The second volume of government’s Economic Survey recently flagged a great risk of faltering economic growth in India, and demanded a loose monetary policy stance from the RBI in the form of further easing of the interest rate to combat this downside risk. The report said, Forecasting “greater downside risks” to economic growth, the Survey, tabled in Parliament Friday, argues that the “scope for monetary policy easing is considerable” and could go up to 75 basis points.
The underlying theoretical basis of this recommendation of monetary policy easing is that a loose monetary policy in the form of lowering of interest rate will revive the economic growth. This means, this policy of loose money will only work if that underlying economic theory is correct. In this article we will analyze this theory and its implications. Is it true that a loose monetary policy can revive economic growth? To understand the answer of this question we need a quick short lesson of sound economic theory, which I present below.
What is the real Wealth of Nation?
As most economic thinkers like Adam Smith, John Stuart Mill, J B Say or Frederic Bastiat etc., of the past age said, the wealth of a country is nothing else but the amount of economic goods that it produces in a given time frame. It is measured by the supply of things like food, potable water, clothes, homes, shoes, cars, computers etc., etc., myriad of endless products. The modern way of measuring wealth, what the mainstream economists call GDP (Gross Domestic Product), by combining these goods and then multiplying them by market price is faulty (see here and here).
What is Economic Growth?
Economic growth is nothing but yearly growth in the above defined wealth of nation e.g., if the Indian economy last year produced 5 homes, 10 pairs of clothes, 15 pairs of shoes and next year it produces 10 homes, 20 pairs of clothes, 25 pairs of shoes then we say that the economy is growing; the economic growth rate can be calculated by above given YoY (year over year) numbers of homes, clothes and shoes.
What Determines Economic Growth?
After understanding what wealth and its growth is, we can now understand what determines the economic growth of an economy. We all know that to produce wealth any economy requires different factors of production. The original factors of production that nature has endowed us with are land and labor. But by using just land and labor the production process is less productive. What makes land and labor both more productive is the use of capital goods like an axe or a spade or a shovel or modern day automatons like factory robots etc. For example, if I ask you to dig a 10 feet deep and wide hole in a ground with your hands then you might take 10 hours to do that job, but if I give you a hand shovel then you will be able to do that job just in an hour. The problem that primitive humans faced was that like land and labor capital goods are not readily available in nature. What makes the capital good a unique factor of production is that we have to produce it first before we use to produce goods meant for final consumption. Only the use of these capital goods will help any economy grow in future. But the problem for any economy is to produce these capital goods in the first place before they can be used to increase the future production of final consumption goods. This means, to understand what determines an economy’s economic growth we have to understand the whole process of producing capital goods first and I now discuss that process. We use the method of Crusoe economics for this purpose. Suppose Robinson Crusoe is stuck on an island and now he needs to survive. He is catching 10 fish with his bare hands everyday working for 10 hours, and he consumes all 10 fish daily for survival. In this condition his life and production method is primitive like our ancestors. He knows that this type of hand to mouth survival is dangerous because if he gets injured or sick for some days then he has nothing in spare for survival; he may die. He decides to better his condition in future. For increasing his chances of survival and standard of living he needs a buffer stock of fish i.e., saving and for that he will have to produce more fish than he is consuming right now i.e., he will have to produce more than 10 fish daily. In our modern day language Crusoe will have to increase economic growth of his economy. What should he do to catch more fish daily? He will need fishing net, of course. Only the use of capital good (fishing net) can increase his labor’s productivity. The problem here is, fishing net is not available ready in nature; he will have to produce it first. Crusoe decides to make the fishing net. Now, suppose making a net requires 10 hours a day work. This means, when Crusoe is making this net he cannot catch fish on that day. This is the economic cost of making the net. He will have to make provision of food for that day when he will make the fishing net so he decides to eat only 5 fish out of his total 10 fish catch today and save 5 fish for the next day consumption when he will sit down to make the net. We can see that he will have to sacrifice some of his present consumption (5 fish) in order to make his future better and secure. The next day now he will invest 5 fish that he has saved yesterday in making the fishing net (basically Crusoe will give wages to himself in the form of 5 fish out of his saving, and he will use this wage for consumption). This way the next day the fishing net (the capital good) is ready and now Crusoe can catch 30 fish using that net working 10 hours a day; he can now consume his daily quota of 10 fish and save 20 for any kind of future unforeseen contingencies. We say that Crusoe’s economy has experienced economic growth; his economy is growing making his life safe and standard of living higher.
We can break down the whole process presented in above analysis in simple economic principles, and I quote Robert Murphy, in the jargon of economics, we can step back and describe what Crusoe has done. By consuming less than his daily income—by living below his means—Crusoe saved fishes in order to build up a fund to guard against sudden disruptions in his future income. Moreover, Crusoe then invested his resources into the creation of a capital good that greatly augmented his labor productivity. (I have replaced coconut, the original example used by Murphy, with fish in this quote).
Now we know what determines any economy’s economic growth. The citizens of an economy first must produce more than what they are consuming, then they must save the surplus production and invest it in producing physical (and human) capital goods. Only this accumulation of physical and human capital will then increase the future wealth (income) of the economy and the economy will grow. There is no escape for any economy from this process. There are no other short cuts.
What is monetary policy? Can it increase economic growth?
After seeing the whole process of generating economic growth above now we can answer our original question, but before that we briefly need to understand what monetary policy is. Monetary policy is nothing but the decision by central bankers to either increase or decrease the supply of fiat paper currency (what they call money) in the economy. We have to understand that money is just a common medium of exchange and nothing else. Injection of more money, via lowering interest rates, will not do anything to increase production of economic goods in future. As long as real pool of saving (i.e., savings of formerly produced goods) and investment is not increasing, economy cannot grow. Injecting more money in an economy will only increase prices of various producer and consumer goods. It will only distort the production structure of the economy by transferring available limited resources, without augmenting them, from productive desirable sectors to unproductive undesirable sectors i.e., it will only generated business cycles further damaging the economy and economic growth.
Here I cannot elaborate all the complex processes involved in above analysis, but those who are interested in understanding can read Peter Schiff’s book, How an Economy Grows and Why It Crashes.
As we saw above, only production, saving, investment and accumulation of physical and human capital can increase economic growth of the Indian economy. Any manipulation of the market interest rates by manipulating the supply of paper currency rupee by RBI will not increase economic growth. In fact, it will only damage the economy by generating inflation and business cycles. This means, RBI and government’s actions will decrease economic growth of the Indian economy.