Monday, November 28, 2016

Will the Indian economy enter a recession on account of the demonetization?

I am sure you have all seen this video by Ray Dalio. If you haven't please see it - it will help you understand what I am saying here. I really like it even though it misses a few things (see below):

1) An very important part of the picture i.e. the role of probability in the economic cycles. What I would like to see added to the discussion is an element of random fluctuation on top of the smooth curves. Obviously as this fluctuations reflect the randomness in each transaction, they would occur on much smaller timescales (daily) than the short-term debt cycle (5-8 years). The collective effects of such randomness over longer timescales (like the long term debt cycle - 75-100 years) is harder to anticipate.

2) The productivity line is actually a wiggly curve just like the short or long term debt cycles. It is easiest to see this behavior in agricultural productivity in various regions of the world [1]. The broad curve trends upwards but there are significant wiggles on it that reflect shifts in the land use pattern. In the combined productivity curve (industrial+agricultural+services+financial) the wiggles are basically representative of the age of the average worker, as the working population ages the cost of keeping the workers on the line rises due to health costs [2,3]. Unless this real decline in productivity is matched by new technical advances that improve production efficiency - we see a significant decline in economic growth - something that can easily compare with a short-time debt cycle. One would also have to account for things like great wars which can deplete the population of entire countries, one normalized correctly to the population size - the net curves should reflect the behavior of a real economy up to the collective effects discussed previously.

3) In Ray's picture - we only see the behavior of a credit heavy economy. The equivalent processes for a cash-heavy economy are not discussed.

This last point brings me to the real topic of this post.

In a cash-based economy (like India) the equivalent of an interest rate hike in a credit heavy economy (like the US) is demonetization.  That demonetization creates the same kind of inflationary pressures inside the system. In a cash economy, unless demonetization is matched by increase in credit (something the RBI and private banks hope to do with all the deposits that come in from this demonetization) - the spending pattern shifts and a recession occurs.

Now fortunately for India, the age of the average worker is low (~28 years) and the debt to GDP ratio is low (~40%) . The likelihood of a short-term debt cycle coupling to a longer term deleveraging is low.

This means the Indian economy could go into a recession on account of this demonetization.

Unfortunately for the US, the age of the average worker is high (~45 years), the debt to GDP is high (109 %) . The likelihood of a short-term debt cycle coupling to a long term deleveraging is high.

The US economy unfortunately stands perilously close to a depression.

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