Friday, July 24, 2015

Interest rates: let the market decide

"The mechanic that would perfect his work must first sharpen his tools."
-          Confucius (Chinese, 551-479BCE)
Word for the day
Risibility (n)
The ability or disposition tolaugh; humorous awareness of the ridiculous andabsurd.
(Source: Dictionary.com)
Malice towards none
Some politician says I will make my God bigger and better than the competition's!
And yet someone else was talking about India as one Nation!!!

Interest rates: let the market decide

I received many interesting comments on my yesterday's post (see here).
Many disagree with my proposition that a marginal rate cut at this juncture will mostly be perfunctory and may not have any material impact on the economic activity. Their argument is mostly based on the premise that rate cut could only stimulate the economic growth by spurring demand, both consumption as well as investment.
I obviously do not agree with them. I believe that Indian economy is already growing at its full potential. To grow at higher rate than the present it would need to change the orbit. This would require escape velocity that cannot be generated by lower interest rates or easier liquidity alone. In fact, this experiment has been tried rather unsuccessfully during 2003-2007 creating a bubble that may take 10yrs to deflate.
Mispricing a critical factor of production (i.e., capital) can only lead to disastrous results. In past six decades of economic planning experience we have experimented with mispricing of labor, materials, land, and capital. The consequences are lower productivity in virtually all economic spheres; systemic as well as commercial inefficiencies; imbalanced and inequitable growth; socio-economic inequalities, and wasteful consumption.
In recent time the system has been moving towards more efficient pricing of natural resources, transportation and cooking fuel, public sector and rural wages, land etc. Not allowing the price of capital to follow the trend by artificially suppressing interest rates may not be appropriate.
It is clear from the trend of past one decade and government's vision that in next couple of decades the growth in India will be highly capital intensive. Even in the traditional labor dominated fields like agriculture and retail trade, capital will a larger role. The demand for capital will obviously be more than the supply; hence the price of capital should remain elevated.
Global supply of capital could help moving the equilibrium to a lower point. But for that our politicians and their allies would need to take a "decision" much faster than their Cuban counterparts.
One reader who is a brilliant student of economics has pointed correctly that the market participants would need to understand that in Indian conditions high growth could co-exist with higher interest rates if inflation remains at moderate levels. Higher price of capital will benefit millions of savers while shrinking margins of few hundred thousand borrowers. It will go a long way in promoting efficient utilization of capital, eliminating the inefficient users and businesses; besides reducing income inequalities.
This is critical, because in the evolving paradigm the level of employment and wage growth is likely to remain low. The capital intensive industrial and rural growth will not generate enough employment opportunities to keep the burgeoning worker population fully employed. The supply of unskilled and semi skilled labor will always exceed the demand.
The interest income therefore will become a critical component of most household's income. So far it has been critical mostly for the pensioners and borrowers. Interest rates will assume a distinct political character; that is if it does not already.

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