GDP, Debt Metrics and Cash Flows

Debt metrics and cashflows:

The following quote is from Rathin Roy’s excellent piece in the Business Standard here that makes a very important point on the discontinuities that dog our economic lives.

“This began with the 2008 financial crisis. The burial of conventional macroeconomic policy — the lazy mainstay of average IMF economists and their poor cousins in the developing country policy ecosystem— is now complete. Even last year, Indian economists would airily talk of countermeasures to the pandemic as countercyclical measures. This sort of sloppy analysis no longer has a market.

The pandemic has also exposed the charade of the so-called data-driven economics since it is no longer possible to extrapolate accurately from past behavior, whether about UK house prices or what drives Indian inflation. Theoretically, empty econometric exercises are now farcical, as is talk of fiscal prudence based on the third-rate empiricism about “debt dynamics” that so irritated me when I worked on India’s FRBM framework. 

Triple digit debt-GDP ratios on their own do not now inform policy judgment on fiscal solvency.

Rather, as I have been arguing since 20081, it now matters how debt is used and what the results of the fiscal deployment of borrowed resources are.

Shopkeeping ideas about fiscal prudence no longer inhibit the shaping of the macro-fiscal framework. Public spending to deliver merit goods and protect incomes and employment is regarded as a good thing to be prioritized over tax cuts and deficit control.

Fiscal policy is judged to be good when it is able to effectively address the fallout of the pandemic.”

At the heart of every borrowing decision is a simple equation:  What is the incremental growth you expect to generate from borrowing, let us call it G, compared with the interest I, that the borrowing entails?  If G, which includes all possible positives from the outcome, exceeds I, including all possible costs associated with the outcome, you borrow and expect to better off by [G-I] times the investment made.

Economists tend to ignore what they cannot calculate as if other alternatives don’t exist.  However, there is always the scenario of doing nothing.  Which is to say, if you do nothing, what would be your payoffs/costs compared to the decision to borrow and spend, assuming G is in fact less than I?

If doing nothing means a loss of say 2% of the GDP, and an increase in the number of those unemployed by 30 million, you will surely borrow to spend even if G - I = 0 or worse.  So the decision to borrow to spend has always depended on the outcomes expected and never on so called debt metrics.  Those are history.  What matters is the future outcomes of what you do now.

So are debt metrics irrelevant?

What do debt metrics tell you beyond what the credit analysts put out in their highly decorative credit reports?

They speak of your track record in meeting what you what you promise with actual fact.  The simple thing is that were it not for the fact that you FAILED to achieve the promised G, when you borrowed with cost I, your accumulated debt would not have grown!!  The fact that it keeps growing means that you consistently fail to judge the [G-I] equation correctly. So while the past is irrelevant, it does speak of your past record in mitigating adverse outcomes.

“Venezuela to slash six zeroes from currency.”  1 million goes to 1.  This outcome not as rare as one would like to believe. This headline was yesterday. 

Between the assumed linearity of economists’ second order partial derivatives with a ceteris paribus caveat, and the nonlinearity of the real world, lies a vast gulf that no economic theory will every bridge.  There is no such bridge in physics,  To expect it in economics would be insanity.  But non-linearity is real, never mind how our rational side works to ignore it.

When does non-linearity raise its ugly head?  That is inherently unpredictable just as earthquakes are unpredictable.  But that unpredictability doesn’t mean you know nothing about earthquakes.  When you consistently fail to keep promises, keep borrowing with a lazy analysis of outcomes, and keep accumulating debt, the probability of a financial earthquake grows.

So is Modi right in his fiscal prudence and his sensitivity to India’s credit rating?

The answer is no.  

Pandemics are once a century crisis.  Normal metrics and pettifogging about debt to GDP ratios don’t apply.  All borrowers are in the same Titanic, and if one goes down, so will the others.  

The lenders are worse off.  With a single default you can penalize the defaulter.  With a systemic default, if you penalize one, your entire debt, and perhaps even your wealth, needs to be written off.  No one outlives a systemic crisis.  So Modi would be right to ignore the credit ratings and should in fact expect forbearance.

The second reason Modi is wrong is because the outcome of doing nothing is worse than doing something.  When your economy is at 80% capacity, & the drop in capacity utilization is caused by an act of God, or Modi himself, you must crank it up anyway you can, even by borrowing, because if you don’t, the lost output will increase your debt to GDP ratio anyway by diminishing the GDP.  For Modi, the equation is as simple as that.

But more than of this irrelevance of debt metrics, is what Modi has actually done over the last 2 years - whether intended or not is irrelevant.

Firstly, he has taken about 2% of the GDP or national income from the bottom half of the income pyramid and transferred it to the top.  That in itself would have been sufficient to tank the GDP by about 2% simply because the propensity to spend incremental income shrinks as you move from the bottom of the pyramid to the top.

As if to prove my point above, none of the incremental income shoveled by Modi from the poor to the corporate coffers has resulted in an increase in investment by the private sector, as measured Gross Capital Formation.  The ratio in fact continues to tank in relation to GDP.  

Instead we have record numbers of HNW individuals fleeing abroad, not excluding some of our top tycoons.  

GCF is about 40% of the economy’s aggregate demand, with the rest being consumption.  So while Modi transferred 2% of GDP to corporate savings, none of that created any incremental demand in the economy.  The whole transfer was in fact destructive of incremental demand in a scenario where the pandemic had shrunk the the incomes of those in the lowest 2 quartiles the most.

If you disaggregate the twin disasters - one of the shock caused by the pandemic, and the second by the regressive tax-engineered transfer from income from the poor to the rich - both of which have impoverished the have-nots the most through regressive incremental taxes to finance direct tax cuts to corporates - the Indian economy is showing a resilience that would be remarkable.

Sure, India’s Covid management has been among the worst in the world, - first by the unplanned shutdown that tanked GDP by 28% and lost 30 million jobs, and second by Modi’ inexplicably delayed vaccine acquisitions - but its people have shown remarkable resilience.  There is no recent example of an economy that faced the catastrophe of having 2% of national income being taken from the hands of the poor straight into the hands of corporates and surviving without a stalled economy.  

Thank heavens the farmers from UP, Punjab and Haryana who stalled a similarly disastrous transfer of income amounting about 1.5% of GDP from farmers to corporate coffers via the so called farm reform bills.  Had that gone through, one shudders to think of the resulting havoc and distress in the economy.

Why am I writing this when I so agree with Rathin Roy sir?

Simply because I think these are issues too important to be left to economists.  They love their models whether they be the delusional “continuous” variety with second order partial derivatives defined on patently discontinuous functions, or the game-theoretic ones that assume a linear world.  These models are insightful, they help disaggregate and understand a problem, but they aren’t reality.

At the end of the day you have to look at any problem with a clean, fresh, blank, slate starting from zero.  This here is the situation I face at point A and I wish to go to point B.  How do I do it?  The past thus becomes a resource for ideas and nothing more.

Having said that, remember what always counts is incremental cashflows that you unleash in the economy. They are real and they affect outcomes.  Ignore them, as Modi has, and you make blunders after blunders.

Who in his right senses would take 2% of national income from the hands of the poor to give it corporates in the middle of a pandemic that’s been with us for more than a year and could go on for another two?  That blunder is possible only if you ignore cashflows. Worse who would dream of taking another 1.5% of national income from farmers to transfer to corporates in the same period?  When you think cashflows, it is only then that Modi’s monumental folly during the pandemic crisis comes to the fore.

“Ātreya instead says that epidemics are brought on by wicked political rulers. It is their evil deeds that cause their lands to be abandoned by the gods and thus afflicted by adverse weather conditions.”

—- Ayuervedic Samhitas

The above may or may not be true, but surely, no ruler takes money out of the hands of the poor, to give to the better off, during the acute distress of a pandemic, as Modi has done.  The pandemic may not have been caused by rulers but they have done much to make it worse than it need have been.