How to think of growth with Covid base effect

If Year 0 GDP was 100, and a pandemic hit economically primarily in Year 1 say, then how should we think of Year 2 estimates?

This goes to the heart of the question about how is output in a given time period constituted - how much of it is “zero base” effect, and how much is incremental/path dependent? Clearly both apply, but I will argue we tend to underestimate the former and understandably so we have probably never had a global pandemic such as Covid-19 before in a modern, semi-prosperous age where governments can and did partially lockdown economies to minimise human loss of life.

Now, let us take that abstract question into the specific case of India. In FY20, we had approximately 200 trillion of nominal INR GDP. Let us say in FY21, we have the same number with real de-growth being balanced out by some inflation. Yes, the last month of FY20 was also hit, yes FY21 number will probably be less not same as FY20, and yes FY22 has seen a massive second wave. But let us first think in terms of first principles for the question posed (if the second wave in this intensity stays much longer, which I do not think it will, we can pose this question for FY23 as I will)

Let us say on a decadal rolling basis, India’s secular trend growth right now based on decadal averages for almost two generations is 6-7% per capita, let us say population growth is ~1%, let us say inflation is 4-5%, and let us add in another 0.5% due to the multiplicative effect to get a nominal INR GDP growth rate of 12.5%. If the “zero base” effect theory is all that there is - aka, growth is the outcome of all factors irrespective of what happened last year, let us play along with that assumption - then FY22 GDP should be ~253 T INR. If path dependence is all there is, it should be around ~225 T INR. If we do a simple average, it is 239T INR and if we push it down a bit due to the second wave say we get to 230T INR. If we move on to FY23, based on the zero base effect, we should be at 285T but based on the incremental thesis we should be at 259T INR (again, these are all very rough numbers). Clearly the divergence gets more and more significant.

In reality of course both factors apply, and the incremental/path dependence aspect is visually clear: take last year’s number and you add (or subtract) something. The zero-basing one maybe less obvious though not necessarily more complicated. It accounts for all the factors of production - population, education, experience, infrastructure, real estate, industries, financial capital, governance etc - and starts from a clean slate, as it were, every year or relevant time period. Hence the allusion to the “Zero based budgeting” concept by me above.

Now, this should not be that terribly controversial. Germany and Japan recovered remarkably fast after the Second World War for a variety of reasons, but part of it was that they already had the human and institutional capital ready to roar again once peace came in whatever form - even if their physical and financial capital was severely dented. Their countries even then were disciplined, hard working and prioritised education compared to many other societies.

In India, last year while the digital divide exacerbated educational outcomes for many of our children unfortunately due to “study from home”, and that remains a crying shame, the impact of that will not be felt immediately and in fact the normalisation of “ed tech” might quite plausibly end up being a net positive. India also built record length of highways, our “second best” policies on industrial subsidies/ foreign investment/ moderate import substitution/ agricultural and labour reform were all excellent even if they remain “two steps forward, one step back” in the context of India’s chaotic but resilient democratic system. Every year, tens of millions are joining the workforce and every year they are more educated, and more digitally native just as the “work from home” trend ignites a new outsourcing boom.

In other words, there is nothing wrong with India’s factors of production compared to our past, if anything they are improving like clockwork. Moreover, the cyclical policies of fiscal and monetary stimulus have been deployed in. India while still not going all out (unlike say the United States) saving us ample firepower for the next few months if the pandemic deteriorates (unlikely but we cannot rule it out) or if the China-Pakistan axis starts a hot war (unlikely but again we cannot rule it out). India could do much more in terms of small savings rate cuts, real estate incentives, decongesting the regulatory cholesterol, cutting peak income tax rates which go against the grain of formalisation that the Union Government has been pushing since demonetisation. All that on top of vaccines, vaccines, vaccines.

But long story short, this natural “economic experiment” - if one can even say that with a straight face given the tragedy one sees all around - would be an interesting one to follow in the coming quarters and years. I do think people are underestimating the “zero base” approach though again that is not the entire story.