The world has faced the present economic crisis after a long break of a moderate economic performance between 1983 and 2007. Initially the crisis started in the financial sector during mid-2008 and it was expected to impact only the real estate sector. But the gradual slowdown in world output growth – currently estimated by IMF to be 0.5% in 2009, much lower than its October 2008 estimate of 3% -- is a clear indication of an approaching recession.

Many economists are already terming the present global economic slowdown as ’Great Depression II’. Comparisons with the first one (1930-36) are justified and hence scary. Some are already suggesting a dose of Keynesian policy, which advocates increasing public spending, as a cure for the sluggish economy. Such a suggestion has been put forward after several fiscal and monetary measures to infuse greater liquidity into the global economic system has not been quite successful in stimulating consumer demand, the key driver of economic growth.

World Economic Outlook estimates that the growth in domestic demand in the advanced economies has reduced to 0.8% in 2008 and will further come down to 0.1% in 2009. In contrast, the domestic demand in 2007 was 2.2%. Declining demand, despite low interest rate, shows the present economy’s proximate approach to the liquidity trap. In this context, Keynes pump-priming theory seems to be suitable for increasing effective demand through increasing public spending, as it was quite successful during 1930s.

India presents a similar scenario of ineffective monetary policy during the present economic slow down. In the last three months the RBI has reduced the repo rate at which it lends short-term funds to banks from 9% to 5.5% and there was also reduction in reverse repo, Cash Reserve Ratio (CRR) and Statutory Lending Rate (SLR). The easy monetary policy has only perpetuated the circular flow of liquidity between the Central Bank and other banks in the system, as the cash flows back to the RBI in terms of deposits and the real sector has been kept outside the circular flow. The domestic demand has come down along with speedy decline in the price level. The Dun and Bradsheet Composite Business Optimism Index showed that domestic demand in India dropped by 42% (q-o-q) during first quarter of 2009. The rate inflation has come down from 10.7% during the end week of October, 2008 to 5.6% during mid-January 2009. In its third quarter review of monetary policy the RBI lowered inflation estimates to 3% by end of March. Overall, the real economy in India has experienced a declining domestic demand coupled with low price level, which presents an overall deflationary scenario and seems to be heading towards recession, as unemployment is also showing an increasing trend.

Being motivated by the Keynes pump priming strategy to remove the recession cycle, most of the governments have become proactive and declared stimulus packages for reversing the economic downturn. After taking office, US President Barak Obama has declared a package of $825 billion and has been passed by the American Congress. The Chinese government has declared a financial package of $700 billion to be spent on modernisation of infrastructure. The Government of India has planned to bring a financial package for the manufacturing sector.

Is Keynesian economics the solution to the present global economic slowdown?

First, the governments have to resort to deficit spending, which Keynes believed is necessary in order to pump life back into a recessed and depressed economy. The present financial packages sanctioned by many governments are not enough to attain a full economic recovery. Again, there is an upper limit for any package beyond which the government can’t spend. The governments of the advanced countries were running a huge deficit even during boom period, because of increasing spending, and their present fiscal condition is bad.

Second, due to the combined impact of a slowdown in the growth of incomes and policies aimed at cutting taxes, government treasury has taken a direct hit. Volatility in the market has put paid to the hopes for increasing capital inflow into the country. Such a financial condition forces governments to make a choice between fiscal discipline and big financial packages to reverse economic slowdown. More often than not, fiscal discipline is left by the wayside

In India the combined fiscal deficit of both states and the Centre has been estimated to reach 8% in the present financial year, which is deviation from a fiscal responsibility mandate of 6%. At this juncture it will be difficult for the government to come out with a big financial package. Hence the situation warrants that the Government of India’s policy of public spending to stimulate the economy must be well targeted.

Increasing spending on employment guarantee schemes has a multiplier effect on income generation and demand creation. The government may consider revising the National Rural Employment Guarantee Scheme by guaranteeing 365 days instead of 100 days of employment every year. A similar policy for urban areas may also be considered.

The government can also mull over reviving the Vajpayee government’s river linking project, which has a high potential for wage-employment generation. Ineffectiveness of expansionary monetary policy and seemingly partial effectiveness of Keynes strategy must warn the governments to prepare for a long-term solution. The Government of India must address the above issues in the coming Vote on Account.