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April 12, 2013

The right kind of pain

For its economic problems, India must choose wisely — between either quick but harsh solutions, or slow but delayed ones.

In a recent online video by Dan Ariely, I heard of his story about pain. He was a patient with 70 percent burns, covered with bandages which needed to be replaced every day. The removing of the bandages was enormously painful. The question he posed was: Do you rip off the bandages in short quick bursts of extreme pain, or do you take them off slowly, causing lesser pain each time for a longer total time? As a patient, his answer was the second – that it was far more preferable to take long periods of lesser pain than to have short bursts of extremely intense pain. The nurses, for many reasons, believed the other way; and it is probably what you and I think as well, that ripping off a bandage is better than a slow, painful removal.

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I believe that the key lies in the words ‘every day’. A short burst of pain is probably preferable when you have to only do it once. But if it were a repeated phenomenon, it is better to deal with it slowly; the other way will cause panic attacks every time a bandage remover walked into the room.

This is quite relevant to economics, as we will see.

The Indian government has, for the most part, subsidised diesel by paying fuel companies an oil subsidy for the losses they make for having to sell at a lower price to retail pumps, while having to buy fuel at market prices. With the vagaries of world markets, the oil subsidy can be small or extremely large; and when it gets too large, like it did in 2012-13, the government will have to clamp down on other spending to make up.

In 2012, the government attempted to bridge the gap by increasing the price of diesel by a record Rs 5 a litre, a 12 percent increase on a price of Rs 42 then. You might think this was a one-time pain, but it was obviously not so, with the oil companies already claiming they would lose over Rs 10 per litre of diesel even after the increase. The high increase, though, was required if the government were to rein in a runaway fiscal deficit. There were protests by various sections of society then, with the premise that a 12 percent increase was ludicrous.

The new approach, since January 2013, has been to raise diesel prices further, but at a rate of 50 paise per month until the deficit is bridged. Three such hikes have already been done, and the difference is palpable – there have been very few protests, other than murmurs of discontent. The pain we feel is minimal if you elongate the time frame in which the changes are made.

Japan is an example of where such a strategy has gone horribly wrong. Its economy hasn’t recovered for over 20 years, and one of the key reasons is that it didn’t take the bitter pill when it needed to. Its banks were insolvent but instead of letting them die and allowing new banks come up, Japan chose to rescue them while the rest of the country suffered. Now, they are choosing to use slow poison again – flooding the economy with Yen hoping to stoke inflation. Their last attempt failed miserably when they printed over 35 trillion Yen between 2001 and 2006. They are now trying another round of the same thing – and yet again, banks might swallow up the reserves and not actually lend out to consumers.

Iceland allowed its banks to default in 2008, much to the chagrin of the international community, which has been used to countries bailing out their banks. In Europe, banks were bailed out by having their countries take over their debt in Ireland and in Greece. Five years later, with Iceland’s interest rates going all the way up to 20 percent and with strict capital controls, Iceland has broken out of its recession, rates are back below 6 percent, unemployment is down, and exports are up.

In comparison, Greece has needed a second bailout, and the situation in Ireland or the rest of Europe (except Germany) does not look good. The failure to let the excesses of the past eat up the banks, and then to rebuild its banking system even if it meant recession, will continue to hurt these countries as it does Japan. The “slow poison” doesn’t work, because what the system really needs is a hard one-time jolt.

Closer home, it’s now evident that many companies, in the airline and infrastructure sectors, are close to bankrupt and cannot repay their loans. It is important to take a decision about the kind of pain banks will take for lending to such companies; will they take a one-time large hit by writing down their exposure and assuming they won’t get back most of what is lent? Or will they follow a process of evergreening where they might give a backdoor credit to the same company to pay back an earlier loan so that they are never too far behind – thus kicking the can down the road? We have chosen, for the most part, the latter approach. But the day of reckoning is not far; in fact, it might just happen this quarter.

Speaking again from an economic perspective, the only solution to the problem of double digit inflation that we continue to see is to raise rates and let the economy slow down to the point where inflation comes back under control. However, this will involve short term pain, of slower growth. Paul Volcker did it – twice – in the 1970s in the US, raising interest rates to as much as 16 percent before the inflation was finally conquered. That led to a near-eighteen year bull run in the US from 1982 to 1999, and inflation has stayed under control since then.

The Indian economy faces serious headwinds. The government struggles to control expenditure in a high fiscal deficit year. The rupee faces devaluation pressure as the current account deficit reaches a new high. Inflation remains stubborn, and many high-debt industries look like they will definitely default. There are quick and harsh solutions, and slow and delayed ones. It’s a period that will define India’s future, depending on what kind of pain we decide to take.

Photo: Joey Parsons


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