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On economic theory and policies

September 01, 2004 12:54 IST

In his 1993 tribute to A K Das Gupta, Amartya Sen lamented that economic textbooks invariably drew their illustrations from the developed world.

The examples they used were part of the experience of those living in Chicago, not Calcutta. In stating thus, Sen was not displaying Bengali parochialism, he is too eminent to need to do that, but he did show a serious deficiency in economic theory.

The late Professor Das Gupta was acutely aware of this type of limitation in economics. In his book Epochs of Economic Theory (Blackwell, 1985), he observed that economic generalisations were circumscribed by particular moments in time.

He concluded that economic propositions do "not satisfy what one might call the universality criterion." Thus, Das Gupta rejected the notion of the economic science having a status similar to physical sciences.

Economic truths are not like scientific truths. In physical sciences objects like apples always fall to the ground in any part of this world.

This is not the case with economic propositions, however logically sound they may be. They do not carry that degree of certainty, nor are they uniformly applicable in different places or at different times.

To give a simple example; ever since Adam Smith it has been widely recognised that economic growth depends primarily on the accumulation of capital.

Further, capital in a society accumulates through refraining from consumption and adding to savings. It has therefore been accepted that an increase in savings is the substance of growth.

But without deferring from the universality of this proposition, Alfred Marshall observed in his Principles of Economics: "In India and to a lesser extent in Ireland, we find that people do indeed abstain from immediate enjoyment and save up considerable sums with great self-sacrifice but they make intermittent provisions (only) for the near future, but scarcely any permanent provision for the distant future: the great engineering works by which their productive resources have been so much increased, have been made chiefly with the capital of the much less self-denying race of Englishmen" (Marshall, op.cit., p. 187).

It would seem from Marshall that just savings are not enough to ensure growth; you need entrepreneurs to undertake investment in enterprises.

This gap between savings and investment was lost in classical growth theory, for as Das Gupta explained in a footnote: "The classical economists identify accumulation with investment; institutions separating the act of saving from the act of productive investment were yet to arrive" (op.cit., p. 20).

This classical error of identifying savings with investment has proved fatal to economic policy. It also seems that Das Gupta was not entirely correct in his assumption of a lack of institutional framework.

After all, banks were fully operational in Adam Smith's time, they provided the institutional framework that enabled savers to be separated from investors.

But it is true that nowhere in The Wealth of Nations do you find the concept of investors as a separate group with purposes different from those of savers. The accumulation of capital can only yield fruit if the proceeds are invested.

However, to a classicist it will have seemed a purposeless act to sacrifice consumption by saving, if the intent was not to invest it productively.

In Adam Smith's world, there were really only two alternatives; either the money was spent on consumption or invested for future income. Das Gupta shows with beautiful clarity the chain of events that lead from savings to raise national income.

He points out that the accumulation of savings would be done by capitalists with that part of the national income that they received but was surplus to their needs and therefore could be justifiably put to risk for future growth.

But economists discovered that complications develop if the saved income is not used for investment but simply hoarded for future consumption. Marshall argued that in India and Ireland people "spend all their savings in lavish festivities at funerals and marriages."

That may explain our poverty; It may also explain the reason for the finance minister to urge bankers to seek out investors for their surplus funds rather than purchase safe government securities.

But he may be cajoling the wrong group; he should surely be finding out why entrepreneurs are unwilling to borrow, not just why banks are unwilling to lend. Either investors do not have profitable projects to take the risk of borrowing, or they cannot overcome the obstacle of bank bureaucracies.

Policymakers further argue that banks do not seek out borrowers in agriculture. But banks need to lend their funds in a manner by which they are able to meet their liabilities to their depositors. If agricultural repayments are uncertain, banks must provide for surpluses as a cushion for bad loans.

Thus, if the authorities are to encourage lending to farmers, this can best be done either by allowing bankers to charge a higher rate of interest or by providing the banks with an insurance that will ensure that induced loans to agriculture can be safeguarded by government guarantees against bad loans.

This proposition reverts to putting the risk ultimately on the government, a course that the authorities are reluctant to pursue; but by denying this alternative the authorities lose all moral right to induce bankers to take risks, which the general wealth of the nation is reluctant to underwrite.

The alternative is to allow bankers to charge whatever interest rate they deem appropriate for undertaking the risks urged upon them by policymakers. If a free enterprise solution is sought for increasing loans to sectors like agriculture, the only logical way out is to abandon ceilings on interest rates.

It has frequently been said that agriculture in India suffers from exorbitant rates charged by rural moneylenders. If such rates are disproportionate to the risks that the lender takes, then banks with their great surpluses will be able to compete. This may lead to higher interest rates but farmers might still prefer that if the quantity of fresh lending is sufficient.

In the galaxy of star economists that Manmohan Singh has assembled in his government, this proposition of allowing banks total freedom must be startlingly obvious. In 1991 Manmohan broke the logjam India found itself in by the simple mechanism of freeing the exchange rate.

His advisers will say that he did much more towards freeing up trade and enterprise, but none of that would have been of any use if he had not hesitantly but firmly freed up exchange rates.

A step of that magnitude and boldness needs to be taken in money markets. If there is a need to increase capital to agriculture, the ceiling on rates of interest for agricultural loans has to be removed.

In his youth, Manmohan had won the Adam Smith prize at Cambridge and it was Adam Smith who pointed out that restrictions on interest rates "like all others of the same kind [are] said to produce no effect and probably increase rather than diminish the evil of usury" (The Wealth of Nations, Book 11, Chapter 4, para 5).

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