The Telegraph
Since 1st March, 1999
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- It might be a good idea to keep interest rates unchanged and see if demand is growing

Yet another round of interest cuts followed the Reserve Bank of India’s recent announcement of a reduction in the bank rate. It seems that the RBI is all set to make the financial scenario in the country gradually look like an international one. The latest interest cuts are but a small step in that direction. But to what end' Following international norms sounds reasonable but can hardly be an end in itself. There has got to be a few macroeconomic advantages as well of having a low rate of interest. Indeed, we are repeatedly reminded of a couple of them. A low rate of interest, we are told, stimulates private investment and stimulating private investment is, of course, injecting fresh blood into our moribund economy.

But apart from private investment, a low interest rate is supposed to encourage private consumption as well. If the rate of interest is low, consumers are tempted to hire-purchase durables against easy instalment payments. This, in turn, is expected to create demand, increase output and generate employment in housing, automobiles, electronic gadgets and other durable goods producing sectors. Again, a boom in these sectors should overflow to other sectors of the economy by increasing overall demand, and the end result is, in short, an economic expansion for the country.

All this, however, is textbook economics; the kind of stuff a student learns in his first year undergraduate macroeconomics course. There is nothing logically wrong with the argument except that, like all economic theory, it is based on certain assumptions, which may or may not hold in reality. Should we blame the RBI for being textbookish in reducing interest rates' Should we blame the RBI at all for reducing interest rates' It is certainly all right to know the basic theoretical arguments as given in textbooks or even to follow them while implementing one’s policy. After all, one needs some sort of a theoretical foundation to vindicate one’s policy stance.

But suppose the textbook theory on which one’s policy is based is repeatedly rejected by empirical observations. Is it not advisable then to think twice before continuing with the policy' Indeed, the recent Indian experience simply does not support the premise that a reduction in the rate of interest will stimulate either private investment or private consumption.

The observed reality is that ever since interest rates have been falling, private savings, especially household savings, as proportions of the gross domestic product are on the rise. This means that the proportion of private consumption to GDP has been falling in response to reductions in the rate of interest. According to the Centre’s latest economic survey, the household saving ratio has increased steadily from 18.8 per cent in 1998-99 to 22.5 per cent in 2001-02. On the other hand, private investment has turned out to be more or less unresponsive to interest cuts. The private investment-GDP ratio has fluctuated around 16 per cent since 1997-98 without any discernable upward or downward trend, though it took a nose-dive to 14.8 per cent in 1998-99. How do we reconcile this with the perceived theory'

Economic science has quite a few riddles, but not too many mysteries. But of the small number of deep economic mysteries, private investment is certainly one. No one really knows why, in a free-market economy, sometimes there is a spree of private investment and sometimes there is a complete lull. The ups and downs in the volume of private investment, in turn, are primarily responsible for business cycles. So if we could pin down the determinants of private investment, we could control macroeconomic fluctuations as well.

John Maynard Keynes, the architect of modern macroeconomics, attributed investments to “animal spirits”, which amounts to saying that the determinants of investment are not well understood. Subsequently, however, he postulated an inverse relationship between private investment and the rate of interest. He did so on the ground that a fall in the rate of interest increases the incentive to invest by reducing the cost of borrowing. Both versions find a place in textbooks, but the RBI seems to prefer the second. Unfortunately, it is rather hard to get systematic evidence to support the theory RBI seems to prefer. The truth is, investments primarily depend on expectations about future profitability and no one really knows how expectations are formed.

The behaviour of aggregate consumption, on the other hand, is easier to explain. Think of two groups of consumers, one consisting of young persons who have just started their career and the other consisting of middle- aged individuals who have started to worry about retirement. An interest- cut will have opposite effects on the two groups. While the first will probably view it as an opportunity to increase present consumption by borrowing at a lower rate of interest, to the second group it will mean a fall in future income. To protect its future income the second group may actually increase current savings and reduce current consumption.

Add to this a third group of already retired people living mainly on interest income. An interest cut will certainly compel this group to reduce consumption. So the net effect of a fall in the rate of interest on aggregate consumption may jolly well be negative with consumption effects of the second two groups dominating that of the first. It is hard to believe that the RBI is ignorant of all this. Why is it then reducing the rate of interest' The reduction is definitely hurting senior citizens who live on interest income and probably the middle-aged ones who are net savers. It potentially benefits net borrowers which include investors and young consumers. But investors can hardly enjoy this benefit because they are investing very little. That leaves us only with young consumers. In the US, senior citizens are well known for their ability to effectively lobby with the government. Not so in India. Neither are young consumers well known in this country as effective lobbyists. So it is implausible that the RBI is adopting its policy with the purpose of serving this interest-group alone. Whose interest is it serving then' The answer is not hard to find. The RBI is clearly serving the interest of the government who is by far the largest net borrower in the economy. By lowering interest rates, the RBI is lowering the debt burden of the government. But a fall in the rate of interest must lower the burden of fresh loans, not of the old ones. Why is the government taking fresh loans in the first place'

For the last few years Indian industries are going through a slump. Industries are facing a general lack of demand and are reluctant to invest. This has led to a situation of excess liquidity in the financial sector. Banks and other lending institutions have excess funds to lend but there are not enough takers. With economic reforms, the problem of finding a lender has become worse because banks are now urged to make profits and so they have to be more careful in disbursing loans. What do the banks do with their excess fund' The funds cannot be kept idle for a single day, for interest has to be paid on them to the depositors. So the banks are lending to the government, that is, they are increasing the share of government securities in their portfolio. On the other hand, the government has no choice but to take fresh loans from the banks to avoid an acute financial crisis.

The government and the RBI are therefore caught in a vicious circle. Because of low industrial demand and excess liquidity, the government has to support the financial sector by taking loans. This, of course, makes its debt burden heavier. To reduce the burden it is reducing the rate of interest. But a reduction in the rate of interest is increasing aggregate savings and reducing aggregate consumption further without significantly affecting aggregate investment. So we are back to square one. To break the circle, it might be a good idea to keep the rate of interest unchanged for a while and see if demand is improving. Indeed, demand creation is the key to our industrial recovery.

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