Consumer is king!

Anup Menon

CUTTING interest rates seems to be the trend with central bankers.

Over the last six months, most central banks have followed in the footsteps of the US Federal Reserve and cut the base rates. The RBI has been no exception. Anyway, the seems to be expecting another rate cut soon.

Nominal interest rates in India are already low. Coupled with high levels of inflation, this translates into low real returns.

For instance, an investment in a one-year bank fixed deposit may give a real rate of return of around three per cent only. Under these circumstances, what is the opportunity cost of holding money for investors? If rates are likely to be cut, the yield on debt instruments would be lower.

Therefore, the investor may decide to spend more and hold less cash. Is this what the central bank plans to achieve? Take a quick look at the implications of the rate cut from the perspectives of both the investment and consumption demand.

Rate-cuts and investment demand: Many economists believe that cutting interest rates helps boost investment demand. The logic is simple: Cut interest rates and companies will demand more money to invest in the business, and generate more output. This will lead to an improvement in the economy as a whole.

But does this work?

May be not. True, companies may borrow more and invest, and produce more output. Is that sufficient? Logic would suggest that post-production, the product has to be sold and the money spent on purchase of the goods will be re-invested to produce more output. Therefore, if the full cycle has to be gone through, consumption of the goods produced is also important.

In the present circumstances, it is assumed that consumption will increase to match the increase in output. However, this may not be the case.

There are cases where an expansion in output is not complemented with an expansion in consumption which leads to accumulation of stock. This again does not augur well.

For instance, take the case of the old economy companies. Many of them pushed investment and increased capacities during the 1992-94 boom period. However, ever since the economy started decelerating from 1995, consumption demand has not increased.

Consumption demand -- a good target: Events over the past few months in the US and Japan would indicate that despite repeated cuts in interest rate,

there has been no improvement in their economies. Therefore, any cut in the interest rate by the RBI can be seen as a move to provide impetus to increasing consumer spending.

Given that investors do not have the incentive to hold money, they are likely to build capital in other forms. For instance, consider an investment in homes. Most consumers cannot afford to purchase a house without resorting to external financing. If this were the case, a lower interest rate regime would encourage housing finance, as consumers perceive it as an opportunity to ensure lower interest payments.

Moreover, real-estate prices have also come down over the last few years. Therefore, an investment in housing could be a good investment opportunity. A boost in the housing sector automatically creates demand for cement, steel, plastics and paints, among others.

Apart from homes, interest rates also have an impact on the same of consumer durables. Given the kind of low-cost financing available to the consumers, they may be tempted to purchase more than they intend to.

Adding to the impetus for consumer spending is the availability of money in the banking system. The problem is that banks have funds, but few investment avenues. No action is being taken to increase investment demand by lending to institutions.

Therefore, alternatively, they tend to invest heavily into government debt. However, beyond a point they find that even that avenue is not feasible. Under such circumstances, banks have little option but to seek retail support for lending.

More consumer spending on housing and durables would mean that banks can structure products in the form of loan schemes and employ their funds to get a better rate of return. This apart, such a move would also ensure there are sufficient funds in the market that consumers can use.

When consumers start spending more, inventories come down, and the economy comes a full circle. Therefore, the consumer is indeed, the `king of the economy'? And will targeting consumer spending work?

A lesson from history?

Are consumers important? Students of economics would be familiar with the famous recipe suggested by John Maynard Keynes, for bringing the economy out of recession in 1928. The story goes that the government paid people to dig holes and fill them up.

If you think it is wasteful government expenditure, you could be wrong. Keynes' logic is that by creating more jobs -- even if it means digging holes and filling them again, and paying the workers for the work done -- the macro level consumption will increase.

In other words, consumers would spend more money in purchasing goods and services, which would effectively reduce the inventory levels in the economy, thereby helping it come out of recession. This means, though we may never realise it, consumer spending is critical.