Neither consumption, nor investment, growth is driven by wages

Bharat Jhunjhunwala

Chief Economist K Subramanian has exhorted Indian businessmen to increase investment to break the present recession. We need to understand the connection between investment and consumption to place his comment in perspective. The story of investment and consumption is like that of the chicken and egg—which came first? For a moment, let us begin with investment. Let us say an industrialist made investment in a textile mill. The investment would lead to an increase in production of cloth. A number of workers would get wages. They will buy goods from the market for consumption. The consumption in the economy will increase. Framed in this way, the driver of growth is investment. We can write the same process in another way starting with consumption. Let us say, the people of the country increased their consumption. This would lead to an increase in demand in the market. The businesspersons will make investments to profit from that opportunity. They will invest. Framed in this way, the driver of growth is consumption. It is clear that investment and consumption are connected with each other in a circle. We can “start” the cycle at any point of the circle just as the chicken and the egg.

As said above, irrespective of whether we begin with investment or consumption, an increase in one soon begets increase in the other. The balance between investment and consumption is reestablished in both the scenarios. If we choose to start with investment, the increased investment is followed by increased consumption and the ratio is reestablished. If we choose to start with consumption, the increased consumption is followed by increased investment and the ratio is again reestablished. We can temporarily increase one or the other but the balance has necessarily to be soon reestablished. We can think of investment and consumption as two cars tied to each other with an elastic string. Either car can pull the other. The ratio of investment and consumption is determined by technology. For example, the consumption will be more and investment will be less if we are farming with bullocks because the labour required is more and the investment is less. On the other hand, the investment will be more and consumption will be less if we are farming with tractors because the labour required is less and the investment is more.

The economy enters into recession if increased consumption does not follow increased investment; or the second car does not allow itself to be pulled by the first car and the elastic string snaps. This is the situation of our economy today. Businesspersons have made investments, they are producing goods and paying wages but the workers are not buying the goods. Consumption is not picking up. It seems people do not have confidence in future and are holding their incomes back. The consumers have gone into a coma. It is as if the car of consumption has pulled the hand brake and is holding back the car of investment.

The present scenario indicates that consumption is more of a driver of economic growth than investment. The shops are full of goods but consumers are not buying them. A further increase in investment would only add to the inventories since the car of consumption has its hand brake on.

A study done by the SDM Institute of Management Development, Mysore has examined whether consumption or investment has added to economic growth in India between 1992 and 2015. It has concluded: “26 percent is contributed to private consumption spending, whereas, investment spending causes only 4 percent variability in the GDP.” I think this is the correct situation. Thus, with due respects, the statement of our Chief Economist Mr K Subramanian that investment is the driver of growth does not hold.

Yet, Mr Subramanian has conceded that consumption drives growth in the developed countries where the income levels are high. Exactly opposite may be the case. The poor use 90 paise out of every rupee of income for consumption. They are willing to consume, they can are willing to buy chappals, buckets and milk from the market but they do not have incomes to do so. An increase in their incomes will immediately lead to increase in consumption and that would drive investment. On the other hand, the rich use only 10 paise who out of every rupee of income for consumption. They have money in their pockets are not buying the goods. They invest in gold or in Time Deposits. Therefore, consumption can especially drive economic growth in poorer countries—which is exactly opposite of what our Mr. Subramanian says. It may be that Mr. Subramanian is giving pep talk to encourage businesspersons to invest, which indeed is desirable. The route to breaking the present recession, therefore, is to increase in incomes of the poor which will lead to increased pull by the car of consumption; and the car of investment will follow.

Former Chief of the Niti Ayog Mr. Arvind Panagariya has said that the Government should implement more economic reforms to jumpstart the economy instead of giving tax exemptions or other stimulus packages to the stressed businesses such as the automobile sector. I agree that stimulus will not work. The reduction price of a car from Rs 5 lakhs to Rs 4 lakhs will scarcely lead to increased sales when the consumer is in a coma. We have seen that repeated reduction in the interest rates in the last year has not led to increase in sales. Thus far he is right. However, his suggestion that more economic reforms must be implemented is dicey because our live experience tells us that the economic reforms have led to the present recession. Might we be giving more poison in the name of medicine? The much touted reforms of demonetization and GST, which were implemented during the stint of Mr Panagariya, have created immense trouble for small businesses, led to less employment generation, less consumption by the workers and thus we have recession. Thus, the recession may get worse if we deepen the reforms such as the GST.

The Government will have to take two steps to break the recession. One, protection will have to be given to small businesses. They use more labour and less automatic machines. The share of wages in the goods produced by them is more. This will place more income in the hands of the poor, lead to increased consumption and investment. Two, the Government must focus on exports of services instead of manufactured goods. The global market for services such as software, mobile apps, translations and online tuitions is continually increasing. We must empower our youth to supply these services to the global market. That will lead to increased consumption and investment.

Dr B jhunjhunwala, Formerly Professor of Economics at IIM Bengaluru

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Sep 4, 2019