the exchange rate might depreciate. This would be desirable as the rupee has been exceptionally strong, stronger than virtually any other emerging market currency in the first half of this calendar year. That means that Indian exporters have lost competitiveness, which is not a good development when the economy is already weak.
 

In sum, recent developments in inflation, employment and consumption are sending a signal to policymakers, a signal that it is time for macro policies to shift. Three measures in the forthcoming budget would be a good place to start: no tax cuts; privatisation of PSUs not throwing more good money into them; and lower interest rates and weaker exchange rates. These steps could help redirect the Indian economy, placing it on a better course to generate rapid growth and jobs.  

Josh Felman is Principal JH Consulting; Arvind Subramanian is Senior fellow, Peterson Institute for International Economics