Planning in India? It needs a thorough change

In the US, both Clinton and Bush administrations believed that market discipline was superior to regulatory oversight in achieving an appropriate balance between innovation and safety, writes Suman Bery.

The earthquake, tsunami and nuclear disaster in Japan and the global financial crisis centred on the US and Britain suggest that decision makers in even the advanced societies experience difficulty in acknowledging, let alone managing, worst-case scenarios in modern, complex systems.

In each case, the underlying 'failures' were more political than technical.

In the US, both Clinton and Bush administrations believed that market discipline was superior to regulatory oversight in achieving an appropriate balance between innovation and safety.

This view was strengthened by the apparent ease with which the US financial markets handled earlier crises, such as the Black Friday stock market crash of 1987, the Long-Term Capital Management crisis a couple of years later, and the succession of emerging market crises, including Asia, Brazil, Argentina and Russia around the turn of the century.

Though this success undoubtedly led to complacency, there was little reason to expect that a widely-expected correction in the US mortgage market would lead to the systemic upheaval that ensued.

However, in retrospect, one can find prescient voices, such as Raghuram Rajan and Nouriel Roubini, who warned of the build-up of systemic risks.

Similarly, in the case of the Japanese catastrophe, the tsunami experienced, though massive, was not unprecedented for the area.

The decision to site the reactors there, and to store spent fuel rods also on site, represented a gamble by decision makers and regulators in the face of opposition from more affluent areas.

It is important to draw the right lessons from these landmark episodes, but it is difficult to know what those lessons are.

This was clear from a fascinating conference at the Lauder Institute at the Wharton School, University of Pennsylvania on new perspectives on global risk following the financial crisis.

What was unusual about the conference was that it attempted to bring perspectives from various disciplines -- sociology, history, business and economics -- to reflect on the nature of the global economic and business risk in the wake of the financial crisis.

The Japanese disaster was obviously unanticipated at the time when the conference was organised, but many of the insights drawn from the financial crisis are in principle transferable to the Japanese crisis.

Some of these insights had to do with the sociology of knowledge elites, and echoed the points made by me in the last month's column (The fund of the future, March 15) citing the International Monetary Fund's own internal evaluation of the tendency for 'group think' within similarly trained cadres.

Within such an 'established paradigm', dissenting voices find it hard to be heard until and unless they are 'certified' by an accepted authority.

Who exactly should and can perform this legitimising role is a somewhat mysterious process.

Clearly, the IMF and much of academia failed to acknowledge these views in the build-up to the crisis. By contrast, since the crisis the IMF has been furiously pedalling to discard one former dogma after the other.

Capital controls! Low inflation!! Fiscal restraint!!!

All of these old arks of the covenant now lie in ribbons, and it

is not clear what will replace them and when, although it is also true that the old rules of thumb did not anticipate that large parts of the world would be caught in a liquidity trap.

It was also important to be reminded of Frank Knight's distinction between risk and uncertainty, as also the fallacies of composition which failed to take into account systemic consequences of behaviour that is rational for each individual actor.

For me, however, the more intriguing issues raised by the conference have to do with the implications for India's own development strategy.

It seems more than likely that the global economic environment will remain turbulent in a number of important respects for some time to come, quite apart from enhanced geopolitical security risks.

Exchange rates, capital flows and commodity prices are all likely to fluctuate within wide ranges.

The question is: how should the society be equipped to deal with this volatility?

A useful start would be to distinguish between the impact at three levels of the nation, businesses and households.

A possible extension would be to examine the impact at the level of the individual states as well.

In the recent crisis, the national level fared relatively well, essentially because a reasonable amount of fiscal and monetary space had been created.

In addition, despite its high debt level, India was protected because its public debt is denominated in rupees and is largely forcibly held by public financial institutions.

There was less protection available for businesses and households, however, and some businesses were themselves sources of vulnerability by taking on unhedged foreign exchange exposure.

The solution is clear, if difficult to implement: tighter monitoring of corporate borrowers by their banks, and continuing the drive to expand the range of hedging instruments.

The most difficult issues, both analytically and in terms of policy, arise at the household level.

As the recent crisis has shown, there is great injustice involved in vulnerable workers being the hapless victims of international forces over which they have no control.

Yet I, for one, have no doubt that as a group India' workers (and farmers, for that matter) are better off integrating with the global economy, and taking on board the additional volatility that this implies, as compared to the alternative of disengaging from global involvement.

It is clear from the recent experience with food and fuel subsidies that the attempts by government to act as a shock absorber are not sustainable in the long run.

There are two more complications.

First, as the recent crisis has revealed, with complex systems it is difficult to anticipate the speed and ramifications of any crisis.

Second, for a fast-growing country like India, it is important to facilitate, and not impede, adjustment and also to put safety nets in place that are consistent with longer-term competitiveness and flexibility.

What does this imply for planning?

It suggests that our planning increasingly should be about scenarios and gaming rather than point predictions, and that the focus should be on contingency planning as much as the base case.

It also raises profound questions about the division of labour between government and the household in bearing risks, which will need to be the subject of a future article.

The author is Country Advisor, International Growth Centre and Member, Prime Minister's Economic Advisory Council. Views expressed are personal