The prime minister has much to think about. So he leaves management of the economy to his finance minister. But he reads newspapers, and travels round the world; the developing global crisis could not escape him forever. He first took cognizance of it while he was in Paris for the Indo-European Union summit at the end of September.

What he said then was lifted almost verbatim out of P. Chidambaram’s catechism: “The Indian economy has grown at an average rate of 9 per cent in the past four years. It is expected to slow down in 2008-09 reflecting the slow down in the global economy. Even so, it will grow between 7.5-8 per cent. More importantly our medium term prospects remain strong based on sound fundamentals. We have weathered the current credit crisis facing the global banking and financial sectors. Our savings rate is touching 35 per cent. Our direct tax collections for the first five months of the current financial year grew by 48 per cent compared to last year. India would, therefore, continue to provide a stable platform for businessmen and investors.”

He was saying that he believed the “slowdown” in India was imported. Figures of industrial growth produced by his own statistical office were showing a slowdown from March 2007 onwards, much before the global crisis; but he either missed them or accepted Chidambaram’s belief that they were hocus-pocus. He had blind faith in high growth being India’s privilege and prerogative. He thought that a high ratio of savings to national income in 2006-07 could ensure high growth in 2008-09; he forgot what Keynes taught: savings are income that is not spent; they actually reduce aggregate demand if they are not matched by investment. If they are so matched, they create capacity which can later outrun demand and reduce investment. Chidambaram has repeatedly cited figures of the high investment ratio in the past few years, quite oblivious of the fact that high investment creates capacity and sows the seeds of a future slowdown unless demand continues to grow rapidly enough.

The prime minister believed in the patriotic Indian ghost called Mr Sound Fundamentals, which he thought could ward off cyclical fluctuations that affect all economies. He forgot that taxes are paid on past income and tell us nothing about profit expectations, which determine investment (the regime created by Chidambaram even ensures that businesses have to pay taxes irrespective of profits, just because they had paid taxes in the past). He missed out on how open India had become since he was finance minister, and assured businessmen and investors that they would be untouched by a global depression.

The government had been taking anti-deflationary measures in the weeks before the prime minister made his speech. In the month following September 15, the Reserve Bank of India took a number of steps to ward off the slowdown. It reduced the cash reserve ratio from 8.5 to 6 per cent and thereby increased the limit on banks’ loans from 11.8 to 16.7 times their cash holdings. It offered to lend them roughly Rs 700 billion or 2 per cent of their deposits and thereby to replenish their cash. So in theory, they would need to hold only (6-2=) 4 per cent cash against deposits, and could lend up to 25 times their own cash.

Banks cannot make people come and deposit money with them. But since people hold only a seventh of their money in cash these days, six-sevenths of the credit banks give may be expected to return to them as deposits. Thus the RBI made it possible for banks to more than double the credit they gave, which stood at Rs 25 trillion on September 12. The RBI announced that it had given “liquidity support” of Rs 1.85 trillion. If it had allowed banks to withdraw that much cash, they could have increased their loans by more than 50 per cent even without any change in the CRR.

They were not so energetic, but they did increase their loans by Rs 1.95 trillion between September 12 and November 7 — by about 8 per cent in less than two months, which is faster than the 26 per cent increase in the year prior to September 12. But their deposits increased by only Rs 1.11 trillion, less than 4/7 of the loans they gave; 3/7 disappeared somewhere. Of the Rs 840 billion that was not deposited with them, Rs 290 billion was taken out and added to the currency the public carried in its pockets. Maybe some people did not trust banks any more; or the people who trusted banks — we urbanites for example — became poorer while the two-thirds of the population that does not use banks — villagers and black-moneywallahs for example — became richer.

How on earth did they manage to get so much cash? Whether it consists of coins or notes, cash is manufactured by the RBI. It does not give or sell cash to anyone; people can get cash only out of banks. So if they started keeping more cash under their pillows, banks’ cash holdings should have gone down. And so they did: they went down from Rs 3.33 trillion to Rs 2.23 trillion — that is, by Rs 1.1 trillion, that is about twice the money that went into currency hoards.

That is much more than the currency withdrawn by the public; where did the rest go? Banks increased their investment in government bonds by Rs 660 billion. Why did they park all that money in 8 per cent bonds when they could have earned 14 per cent and more on commercial loans? Maybe no one wanted to borrow from banks. That sounds unlikely; what is more likely is that banks did not want to lend. They thought lending to business was too risky. And that perception must be based on some observations — borrowers are no longer so regular in repaying loans — and some expectations — banks foresee worsening of business conditions.

This is how I read the figures published by the government’s own RBI. But the prime minister’s reading is different. In the statement on the crisis he made to Parliament on October 20, as well as in the talks he gave to tycoons on November 3 and 21, he repeated his description of the RBI’s measures. He gave assurances that banks were safe. He boasted of the money he threw in the last budget at the farmers who had taken bank loans, saying it was a Keynesian anti-cyclical measure.

It is irrelevant whether the prime minister is misled, mistaken, or dissimulating. The point is that he is wrong. Producers in this country are running into losses and out of cash, and cutting production and employment. The government’s solutions, namely removing the constraint on banks’ lending capacity and rewarding potential voters, cannot reverse the depression that is coming. A great economist he may be, but the prime minister’s reading of the economy is erroneous, his choice of weapons to combat slowdown is inappropriate, and he is bound to fail in overcoming it. Throughout the great boom of 2004-07, his government followed a procyclical macroeconomic policy. He has changed his error, but his action against the depression will be limited to fine words.