Whether to focus on supply side or demand side is the dilemma governments often face while deciding the measures to cure the ailing economy. This article explains using basic economics and evidence from across the world to make the case for a focus on the supply side. In doing so, it explains the problems with demand side measures such as cash transfers and tax rebets.

Issue of neglect of demand side

• The Union government is often criticised for its apparent neglect of the demand side and its excessive focus on the supply side.
• Structural reforms — the COVID-19 package was no exception.
• Low credit growth, weak inflation, and flat wage growth are the factors focused by demand-side proponents.
• The deand side proponents suggest measures such as cash transfers, income tax cuts, and cheap credit to consumers.

So, let’s focus on Demand vs. Supply side debate

Low growth in credit to MSME

• A demand shock typically leads to a rise in both volume and the price.
• A supply shock not only hurts the volume but also leads to price rise.
• In banking, a good proxy for the price of credit is the spread.
• Spread is difference between lending rate and the funding rate  repo rate or deposit rates for the banks.
• The spread reflects the risk premium banks charge to their customers.
• The spread has consistently risen from just below 4 per cent at the start of 2018 to around 6 per cent in January 2020.
• That means, the banks charged 4-6 per cent more on loan than it paid to its depositor or to RBI on the funds it got from them.
• The fact that spreads are rising was highlighted by the 2019 Economic Survey as well.
• At the same time, the credit growth — especially for public banks and to the MSME sector — has been sluggish for the previous two to three years.
• The MSME sector witnessed sub-zero credit growth for the whole of 2017 and even now, the credit growth is very tepid at around 2 per cent Y-o-Y.
• Rising spreads with lower credit volume provide a clear sign that credit supply is broken.

What a paper by Nobel laureates on MSME says?

• Paper by Nobel laureates Abhijit Banerjee and Esther Duflo examines the reasons for MSME problems.
• The paper amply highlights the fact that the MSME sector suffers from lack of credit availability to finance investments rather than the lack of demand for credit.
• They showed that when the government changed the definition of small firms, the firms newly covered by the priority sector lending programme used the extra credit to increase production and investment.
• If there was no demand for credit, cheaper credit under the priority sector programme should have been used to repay the older expensive sources of borrowings.

So, how will the recently announced package help MSEs?

• Consistent with this view, we think that the government’s approach of guaranteeing SME credit by resolving the risk-sharing problem for banks will expand credit to credit-starved SMEs at lower credit spreads.
• Similarly, expansion of the universe of small/medium firms will bring fresh investments from the firms, which are newly covered under priority sector programme as they will be able to get cheaper credit.

2 Measures to increase consumer demand and issues involved

1. Direct transfers schemes

• No doubt that cash-transfers are superior to distortive subsidies and the “Garib Kalyan” package was a step in this direction.
• In fact, the government has already transferred close to Rs 40,000 crore to bank accounts including Rs 10,000 crore to women under PMJDY.

But is cash-transfers the ultimate solution to recovery?

• In fact, the PMJDY account balance has increased.
• The increase is from close to Rs 1,17,000 crore before the advent of COVID-19 to Rs 1,35,911 crore as of May 13 .
• This is a massive jump of close to Rs 18,000 crore.
• Recent research by Prasanna Tantri and co-authors shows that PMJDY account holders actively use the accounts — 1.12 transactions per quarter compared to the World Bank standard of one transaction.
• In fact, PMJDY accounts see withdrawals when account holders are in distress, according to the study.
• So the rise in balances is not mechanical.

So, why are they not spending?

• It’s not that people covered under PMJDY are comfortable financially.
• A number of papers show that tax rebates boost demand in the short-run, but the quantum is limited.
• For example, Sumit Agarwal and his co-authors show that the 2001 tax rebate programme in the US led to an average spending of only $60 on $500 rebate over nine months.
• A recent study at the Kellogg Business School by Christian Borda and co-authors shows that tax rebates after the 2008 crisis in the US led to rise in spending, but by only 3.5 per cent in the first month of the rebates.
• The crux is that no rational consumer goes on a consumption spree when he is facing job uncertainty!

2. What about providing cheap credit to customers?

• Trying to boost demand by providing cheap credit to consumers is not a good idea either as evidenced by the debt-financed housing boom in the US, which led to the 2008 crisis.
• In fact, Atif Mian and Amir Sufi, using a large panel of 30 countries, uncover a more general pattern — an increase in household debt to GDP ratio leads to a sustained drop in future GDP, investments, and unemployment.
• On the other hand, the economic cycles are much more muted when the initial growth is caused by structural reforms as pointed in a recent IMF study covering over 80 countries.

Consider the question “Whenever governments decide on the stimulus package amid financial crises, supply side vs. demand side debate flares up. This has also been the case in India as the government announced the stimulus package recently. In light of this, examine the issues involved in demand side measures.”

Conclusion

To put the burden of recovery on risk-averse consumers, incentivising them to spend rather than save when there is employment uncertainty, is against any reasonable risk-sharing principle. Risk should be borne by those who have the appetite — the firms and government.

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