An slowdown caused by economic orthodoxy?

This is in continuation to earlier posts here, here, here, and here.

Harish Damodaran characterises the ongoing economic slowdown in India as a western style demand-side slowdown and blames it on commissions and omissions of policy. 

While we all agree that this is a demand-side slowdown, I think that is only a part of the picture. We may be missing the big picture necessary to address the underlying nature of the economic trends. Ashoka Mody got part of the remaining elements right, but not fully.

Here is my hypothesis. While we have an economic slow-down, from 8% to 4.5%, I feel that the 8-9% growth in the first place was itself built on shaky foundations. We therefore have a demand slow-down which has come on top of unsustainable booms. This makes the slow-down appear even more steep.

The capital foundations (human resource, physical infrastructure, financial capital, institutional strength, and market demand) required to sustain the high growth rates were never in place. This was outlined in Can India Grow. In the circumstances, the two spurts of growth – 2003-04 to 2007-08, and 2009-10 to 2010-11 – were built on two bubbles. The former was the capex and construction boom, especially driven by infrastructure companies, and the latter by the lagged effects of the transfers boom, especially driven by rises in MSP and NREGS spending and monetary accommodation. The former spawned a financial cycle, whose ruinous effects are seen in the banking and non-banking sector crises. The financial cycle was also associated with massive resource misallocation towards real-estate and construction (property prices went over the roof, and the pile up of massive real estate inventory has its origins in that cycle).

I am inclined to believe that in the absence of these two bubbles (excessive capex and construction investments, and excessive transfers), the economic growth would perhaps have been, in the range of 5-7%. 

While the signatures of decline in high-frequency indicators can be traced back to September-October 2018, it can be argued that the underlying drivers of growth had run out of steam much earlier. The euphoria surrounding the new government in 2014-15 provided tailwinds to sustain growth despite all the credit market and corporate balance sheet problems. This momentum was perhaps completely snuffed out by the triple shocks – demonetisation, GST, and regulatory over-kill and tight money policy by RBI – and the decline had started by early 2017. In other words, the triple-shocks were merely expediting and exposing the shaky foundations. 

Despite this ongoing economic weakness, the financial cycle appears to have remained buoyant and may be ebbing only now. This is borne out by the high FDI inflows, the vast majority of which went into finance, real-estate, renewables, and consumer technology services sectors. Less than 5% of FDI went into manufacturing. The solar investment bubble, where the chickens are now coming home to roost, was significantly inflated by private equity. Same with commercial real estate. In fact, PE has been consistently 40-60% of the total FDI, largely in the form of buyouts. QE and the global search for yields too were tailwinds sustaining this financial cycle, amidst the continuously weakening economy.

R Nagaraj has pointed to a financialisation dimension of FDI flows, highlighting the close correlation between inward and outward flows, and the possibility of tax arbitraging and treaty shopping. The IMF's latest Fiscal Monitor identifies almost 40% of global FDI as "phantom FDI" driven by tax avoidance.

The misleading economic data till recently gave the false impression to the government that everything was alright. It created a sense of complacency and came in the way of recognising the problems early on and taking measures to address them head-on. It also led to the Inflation Targeting regime and fiscal conservatism being pursued well beyond their limits.

Economists scorn at demonetisation. But ironically the remaining contributors to the mess were straight out of the orthodoxy - Inflation Targeting, Basel III adherence, fiscal conservatism, GST, RBI's slew of regulatory actions, IBC etc. For an economy struggling with the twin-balance sheet problem (corporates and banks), the combined squeeze due to all these, coming at more or less the same time, was understandably back-breaking. Complementing these was the enthusiastic embrace of cross-border capital flows and the crack-down on black money and shell companies. All these were best-in-class policies implemented at the behest of  technocrats with limited skin in the game. Why is no one discussing these? Where are the economists queuing up to study the effects of the sledgehammer shock from RBI?

Realising this structural dimension is important now as we pursue measures to revive the economy. The QE was pursued far beyond its relevance on the false assumption that economic growth (in the US etc) could be restored back to that of the Great Moderation era. Policy makers in the US were unwilling to accept the more realistic 2-3% growth rates. India’s policy makers too need to acknowledge the reality that a return to sustainable 8% growth rates is not possible without addressing fundamental capital accumulation deficiencies.

Demand-side measures are urgently required to ensure that the economy does not get entrapped in a vicious downward spiral and ends-up like the Latin American economies and gripped by the problems of the middle-income trap. But it will have to be accompanied by deep structural reforms on all the four fronts of capital accumulation – human (fixing education), physical (infrastructure investments), financial (intermediation, savings), and institutional (state capacity, management of cities). This will have to be accompanied by policies that address problems in agriculture and manufacturing.

We cannot afford a sequential path, get immediate demand-side measures and then tackle the other structural issues. In fact, all these should have been solved yesterday!