This article was first published in the business section of
www.rediff.com on March 12, 2014; Co-author: Khemchand H. Sakaldeepi
In the first article in the
series of understanding how the economic machinery works, we introduced
transactions, credit, interest rates and inflation (the article can be read here). This part will deal with the importance of
credit and introduces deleveraging. The third part will talk about the impact
of deleveraging and introduces fiscal deficit. The concluding part, weaves all
the different parts of the economic machinery together to help the readers take
a view on the current economic scenario in India.
But why is credit important?
Credit allows the borrower to
increase his spending today. Remember that the borrower is required to improve
his productivity so that he can pay for his past expenses in the future. Credit
is good because spending drives the economy. One persons spending is income for
another. It is the fuel to the engine.
When someone’s income rises he
can borrow more and spend more as his creditworthiness increases.
Creditworthiness is made up of two things – his ability to repay and his real
assets that he bought from his rising income. This process continues until the
spending at the origin stops. This whole process is cyclical. Hence the short
term credit cycles are formed.
Credit is relevant in the short
run but what actually matters is productivity in the long run. That is the
amount of goods and services our country produces. This is measured by GDP. The
credit created just acts as the motivational force to improve our
productivity. It helps businessmen to compete in the market and produce
more efficiently.
In fact, credit is an outcome of
human behavior. We want to spend more that our neighbors. Sometimes greed and
envy take over the thinking process, making people irrational.
In a country like ours, the
culture can actually help us be better economists. Our wisdom of ages teaches
us not to be overly greedy and not overly materialistic, as is evident from the
high savings rate of our households. If we all were to work rationally then our
country will automatically become more productive in the long run.
The only problem with credit is that it forces us to consume
or spend more when we acquire it and it forces us to spend less than we produce
when we have to pay it back. Hence if we take credit, it is of utmost
importance that we also produce more so that we can maintain our spending
status when we have to repay.
This does not always happen. An
example is the US housing bubble when people borrowed more than they could
produce. This bought the lenders to their knees.
This does not mean that credit is
bad. It is bad only if you borrow to consume but do not increase your
productivity. Credit does create inflation due to more money coming into the
market and creating more demand for goods and services.
Now let us talk about credit
cycles that are long term in nature and the most dangerous. The short term
typically lasts for 5-8 years but the long term cycle lasts for 75-100
years. This happens because people are more willing to borrow and spend
than to pay back and assume that productivity will naturally increase. They
think that things will forever be great and that credit will always be
available.
Now imagine a weighing machine.
On one hand we have income (productivity) and on the other hand we have debt.
When debt is increasing and incomes rise with the same rate then we have little
to worry. In such an environment assets value soar and inflation is observed
(Inflation is a proxy of growth here). But this environment does not last
forever.
When the debt repayment increases
more than the income we must believe that recession is at hand.
But there can be a worse
scenario. In the developed world in the years 1929 and 2008, the rate of
increase in debt had outpaced the rate of growth of income. This led to the
peak of debt cycle and recession. The consequences are as expected. Incomes
fall, people cut spending, asset prices drop, credit disappears, stock market
falls, social tensions rise, people feel poor. This scenario is called –
Deleveraging
Deleveraging
A vicious cycle begins –This is
different from recession because interest rates cannot be further reduced.
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If the interest rates are already
very low (even close to 0%), lenders stop lending, borrowers stop borrowing.
The economy comes to a halt. This is something that has not happened in India
since 1991, just before the financial reforms. We as a country have this
opportunity to learn from others’ mistakes as well as our past and can actually
be careful in creating CREDIT BUBBLES.
In 1991, the government of India
was close to default. The central bank had refused to new credit with which the
country runs and foreign exchange reserves had dried up. Remember this was a
world where the government used to run all the businesses and there was little
private participation. We had to airlift our gold reserves as a pledge with IMF.
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