If a fortnight is a long time in politics, a week seems like an eon in the Indian economy! The last week began with a whimper on foreign direct investment in retail, but ended with a bang of bad news of mid-year analysis. The first two days of this week made it worse: industrial production didn’t just slow down but

actually declined (infelicitously termed “de-growth” by the electronic media) by five per cent in October. The rupee, already in the intensive care unit with a below-50 exchange rate against the dollar, seems to be in need of life-support with its latest fall to 54-plus. The Sensex, which had briefly crossed 21,000 earlier in the year with punters dreaming of 25,000 or more by the year-end, has fallen below 16,000.
The net result is that the 7.5 per cent growth for the year so confidently predicted by finance minister Pranab Mukherjee only last week now looks a distant dream. Most analysts expect it to be below seven per cent, with an attendant rise in the budgetary deficit to possibly five per cent or more. This column cannot take comfort in having anticipated these possibilities earlier (The inflation hocus pocus, December 9, 2011), nor having made allusions to six per cent being the new Hindu rate of growth (repeated over the weekend by many other columnists), because that would be ghoulish.
Mr Mukherjee sternly lectured Parliament about political stability being the pre-requisite of economic stability and said that the Eurozone crisis would certainly affect us, because we were not living on a different planet. He obviously counted on the proverbially short public memory; not too long ago, the government was in a self-congratulatory mood as it claimed that India had shown resilience in the face of the 2008 global recession.
We need to revisit our recent economic history to understand the current reversal of fortune. Our growth, especially in the last decade or more, has been largely aspirational. It has been driven by consumer demand for the good things of life, long pent-up under pseudo-socialistic beliefs. We wanted more cars, more white goods, better food, housing, quality education, and anything else that meant or symbolised better living. Even though a relatively small proportion of Indians had the means to pay for these to start with, the large population ensured that the demand for consumer goods, durable as well as non-durable, grew annually at double digit rates for most items. The resulting higher production led to higher incomes with further increases in demand. We believed we had found the economic perpetual motion machine, which would lead us to annual economic growth rate of over 10 per cent year after year and we would overtake the United States to emerge as the second largest economy in the world after China by the middle of the century.
This was all very well except that we neglected to note that long periods of growth are sustained by stable prices, as was the case with the US in the 1950s and the 1960s or, more recently, in the 1990s in the Clinton presidency. The growth period of Western Europe was similarly marked by stable prices. Our own inflation levels during the confidence-building period up to 2007 were low, under five per cent a year and manageable.
Indian policymakers have been concerned about inflation, but have also held the belief that moderate inflation was the necessary consequence of growth and was most likely good for it, right from the days of Morarji Desai as finance minister. Some analysts even tried to explain the current price spikes as indicators of continuing consumer prosperity.
The simple fact is that booms, as noted above, accompanied by price stability lead to higher incomes caused by increased production and productivity, which in turn lead to greater demand. This virtuous cycle is broken when inflation raises its ugly head. It slows growth in two ways: first, as essentials cost more, families have less money to spend on discretionary items — cars, gadgets, fancy holidays and so on. This contraction of demand affects production and employment in those industries. Witness: declining car sales in India for the last several months.
Second, rising costs reduce savings available for investment and at the same time increase the requirement of capital for producing a given amount of output.
Our simple calculation of a nine per cent rate of growth is based on an observed 36 per cent rate of savings and a capital:output ratio of four (one unit of output requires four units of capital). If the
savings rate declines to 34 per cent, and the capital:output ratio increases to 4.25, entirely likely under the present levels of inflation hovering around 10 per cent a year, the growth rate reduces to eight per cent.
Not much attention has been paid in India to the global hardening of commodity prices in the current decade. Jeremy Grantham, a respected commodities analyst, shows that prices for all commodities except oil declined by 70 per cent in the 100 years up to 2002, but rose so sharply in the remaining years of the decade as to wipe out the entire decline. He had warned last April that growth of countries such as India was especially
vulnerable to this
phenomenon.
The mounting pressure on prices has led to an inflationary psychosis in India. Anyone who has raised prices in anticipation of a price spiral, thereby making it a self-fulfilling prophecy. How else do we explain the recent price increases, often more than 10 per cent, in multiplex admissions, asthma inhalers, shampoos and branded soda water, none of which entail a significant material component?
Our response was that of text-book application of monetary corrections, a gradual yet inexorable increase in the interest rate. As noted in the previous column, this has failed to yield the expected result so far, and now the whole growth process is threatened by gathering clouds of global conditions and domestic mismanagement.
The silver lining is that the clouds are as yet distant and corrective actions are still possible. The government needs to shake off its inertia and take muscular action: say, for example, removing the fetters from mining and power generation, the two key pillars of infrastructure. The fall of the rupee could be arrested and simultaneously, its lower value could be used to further boost exports, the one area of strength in the recent past.
Weathering the storm is never easy, but not impossible either.

The writer taught at IIM Ahmedabad and helped set up the Institute of Rural Management, Anand. He writes on economic and policy issues.