An Economic Crisis Is Slowly Building up in India's Informal Economy

The government is repeatedly acting on the assumption that the shocks it is applying to the economy are transitory and that the formal sector is immune to shocks experienced by the informal sector.

The policies, such as demonetisation and restriction on cattle markets, are the result of Modi government’s flawed understanding of economics. Credit: Reuters

The policies, such as demonetisation and restriction on cattle markets, are the result of Modi government’s flawed understanding of economics. Credit: Reuters

During the demonetisation process, many economists argued that its effect on economic growth would be negligible. When the estimates of growth for the third quarter of 2016-17 were published in March, they quickly declared that the fear of lower growth was the result of a lack of understanding of economics and hard facts. They were basically arguing that it does not matter if people consume less during the demonetisation process because either the consumers will start spending more than normal after that, or the producers will not lower their production despite the lower sales. A complicated analysis is not needed in order to know what is wrong with these assumptions – they require either consumers or producers to behave unusually.

Now, the provisional GDP estimates for the fourth quarter are out. The estimates show that the Indian economy grew at 6.1% in the fourth quarter of 2016-17 compared to the expected 7.1%. Gross value added growth at basic prices also declined from 6.7% in the third quarter to 5.6% in the fourth quarter and is much lower than 8.7% in the fourth quarter of 2015-16. Since the effect of demonetisation on informal sector is likely to be underestimated, the real situation may be much bleak than presented by these estimates.

The informal sector, which had not recovered from the effect of demonetisation, is facing another shock in the form of restriction on cattle markets. The new regulation banned the use of these markets for the purchase of cattle for slaughter. The cattle market restrictions are especially damaging to farmers, as it will lower the price of their livestock and make its sale difficult. The ban will also adversely affect the livelihood of millions of people working in beef and leather industry.

Cattle economy

The policies, such as demonetisation and restriction on cattle markets, are the result of Modi government’s flawed understanding of economics. The government seems to think that these shocks are just temporary and the formal sector is immune to shocks experienced by the informal sector. The government is repeatedly acting on the assumption that they can change a variable in isolation, ignoring the fact that the economy does not move from one point to another. It more often moves from one equilibrium to another.

The reason for this ignorance is the way present crisis is building. Most of the shocks known to economists start in the formal sector, and the informal sector is affected later. Or at the very least, economists are taught that this is what happens. These analysts, therefore, often do not watch the changes happening in the informal economy in the way they do for the formal sector. Therefore, they are likely to ignore or underplay the economic crisis building up in the informal economy. This situation can be compared to tsunami waves before reaching the coast.

What worsens matters is that the government simply doesn’t have enough information on the informal sector. They see the informal and the formal sector as two clearly distinct groups. As a result, many of their arguments are based on a hidden assumption that the informal sector is not involved in the market exchanges with the formal sector.

In reality, there is a range of businesses from very small to very large in the economy. These businesses are directly or indirectly linked to each other. The informal sector sells products to the formal sector or people working in the formal sector. Also, the informal sector and people working in it purchase commodities produced by the formal sector. Therefore, the shock in one of them will affect the other.

If the shock is small, it does not have significant effect on others. The producers, based on their experience, also consider the possibility of small shocks. However, a shock, as big as demonetisation and restriction on cattle markets, is likely to cause significant disturbances and, as a result, may lower production in all sectors.

It is because if the producers in a sector have unsold goods, then the others who were selling goods to them must have unsold goods too unless they are ready to accept less goods in exchange of their produce (i.e. lower the price of their products). It is as JB Say wrote, “products are paid for with products.” It implies that if the production in informal sector drops, people working in that sector will buy less from the formal sector unless the prices in the formal sector decline.

Thus, the decline in sales and prices spreads from the informal sector to the formal one. As this effect spreads to all sectors including the financial sector, the economy starts moving towards a new equilibrium. To prevent this movement, the government without any delay should start thinking about restoring health of the economy, and avoid taking more disastrous steps. The delay in recognising and treating the economic problems of this size may prove costly for India.

Wrong diagnosis, wrong treatment

There is also a danger that the wrong diagnosis of the problem may result in wrong treatment of the problem. With the present deceleration of growth rate, the government may soon come up with a policy to tackle this issue. It is highly likely that the government will respond to the crisis with policies that boost investment in the formal sector. Since the current crisis is built in the informal sector, an investment push to the formal sector may not work in this case. At this point, the formal sector of India has a limited capacity to create employment. In addition, the dismal state of education level in India will not allow the formal sector to absorb the unemployed people in large numbers. In such a situation, the investment push in the formal sector may only lead to mechanisation.

The solution to this problem lies in increasing the income of people working in the informal sector by giving it an investment push. MNREGA must be strengthened and getting rid of the regulations and bans on agricultural and cattle markets (including lifting the beef ban) may help.

Before being voted in, Modi and his advisors openly expressed their disbelief in the planned economy. They even talked once of minimum government, maximum governance. However, demonetisation and restrictions on cattle markets indicate the opposite; worse even as these measures are often not backed by a strong economic rationale.

The government must understand that denying reality will not change it. A bad idea will remain bad, no matter how strongly one tries to prove otherwise.

Indervir Singh is at Department of Economic and Public Policy at Central University of Himachal Pradesh.