Business needs an economy

The viability of a business depends on the vitality of the economy in which it is embedded

News of a continuing improvement in India’s ranking according to the World Bank’s ‘Ease-of-doing-business’ Index appears to have come in handy for a government otherwise beleaguered by seemingly endless bad news on the economic front.

The Finance Minister was quick to express both satisfaction and a determination to take India into the top 50 countries — it is pegged at No. 63 now among the 190 ranked according to this index. In a country where economic policy has for long remained impervious to the challenges faced by its smaller businessmen, any real attention their condition gets is to be welcomed.

Enable the self-employed

The scale of the problem is better understood if we recognise that by far the largest number of working Indians is self-employed. Among them are our carpenters and service providers, and neither the grand industrial policy statements of the Nehru era nor Narendra Modi’s ‘Make in India’ programme appear to have realised that they need to be enabled too.

So there is much to be said about concerns with the ease of doing business in India, no matter that the World Bank’s perception is overly based on the regulatory regime without adequate attention to infrastructure, and is embarrassingly narrow in its coverage, being confined to Delhi and Mumbai.

Having said the ease of doing business is important, it needs to be emphasised that a business cannot flourish on its own. Its fortunes are tied to the health of the economy within which it is embedded. This proposition is best illustrated through a secular parable. Think of a businesswoman considering the establishment of a glove factory. She is aware that her workers will buy at least some of the gloves to be produced but that this is unlikely to turn a profit sufficient to cover the initial costs to set it up. This would lead her to shelve her investment plan. Imagine though that at the same time a businessman decides to actually set up a factory making cloth for export. This would encourage our businesswoman in her plans as she realises that the workers of the cloth factory will buy the remaining gloves that she will produce. She goes ahead with her investment plan and a business thrives.

Creating demand

This simple story, borrowed from the work of early development economists, shows how the viability of a business depends on the vitality of the economy in which it is embedded. The ease of doing business alone could not have helped our businesswoman had the cloth factory not been set up. And the cloth factory itself may not have been set up had its owner not been sure of the demand for his product emanating from the rest of the world. It points to the importance of what economists refer to as ‘aggregate demand’, without which neither the benignness of the regulatory environment nor the entrepreneurial capability of businessmen can make much of a difference to their fortunes.

To put it starkly, our economic policymakers would today be making a mistake if they spend all their energy on improving the ease of doing business while ignoring the state of aggregate demand in the economy. This is suggested precisely by the fact that, when judged by the above-mentioned ease of doing business index, things have improved rapidly and significantly in recent years. India’s rank improved from 142 in 2014 to 77 in the report for 2019, and 63 for 2020. However, this has done little for private investment, which, when measured as share of GDP, has remained unchanged since 2014. And, the recent surge in India’s ranking on the ease of doing business has come at a time of a distinct slowing of growth. It appears that we would be unwise to judge the state of the economy by observing movements in the ease of doing business index.

That the Indian economy is facing an aggregate demand slowdown is indicated by the fact that aggregate investment, as a share of GDP, peaked in 2011. Now, it is about 10% lower. There have been exhortations to the government to resort to deficit spending. This is of course the classic Keynesian recommendation in times of an aggregate demand slowdown. It recommends itself in principle, and the exhortation itself is a useful counter to the government’s self-righteous adherence to pre-set fiscal deficit targets. However, some familiarity with the experience of the last fiscal stimulus undertaken in India would be useful in the context.

Impact of fiscal stimulus

During 2008-09, in the wake of the global economic crisis, the fiscal deficit was hiked from 2.5% to 6% of GDP, rising further in the next year. Such high increases have been rare, if at all, in India. As a result we did not encounter the steep decline in growth observed in parts of the western hemisphere. However, as soon as the deficit was taken back to levels dictated by the Fiscal Responsibility and Budget Management Act, 2003, the growth rate declined compared to what it had been before the fiscal stimulus.

This holds an important lesson. The composition of the public spending matters for growth; increases in the fiscal deficit that take the form of a rise in public consumption rather than public capital formation can have only a temporary effect. In the two years of an exploding fiscal deficit in 2008 and 2009, public capital formation increased little.

It is not surprising then that the significant fiscal stimulus could have no lasting impact on the growth rate of the economy. Had the unusually high increase in the deficit gone entirely to capital formation it would have both increased aggregate demand and raised the potential supply of the economy. Its growth impact would have lasted much longer.

Reasons for a slowdown

A slowing of aggregate demand growth can take more than one form. In the textbook view it is part of the investment cycle, and deficit spending can take the economy out of it. But what we may be witnessing right now could be a demand slowing with Indian characteristics. This is related to the fact that the greater part of the population is located in a very slow-growing agricultural sector, putting a brake on consumption growth. The grimness of the situation is summed up by the dual feature that around 70% of the population is rural and in half the years of the decade since 2008, we have had zero or negative growth in crop agriculture while the non-agricultural economy has grown steadily.

Now, as the income distribution shifts away from the overwhelming majority of the population, aggregate demand growth slows. Anecdotal evidence that luxury cars fared well during this Deepavali while sales of the most basic items of clothing did not, points to the likelihood of such an income-distributional shift having actually taken place. The recent corporate tax cut could feed a private investment surge but it could also just as well end up adding to the ongoing shift in income distribution, further lowering aggregate demand.

When faced with an aggregate-demand growth slowdown an active macroeconomic policy is needed. Of monetary policy it seems we are doomed to see a change too little too late after years of the Reserve Bank of India having nursed a high-interest rate regime. Fiscal policy alone holds some promise but calibration would be necessary in its use. Spending must focus on the rural sector to raise agricultural yields and build the infrastructure needed to support non-farm livelihoods so that pressure on the land can be reduced. This will also expand aggregate demand. Right now the government needs to be pro-active rather than adopt a hands-off approach. Business cannot go it alone.