After the announcement of a new hydrocarbon drilling and exploration policy which fixed many of the past ills, the government has taken another bold step and a right one, under the circumstances, by reducing interest rates on small savings schemes. Interest rates will also be adjusted on a quarterly basis rather than annually. They will be benchmarked to government borrowing costs in the bond market. All these are very sensible steps. Those of us who have been looking for ‘reforms’ should update their scorecards.
Here is an article on the government’s decision. Not a bad one. The article has a good table on the old and new rates.
The author is right about the money illusion. Problem: people’s inflation expectations in India have hardly come down, despite the measured inflation rate coming down. Hence, are they really suffering from money illusion? Or, are they measuring their cost of living increases wrongly? Those are separate and interesting research topics in themselves.
One is better off visiting the Press Information Bureau website (www.pib.nic.in), clicking on ‘Releases’ at the top-left corner and choose 18th March 2016, click on the ‘Ministry of Finance’ and click on this release to get the factual information. See the attachment below at the bottom of the post.
Some of the media headlines (1st page of ‘Google Search’ outcome) are polemical, misleading and deliberately inflammatory. Some samples:
Firstpost: ‘Political, public outrage as NDA government cuts PPF, NSS, saving scheme rates’ [Link]. Provocative, needlessly.
DNA begins its story with the first line, ‘in a move that will hit the common man’. Very bad. [Link]
For a quick, immediate impact assessment, read Jaggi’s piece in ‘Swarajya’. They should have avoided ‘savers face the axe’. It provokes anger when the purpose of the piece is, perhaps, the opposite.
What follows is a long, text-bookish explanation of the issues surrounding the issue of interest rates, their roles in saving and borrowing, the generation of perverse incentives to borrow, etc. Long one – pl. ignore, if you know these stuff already:
(1) This was written in response to a friend’s statement that India should be encouraging savings and not spending and extravagance implying that lower interest rates do the opposite.
(2) To add to that, it is generally healthy for an economy that private consumption (spending) should not be a cause of economic growth but a consequence of economic growth.
(3) I had underlined the word, ‘generally’ to draw your attention to the fact that there would be exceptions. Nothing is or should be sacrosanct in economics. There are very, very few (if any) absolute, inviolable, immutable truths in economics. Of course, you would not realise if you follow public discussions between economists or columns by economists (Paul Krugman comes to mind) in the US or in India. Some of it is political and some of it is ignorance and some of it is combination of two.
(4) The American emphasis on consumption spending is not a time-enduring phenomenon either. It is of recent vintage. Probably, last thirty years. That is why we feel that is the American way of life. We should not forget that that country has a history of 240 years. It has not always been like this. Even they are beginning to wonder and worry if what they had been doing in the last thirty years has been counterproductive and wrong. But, these debates, changes and course-corrections happen more slowly than we think or we would like them to be.
(5) Again, in general, today’s economically developed countries, much saving and investment had happened during their growth and development years. So, they feel that there is scope to drive the economy forward through spending. Unfortunately, America also developed a taste for a lot of borrowing and financial market speculation. It was a lazy approach to economic growth. But, America could get away with it, given its advantage with the global currency US dollar, with its geopolitical dominance, intellectual dominance, etc. But, those are separate threads and each one is worthy of discussion separately.
(6) However, one of the threads that is important is the one on intellectual dominance. Most developing country scholars went to the US (UK influence waned quickly) for higher studies and hence, it is natural that they are influenced by the discourse there on economic models, what works and what does not work, etc., without adjusting them for context, for the path that countries had taken, their current position in the development cycle, etc.
(7) That is why lower interest rates are often chanted as a mantra and the only formula for boosting investment, employment and economic growth. Most people think immediately of large and tall chimneys, plants and machines when they visualise the word, ‘investment’. However, the moment we do that, we should also remember that there are many other factors that influence such investment decisions and not just interest rates.
(8) Indeed, even in the context of economically advanced countries – like the US or the UK or a region like Europe – the efficacy of low and lower interest rates is very much in doubt. This blog has written extensively on it.
(9) Do not get me wrong. Lower interest rates are useful and they had worked. Lowering interest rates when appropriate and raising them when needed, do have the intended effects. But, what I have warned about in the above bullets is the tendency to elevate them to the level of a religion or a deterministic science. Context and other considerations matter.
(10) Economic theory tells us that low interest rates should result in higher borrowing, everything else being equal. The problem is that economists forget that or deliberately ignore that condition. In real life, other things are not equal. They are constantly evolving and changing. In physical sciences, in laboratories, the experimenter/scientist can control all factors and vary just one and see the difference. In real life, one cannot do that. That is why is very, very hazardous, misleading and difficult to make predictions based on economic theory. At least, one should be very humble about the reliability and accuracy of those predictions, given the moving parts in real life. Yet, many economists sound as though the science is deterministic and not, at best, probabilistic. On many occasions, they are nothing better than guesses, let alone being educated guesses.
(11) It is this failure to take account, the ‘other things being equal’ condition that have sent many advanced countries down the path of zero interest rates and even negative interest rates now! Can you imagine receiving interest to borrow from a bank and paying interest to deposit money in a bank?! But, voices are rising against this tendency to keep pushing interest rates lower and lower into unprecedented low levels. Again, it is not necessary to go into details here. India’s Raghuram Rajan is one of them. Intellectually, they are not yet winning the battle yet.
(12) But, nothing changes human behaviour (including that of politicians and policymakers) more than an actual crisis. Think of how we adjust our lifestyle only after a visit to the doctor that revealed a nasty surprise and how we delay or deny the problem until it is often too late. Economists, politicians and policymakers are not much different. So, things will change but, unfortunately, only after some bad crisis. It appears that 2008 did not turn out to be enough of a warning.
(13) So, this elaborate backgrounder is to agree on the scepticism of lower and lower interest rates, etc., in general. Now, let us come to the Indian context and this particular decision.
(14) Any entity – PF authorities in this case – cannot give guaranteed return because the investments they make do not often give them guaranteed return. They fluctuate. Therefore, the return they offer should also fluctuate.
(15) Interest rates that banks offer on deposits cannot be too low or too different from interest rates available in other instruments like the Small Savings interest rates. If they are, the public will divert their savings to those instruments. Banks cannot raise funds and lend them. Now, let us not get into a debate on whether bank loans are being made properly, etc. The current banking crisis in India might colour our debate. But, that has to be a separate topic.
(16) The government cannot undermine or undercut its own banking system by offering different interest rates on some of its administered schemes.
(17) Technically, it is correct that RBI sets the rate at which it lends to banks and accepts deposits from them. It does so six times a year now. The rate it charges and offers banks forms the basis for other interest rates. However, these administered schemes still exist and the government of the day, sets them! That in itself is an anomaly.
(18) The logical ‘bigger picture’ question that arises then is concerning the relationship between interest rates and inflation. The official inflation rate is 5.2%. But, even in RBI quarterly surveys of households in sixteen cities (that include housewives, working men and women), it comes out clearly that people perceive their inflation rate to be 9% or 10% and continue to expect that their cost of living will keep rising at double-digit rate. In that context, it is right to ask the question if the interest rate should be lower than the rate of inflation. Savers lose their purchasing power. That is a valid question.
(19) There are no easy answers. Governments and central banks like RBI will work only with official inflation rates. On that basis, the ‘new’ interest rate of 8.1% is still above the inflation rate. Also, survey answers given by households are not necessarily based on properly and accurately measured rate of increase in their cost of living.
(20) India does need higher savings to finance its investments. If not, we depend on foreigners for aid, loans or have to give them ownership. That comes with its own baggage of pressures, fickleness and other issues such as inferior technology. Again, pursuing that thread will lead to other issues such as the quality of our higher education, our investment in and commitment to R&D, etc., etc.
(21) We need to invest in public health, education and also infrastructure. East Asian countries, when they were growing, had savings rates above India’s. Moreover, their savings rates kept rising. Ours has not. Based on official data, our official savings rate (proper title is ‘Gross Domestic Savings Rate’) was 21% of the nation’s GDP in 1978-79. It declined after that. But, it took another 11 years to cross that again. In the 1990s and up to 2006-07, it kept rising steadily. Since then, it has declined. Now, it is estimated to be around 30%. That is not good.
(22) For the decline in the savings rate in the most immediate period (2007 to 2015), we can partly (or, largely) blame the UPA government. But, there are deeper problems. They need to be discussed separately.
(23) So, yes, one can judge that the government was right to lower the administered interest rate on Small Savings Schemes or that it was wrong to do so. It depends on which criteria we apply. Criteria suggested in (14) to (17) mean that the government did right. But, bigger discussions on savings and inflation would suggest a different answer.
(25) So, for policymakers, as it is the case in our own lives and decisions, we constantly trade off bigger picture/structural/long-term considerations vs. short-term compulsions, necessities and other pressures. Just think of how we deal with our children sometimes and whether all the decisions we take are ‘long run optimal or ideal’. They have to assess the costs and benefits of favouring one set of consideration vs. the other. Yes, of course, there are political factors. But, even if we set them aside for the moment, what this tells you is that it is possible for reasonable people to disagree on the final decision, without one of them being necessarily wrong.