Maynard Keynes on How to Be a Good Economist

From Facebook, April 11, 2011

Since the name of Keynes is back to being used somewhat in vain around the world, it may be appropriate to recall Maynard Keynes’s description of his own role-model as an economist, his master Alfred Marshall.

“The study of economics does not seem to require any specialised gifts of an unusually high order.  Is it not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science?  Yet good, or even competent, economists are the rarest of birds.  An easy subject , at which very few excel!  The paradox finds its explanation, perhaps, in that the master-economist must possess a rare *combination* of gifts.  He must reach a high standard in several different directions and must combine talents not often found together.  He must be mathematician, historian, statesman and philosopher — in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood: as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.”

JM Keynes “Alfred Marshall, 1842-1924” in Memorials of Alfred Marshal, edited by AC Pigou, 1925, p. 12.

Keynes himself was trained as and always thought like a mathematician, though he invariably spoke in words about practical realities. Marshall was his master, and so too, to a lesser extent, was his father, Neville Keynes.

I came to quote Keynes’s statement in Chapter 9 “Mathematical Economics and Reality” of my 1989 book *Philosophy of Economics*...

 

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Did Donald Trump & Bernie Sanders get their Trade Policy from my 1983 Cato talk?

In 1983 Dr James Dorn of Cato Institute invited me to come from Blacksburg to comment on the influential papers then being given by the prominent trade economist Dr J Michael Finger.  I think I might have said I  hadn’t worked on trade since LSE days a decade earlier but Jim said something sweetly persuasive like “We want to put you in the limelight” — and limelight there was, a full house in Washington (the Capitol Hill Hyatt Regency I think), with the bright camera lights of C-Span and local television.

I do not recall what current trade issues dominated the agenda, certainly it was years before NAFTA or China were being discussed, perhaps tariff removal on US textiles, probably Japanese auto-imports: Michael Finger certainly gave a devastating example of the difficulty US beef exporters had entering Japan’s beef market at the time.

But whatever I said, as a 28 year old Indian from Cambridge and India,  was very well received by that packed Washington audience. And I did not say much more than offer a Hahnian-Keynesian scepticism about textbook economic theory being divorced from ground realities.

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I seemed to recall coming from Blacksburg by car to give the Washington talk, but the letter Jim Dorn sent was to Menlo Park, California, where I had been in the summer; and later in Fall 1983 I was visiting at Cornell; I have not yet been able to reconstruct how I travelled to Washington, I would be surprised if I drove from Ithaca and back but perhaps I did.  (I had just driven from Blacksburg to California and back, then up to Ithaca).  The phone conversation about “limelight” must have been in the summer.

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This was the operative part of my The Political Economy of Trade Policy: A Comment http://heinonline.org/HOL/LandingPage?handle=hein.journals/catoj3&div=72&id=&page=

From Twitter 21.10.2016 et seq: I recollect three interactions after the talk, Donald J Trump or someone like him was seated midway in the hall in an aisle, introduced himself praised the talk to me, and may have said “Remember the name”! (He looked like a “preppie”, like myself.) Bernie Sanders, or someone like him made a momentary comment as he charged by at speed; a third man said I “waxed eloquent”.
(Trump sat toffishly dressed in an aisle seat, congratulated me and introduced himself, Sanders charged out at speed after a momentary word…I recall three interactions after the talk, one each with Trump and Sanders, or someone like them.)

Half a dozen years later at the University of Hawaii in March 1989 I amplified the argument a little bit as follows:

“Risk-aversion explains resistance to freer trade (and explains  protectionism during a recession)

Textbook economics suggests world trade improves material welfare: consumers are better off when imports may compete freely in the home-market.  Yet from Adam Smith’s critique of mercantilism to modern theories of rent-seeking, domestic producers in import-competing industries have been described as trying to restrict international trade by tariffs or other means.  How is it producers so often succeed in persuading governments of the social costs of imports?  Why are there not (or not as many, or not as powerful) consumer lobbies?  Certainly there are high costs of organizing consumer lobbies relative to producer lobbies, but leaving that aside, is it possible  consumers are ignorant and irrational?  J. Michael Finger (1982, 1983/84) argued that in this respect consumers are in fact ignorant of their own best interests.

Roy (1983/84) suggested that a simple Keynesian observation offers a different explanation.  A domestic household may be definitely better off by trade-liberalization on the expenditure side of its budget but the increased competitiveness of the economy accompanying liberalization may so decrease the expected value of its income that a risk-averse household would prefer the trade-protected status quo and have no incentive to lobby for trade-liberalization.  Conversely, in a recession when the expected value of a household’s income declines, households have an incentive to lobby for trade-protection despite this worsening the expenditure side of their budgets.

The simplest of examples suffices to show all this.    Let x1 be a non-traded domestic good, and x2 an imported good, and let a domestic household have preferences

U (x1, x2) = x1α . x2β

α + β < 1; 0 < α, β < 1     (1)

Let x1 be numeraire, p’ and p be the world and domestic prices of x2 respectively, and t be the tariff-rate on x2 such that p = (1 + t). p’.  Let the household’s expected income be ya in the trade-protected state and yb in the trade-liberalized state, so its budget constraint is either

ya = x1 + (1 + t).p’. x2 in the trade-protected stated  (2a)

or

yb = x1 + p’. x2 in the trade-liberalized state      (2b).

Maximizing (1) subject to (2a) gives a “final utility” in the trade-protected state, Ua*.  Maximizing (1) subject to (2b) gives a “final utility” in the trade-liberalized state, Ub*.

Hence   Ua* >     Ub* as

[ya/yb]  (α + β)/β >     1 + t         where  (α + β)/β  > 1.

If income is certain in the trade-protected state but uncertain in the trade-liberalized state, a household’s risk-aversion will require loss in the expected utility of income in the trade-liberalized state to be offset by a gain in final utility that it receives as a consumer due to tariff-reduction.

E.g.,  let α = β = ½ and let the household have a certain income in the trade-protected state of $20,000; let it place a subjective probability of 1/4 on being unemployed with zero income in the trade-liberal­ized state, and 3/4 on maintaining the same income of $20,000.

Then Ua* > Ub* as [4/3]2 > 1 + t.

I.e., for any tariff-rate less than about 78% with these  particular data, the household may rationally think itself better off in the trade-protected state than in the trade-liberalized state, and hence have no incen­tive to lobby for the latter.

Cooper (1987) remarked: “There should of course be a strong appeal to consumers of imported goods for removing restrictions.  For a variety of reasons, political mobilization of consumers has been difficult in most countries.  Many of these consumers also are employed in producing tradable goods, and they worry more about their jobs than about the purchasing power of a given wage. But most goods that move in international trade are not consumer goods.  They are capital goods and intermediate products, and it should be easier to appeal to buyers of these intermediate products for import liberalization, because such buyers would enjoy a reduction in their costs.”  The sentence italicized above may be consonant with the simple point made here.

References
Richard N. Cooper “Why liberalization meets resistance” in J. Michael Finger (ed.), The Uruguay Round, A Handbook on the Multilateral Trade Negotiations, World Bank, November 1987.
J. Michael Finger, “Incorporating the gains from trade into policy”, The World Economy, 5, December 1982, 367-78.
“The political economy of trade policy”, Cato Journal, 3, Winter 1983/84.
Subroto Roy, “The political economy of trade policy: comment”, Cato Journal, 3, Winter 1983/84″

I sent it to Economic Letters but the editor Professor Jerry Green rejected it, perhaps because it was too simple and unpretentious. And it remained unpublished until I put it on my blog in March 2009.

Yes it is relevant to the trade-problem America may face today, and yes perhaps both Mr Trump and Mr Sanders were in my audience at Cato, I do not know.

From Twitter 21.10.2016: I recollect three interactions after the talk, Donald J Trump or someone like him was seated midway in the hall in an aisle, praised the talk to me afterwards; he looked like a “preppie”, like myself. Bernie Sanders, or someone like him made a momentary comment as he charged by at speed; a third man said I “waxed eloquent”.
From Twitter 09.11.2016: Trump sat toffishly dressed in an aisle seat, congratulated me and introduced himself, Sanders charged out at speed after a momentary word…I recall three interactions after the talk, one each with Trump and Sanders, or someone like them

see too https://independentindian.com/2016/11/24/fixing-washington-on-improving-institutional-design-in-the-united-states/

“A Dialogue in Macroeconomics” 1989 etc: sundry thoughts on US economic policy discourse

I have said here recently that some of the wisest advice President Obama or any leader anywhere can receive is that contained in Oliver Cromwell’s famous words “Think it possible you may be mistaken”.

This seems especially significant in context of new American macroeconomic and financial policies.  Mr Steve Clemons reports today there may be less intellectual diversity in the new President’s economic team than is possible or desirable; if so, conversation may become stifled and a greater propensity towards groupthink may arise, hence a greater likelihood of mistakes.

It is possible the directions that different people might like to see the conversation extended are different, and that would be a good sign of course!  For example, someone might think a Barro or a Mishkin could be the right addition of intellectual diversity, whereas others might suppose that to be the wrong direction towards more “market fundamentalism”.    But it would be a pity if the economic conversation within the new Administration came to be artificially or ideologically circumscribed in any direction.

Certainly I believe macroeconomic policy-discourse in the United States or elsewhere needs to proceed to a recognition of the existence of JM Keynes’s original concept of “involuntary unemployment” as well as to ask whether the actual unemployment happens to be or  not be of this sort.   (It may be “frictional” or “structural” or “voluntary” or “seasonal” etc, not the involuntary unemployment Keynes had meant.)  Furthermore, even if significant involuntary unemployment is identified, it needs to be asked whether government policy can be expected to improve or worsen outcomes.   The argument must be made either way, and, in John Wisdom’s phrase,  “Argument must be heard”.

“A Dialogue in Macroeconomics” which was Chapter 8 of my 1989 book Philosophy of Economics (Routledge,  Library of Congress HB 72.R69)  may provide some useful ballast.  The saga  that followed the  book’s publication left me unable to write about the US economy anymore, except briefly in 1992 and 1994-95 in Washington and New York, read only by a few friends.   Now in late 2008, I have published “October 1929? Not!” and “America’s divided economists” which may be of interest too, and which are republished below as well.

I have also added a couple of sundry points from an international perspective that I pointed to last September-October, namely

(i)  foreign central banks might have been left holding more bad US debt than might be remembered, and dollar depreciation and an American inflation seem to be inevitable over the next several years;

(ii) all those bad mortgages and foreclosures could vanish within a year or two by playing the demographic card and inviting in a few million new immigrants into the United States; restoring a worldwide idea of an American dream fueled by mass immigration may be the surest way for the American economy to restore itself.

Subroto Roy

I.

from Philosophy of Economics Routledge 1989

“Chapter 8.
A Dialogue in Macroeconomics

OUR next example is of quite a different sort, namely, the academic debate which has occurred in macroeconomics and monetary theory since Keynes’s General Theory of Employment, Interest and Money. This has of course received a great amount of attention, with innumerable commentaries having been written by many scores of protagonists and moderators around the world. Only a brief and highly simplified summary of these many conversations can be attempted here, within our limited objective of illustrating once more how it may be possible for critical discussion to be seen to proceed freely and yet objectively in economics. In the previous chapter we were fortunate to have had an actual conversation to consider; here our method shall have to be one of constructing a model of a conversation. In honour of Plato, we might name our conversants Athenian and Stranger.

ATHENIAN Tell me, have you perhaps been following the discussions among macroeconomists? I shall be interested to know what you take their present state to be.

STRANGER Indeed I have, though of course it is not possible or worthwhile to follow all of what has been said. But yes I have followed some of it, and certainly we can make it a topic of conversation.

ATHENIAN Please begin.

STRANGER Very well. Shall we do so in ‘36 with the publication of Keynes’s book? Rightly or wrongly, this must be considered a watershed in the history of modern economics, if only because most economists since have had either to admit its arguments in some measure or define and explain their disagreement. You’ll remember at one time it was said by many that Keynes had fathered a revolution in economic science.

ATHENIAN Except Chicago and the Austrians.

STRANGER Quite so. Now more recently a renewal of neoclassical thought has been under way, and many doubts have been raised about the keynesian consensus, so much so that some of the main questions of the thirties seem in modern form to continue to be at issue today.

ATHENIAN The more things change, the more they stay the same! But when you say Keynes has been a central figure, I take it you mean only that he has been among the most influential and most discussed and nothing more. It is not to preclude judgement on the merits of his book, which is itself of very uneven clarity. Besides there has been too much idolatry and hagiography.

STRANGER Yes, there is so often a rush to belief and worship. There may have been less if Keynes had survived longer. Yet I should say the broad aim of the work is not hard to see. Keynes himself clearly believes that he is starting a revolution — going so far as to suggest a comparison with contemporary physics. The first chapter says the book aims to provide a “general” theory, which will explain the traditional model as a “limiting” case. The second chapter says the theory of value has been hitherto concerned with the allocation of given resources between competing ends; Keynes is going to explain how the actual level of employment comes to be what it is.

ATHENIAN And so begs the question?

STRANGER Or does traditional theory? That seems to be at the heart of it.

ATHENIAN Go on.

STRANGER The theory will be of the short run in Marshall’s sense of taking capital as a fixed factor. Traditional theory is said to postulate about the labour market (i) that the real wage equals the marginal product of labour, so there is an assumption of profit maximization by competitive producers giving rise to a short run demand curve for labour; and (ii) that the utility of the wage at a given level of employment equals the marginal disutility of that amount of employment; i.e., the real wage is just sufficient to induce the volume of labour which is actually forthcoming. So it can account for unemployment due to temporary miscalculations, or intermittent demand, or the refusal or inability of labour to accept a job at a given wage due to legislation or social practices or collective bargaining or obstinacy, or merely a rational choice of leisure — i.e., it can account for frictional and voluntary unemployment but not for what Keynes wants to call involuntary unemployment. What it can suggest is either such things as improvements in foresight, information, organization and productivity, or a lowering of the real wage. But Keynes’s critique will not have to do with such causes of the contemporary unemployment; instead the population is said to be seldom “doing as much work as it would like to do on the basis of the current wage…. More labour would, as a rule, be forthcoming at the existing money wage if it were demanded.” But it is not being demanded, and it is not being demanded because there has been a shortfall of “effective demand”. That is why there is as much unemployment as there is.

ATHENIAN Or so Keynes claims. And he would take it the neoclassical view would be that it must be the real wage is too high; it is only because the real wage has not fallen by enough that unemployment continues.

STRANGER Right. To which there are two observations. The first has to do with the actual attitude of workers towards the money wage and the real wage respectively. The traditional supply function of labour is a function of the latter; Keynes claims that at least within a certain range it must be workers are concerned more with the former.

ATHENIAN How so?

STRANGER By the interesting and perhaps plausible claim that workers are found to withdraw labour if the money wage falls but do not seem to do the same if the price level rises. A real wage reduction caused by a fall in the money wage and the same real wage reduction caused by an increase in prices seem to have different effects on labour supply. “Whether logical or illogical, experience shows that this is how labour in fact behaves.” And he cites U. S. data for ‘32 to say labour did not refuse reductions in the money wage nor did the physical productivity of labour fall yet the real wage fell and unemployment continued. “Labour is not more truculent in the depression than in the boom — far from it.”

ATHENIAN And the second observation?

STRANGER This may be of more interest. “Classical theory assumes that it is always open to labour to reduce its real wage by accepting a reduction in its money wage… [it] presumes that labour itself is in a position to decide the real wage for which it works…” Keynes does not find a traditional explanation why prices tend to follow wages, and suggests it could be because the price level is being supposed to be determined by the money supply according to the quantity theory. Keynes wants to dispute the proposition “that the general level of real wages is directly determined by the character of the wage bargain…. For there may be no method available to labour as a whole whereby…. [it] can reduce its real wage to a given figure by making revised money bargains with the entrepreneurs.” Hence he arrives at his central definition of involuntary unemployment: if the real wage falls marginally as a consequence of the price level rising with the money wage constant, and there is greater employment demanded and supplied in consequence, the initial state was one of involuntary unemployment.

ATHENIAN You are saying then that Keynes’s intent is to establish the existence of involuntary unemployment?

STRANGER At least a major part of the intent yes. To make the concept meaningful, to argue that it refers to a logical possibility, and also that much of the actual unemployment of the time may be falling under it, and is a result of lack of “effective demand”.

ATHENIAN The neoclassicals have been said to be cavalier about fluctuations in economic activity, when in fact Wicksell and Marshall and Thornton, let alone Hawtrey or Hayek as Keynes’s own critics, certainly had profound enough theories of the cycle. Before we go further, I think we should remind ourselves of what they actually said.

STRANGER Very well.

ATHENIAN Would you agree that can be summarized, then as now, as the quantity theory of money married to the theory of general equilibrium?

STRANGER Though it may be better to speak of divorce perhaps rather than marriage, in view of the dichotomy.

ATHENIAN From Smith to Mill, political economists broadly agree the role of government should extend and be restricted to such activities as defence, civil protection, the rule of law, the provision of public goods, education, the encouragement of competition, and so on. The traditional agenda does not as a rule include direct activity to restrain or otherwise change the natural course of trade, production, or consumption, and certainly no theory of what today is called macroeconomic policy. Underlying it is a broad belief that the competitive pursuit of private welfare within the necessary and minimal framework of the institutions of government, will result in tolerable social outcomes, and any further activity may be counterproductive. The State is after all endogenous to the economy, without any resources to its own name.

STRANGER The minimal state, though not so minimal perhaps as we sometimes think.

ATHENIAN The main function of money is seen to be that of facilitating real transactions. Hence the main component of the demand for money is the transactions demand, and the broad objective of monetary policy is the maintenance of the stability of the price of money. But this is recognized to be something elusive in practice, and fluctuations in economic activity are expected to occur in spite of the best intentions of the monetary authorities.

STRANGER How so?

ATHENIAN Well we might imagine two or three distinct but related markets: one for real investment and savings determined by intertemporal preferences, resources, and technologies; one a market for investment and savings defined in terms of money; one a short term credit market. The market for real investment and savings is, as it were, unobservable to the naked eye. Yet it drives the second and third markets for nominal savings and investment in which we actually participate. Monetary equilibrium requires the observable money rates of interest to equal the unobservable real rate of return on the market for physical capital. In particular, the real or natural rate of interest determined in the equilibrium of the first market is not, and perhaps ultimately cannot be, affected by nominal or monetary disturbances in the second or third markets.

STRANGER Why call it “natural”?

ATHENIAN In the sense it is a function of the real data of intertemporal preferences, resources, and technologies being what they are. If these data changed it should be expected to change too. But given these data, it would be the rate at which intertemporal constrained maximizations by individual agents resulted in planned present consumption equaling planned present production at the same time as planned future consumption equaled planned future production.

STRANGER In other words, real planned savings equal real planned investment.

ATHENIAN Exactly. It is the real interest rate, or rather the whole structure of own-rates and cross-rates at various terms, which is the key price signal for macroeconomic equilibrium.

STRANGER “Natural” seems to me to carry a physiocratic connotation. A better nomenclature would replace it with something else — perhaps “equilibrium real rate” or just “walrasian” rate.

ATHENIAN Very well, though I for one do not bias myself against the physiocrats! Now consider how a simple business cycle might occur on wicksellian lines. From a position of full real and monetary equilibrium, an expansion of credit has its first effect on the banks, increasing reserves and inducing more lending for reserve/deposit ratios to be restored, and so lowering the loan rate. But customers are only able to perceive a lowering of this nominal rate of interest and cannot know the equilibrium real rate has not changed. As far as households know, the relative price of present consumption has fallen and there is an incentive for greater consumption and lesser savings. As far as businesses know, the relative price of the future good has risen, and there is an incentive for greater investment. Inventories are run down, and markets for both consumer goods and capital goods are stimulated and show signs of excess demand. But if there was a walrasian equilibrium initially, then the economy will now show signs of inflation; with a gold standard, there would be increased demand for imports and an external drain of reserves, and even perhaps an internal drain if there was a panic and a run on the banks. The loan rate will have to rise once more to reign in reserves, but if the rate is now raised too high relative to the still unchanged real rate, there would be the makings of a recession.

STRANGER Your point being that economists before Keynes had recognized the decentralized economy may be fluctuating continually.

ATHENIAN Surely they had done so quite fully. A first set of causes such as wars, disasters, discoveries and migrations would change the real data of the economy, while a second set would be monetary disturbances like the failure of the authorities to adequately follow the dictates of the real data of the economy, i.e., failure to observe the equilibrium real rate of interest. It may even be intrinsic to the problem that they must fail in the attempt to observe, let aside compute, the equilibrium real rate warranted at a given time by the structure of the real data.

STRANGER Hence the conclusion that they cannot hope to do better than establish a climate of monetary and fiscal stability, such as by declaring a long term policy and staying with it.

ATHENIAN Exactly. Private economic agents already face endemic uncertainty with respect to changes in the real data, and must be assumed to not want more added by government policy. You appear to have seen my point nicely.

STRANGER Very well. But you have jumped ahead as this kind of a conclusion sounds very modern to me. You made me stop all the way back at Keynes’s notion of effective demand!

ATHENIAN As I said, the more things change, the more they stay the same.

STRANGER Let us go back a little. I think we may be able to rejoin our initial route at a point which may bring us close to where we seem to have come by the route you have taken. Specifically suppose we go back to the question of the money wage and the real wage, and of the real wage being “too high”.

ATHENIAN That has been interpreted a number of ways, has it not?

STRANGER Yes it has. One would be to say Keynes was merely simple minded and assumed money illusion on the part of workers. Another would be to say Keynes assumed a short run context of fixed prices, so it would not make a difference whether labour happened to be concerned with changes in the real or the money wage. Yet a third would be to say Keynes, whether he realized it or not, had come upon a recondite truth about the sort of complex monetary economy in which we live — namely, that when transactions are quoted and made in a monetary economy, it may become difficult ipso facto for the walrasian equilibrium to be achieved. Even workers might fully recognize the real wage to be too high and be prepared to work more at a lower wage, but be unable to signal this willingness to potential employers.

ATHENIAN So involuntary unemployment becomes another sort of equilibrium outcome.

STRANGER Exactly. Not only of labour but of machines too, along with the unintended holding of inventories. It is as if firms would have sold what they had planned to if only workers had the income to buy it, which they would have done if only they had been able to sell as much labour they had planned to, which they would have done if only there had been an effective demand for it, which there would have been if firms had not cut back on production because they found themselves unable to sell what they had planned to sell. A kind of vicious circle, due to pessimistic and self-fulfilling expectations all around.

ATHENIAN An unhappy solution to a non-cooperative game you might say.

STRANGER Quite so. Keynes does not deny there may be a monetary route out of the impasse. A wage deflation would eventually lead to price deflation, raising the real value of money holdings, so via liquidity preference lead to an increased demand for bonds, raising their price and lowering money interest rates, which through the investment function would lead eventually to increased effective demand. But the fiscal route may be more direct and quicker in its effect on expectations. Trying to deflate across the board in the face of what seem to be excess supplies of goods and labour might be counterproductive, causing unexpected transfers from debtors to creditors and precipitating bankruptcies. Instead: “Government investment will break the vicious circle. If you can do that for a couple of years, it will have the effect, if my diagnosis is right, of restoring business profits more nearly to normal, and if that can be achieved then private enterprise will be revived. I believe you have first of all to do something to restore profits and then rely on private enterprise to carry the thing along….”

ATHENIAN A shot in the arm for enterprise in the hope of breaking the pessimism. But Keynes was hardly alone in such thinking.

STRANGER Quite true.

ATHENIAN And he certainly seemed to treat the opinions of others without due respect, which is to say he may have exaggerated the significance of his own. Hinting that he was the Einstein of economics set an especially bad example. Only the other day one eminence was comparing himself to Newton, and another was calling his friend Shakespeare. It will be Joyce and Pasternak next!

STRANGER Flattery and nepotism are common weaknesses, my friend. Like the rush to belief and worship.

ATHENIAN Besides you would have to assume the government to be outside the game, and only so being able to see the problem which private agents could not from inside the game. That may be too large an assumption, don’t you think?

STRANGER Yes it may. Yet it seems to me pump-priming was a possible solution being offered to a temporary problem. Many of the controversies may have come about because it became institutionalized, because discretionary fiscal policy became a permanent part of the government agenda.

ATHENIAN And a more direct route out was available too, was it not? With wealth placed in the consumption function directly, a deflation would increase the real value and affect effective demand directly. We would not have to wait for the roundabout effects through so-called liquidity preference.

STRANGER Which in a way brings us back to a central pillar of traditional theory: with given real data and given velocity of circulation, desired holding of real money balances will roughly be constant. In particular the demand for real money balances should not be seen as a function of the interest rate.

ATHENIAN The real rate or the monetary rate?

STRANGER For neoclassicals certainly the real; Keynes does not seem clear.

ATHENIAN There may lie a problem.

STRANGER The title of the book says “Employment, Interest, and Money”. No question employment is real and money is money — interest is the bridge. If you ask me to bet I would say Keynes’s agents make real responses to signals expressed as they must be in a large economy in monetary terms.

ATHENIAN Perhaps we ought to move on. Tell me, if you think Keynes’s book rightly or wrongly ranks as the most influential document of the last fifty years, would you agree it is Friedman’s address on the role of monetary policy which must rank second to it if not on a par with it?

STRANGER Certainly there can be few competitors.

ATHENIAN Well then, it appears to me the net effect of Friedman’s critique has been a restoration of the wicksellian theory and a banishment of the keynesian theory.

STRANGER Friedman of course makes his approach via a critique of the Phillips’ Curve.

ATHENIAN Yes, but it is Wicksell whom he acknowledges in advancing the notion of a natural rate of unemployment, one which has been “ground out by the walrasian system of general equilibrium equations” — in other words, one which happens to be consistent with the structure of the real data of the economy at a particular time.

STRANGER Though again we may as well speak of walrasian instead of natural.

ATHENIAN A monetary policy which tried to peg unemployment at lower than such a rate (if such a rate could be determined, which it cannot) is likely to be counterproductive. The initial effect of an expansionary policy on a walrasian equilibrium may be to increase real output. Workers assume the increase to reflect an increase in the unobservable real demand for their services, and hence they expect a higher real wage. Businesses see the same and assume it to reflect an increase in the unobservable real demand for their goods. But given there was no real excess demand in the first place for either labour or goods, the effect outside anything but the short run will be a return to the initial structure of real wages, and the temporary decline in unemployment is reversed to the walrasian rate at higher prices. If the government tries to maintain unemployment at less than the walrasian rate, it will have to concede — indeed it will have caused — accelerating inflation without any real fall in unemployment.

STRANGER And vice versa perhaps, so there would be a kind of knife-edge.

ATHENIAN Now your remark about Friedman making his approach via the Phillips Curve seems to me interesting. We may have been too hasty to make a comparison with the debate in the thirties. For the world suffers a very real and severe shock between Keynes’s book and the keynesian consensus, which is the Second World War itself.

STRANGER I am not sure I follow.

ATHENIAN Well think of the consensus afterwards on the need for macroeconomic policy — it is actually Tinbergen’s notion of a “policy-maker” which is married to what seems to be Phillips’s finding of a trade-off between inflation and unemployment. It becomes the role of the macroeconomist to advise the politician on how to minimize social disutility from inflation and unemployment subject to the Phillips Curve. Macroeconomics becomes a so-called “policy science”. Give your expert economist your social utility function, and he will tell you where to slide to on your Phillips Curve.

STRANGER The available instruments being money supply and tax rates. That is what I meant in saying Keynes’s idea became institutionalized.

ATHENIAN It seems to me this consensus is born out of the War.

STRANGER How so?

ATHENIAN Well just think of the structural problems of the time: demobilization of large armies, reconstruction, all the displaced peoples, and so on. What are democratic governments to do? Say to their voters, right, thank you very much, now could you please go home quietly? What could have been expected except an Employment Act? Governments were going to help their returning citizens find work, or at least it would have seemed irresponsible if they had not said they were going to.

STRANGER You are saying then that Friedman may have been arguing against a new orthodoxy, grown out of what might have been a sensible idea.

ATHENIAN Exactly. The world is a very different place now than in 1945, in ‘45 than in ‘33, in ‘33 than in 1914. Real shocks every time. It may be a grave mistake for us to look for a unique and universal theory which is supposed to explain all particular circumstances, all of history.

STRANGER Reminds me of the historical school.

ATHENIAN Why not? Again I hold no prejudice against them! Anyhow, consider that Lucas and others have followed Friedman to argue it is a mistake to formulate the problem as Tinbergen had done, with unemployment as a target in a social utility function along with inflation. If it ought to be assumed that people will not continually make the same mistakes in predicting policy, then a systematic employment policy is going to be discovered quickly enough and rendered either ineffective or counterproductive. This idea too has its origins in Wicksell. Examining an opinion that inflation might stimulate enterprise and free debtors, Wicksell says: “It need only be said that if this fall in the value of money is the result of our own deliberate policy, or indeed can be anticipated and foreseen, then these supposed beneficial effects will never occur, since the approaching rise in prices will be taken into account in all transactions by reasonably intelligent people.”

STRANGER Wicksell said that?

ATHENIAN Precisely that.

STRANGER It does sound very modern.

ATHENIAN Now Lucas speaks of how the advice that economists give should be limited only to “the well understood and empirically substantiated propositions of monetary economics, discouragingly modest as these may be.” What can we take him to mean? It seems to me he is sharing Friedman’s scepticism of the possibilities which had been claimed for macroeconomics by the keynesian consensus. And that surely has been a healthy scepticism, befitting good economists.

STRANGER As I said, there is so often a rush to belief.

ATHENIAN Which is really disastrous when combined with the craving for power.

STRANGER But the question remains, does it not, as to which propositions of monetary economics are to be considered “well understood and empirically substantiated”. I cannot help think the propositions taken to be well understood and empirically substantiated in Chicago may be very different from those taken to be well understood and empirically substantiated in Cambridge, or for that matter, those in the U. S. from those in Europe.

ATHENIAN I don’t see any difficulty in this. For first, it would have been granted there are propositions in economics which can be well understood and empirically substantiated. And that must be counted as progress! For something cannot be well understood if it cannot be understood at all, and where there is the possibility of understanding there must be the possibility of objective knowledge as well. And second, why should we not say the most appropriate task of economic theory or analytical economics is simply one of clarification and elucidation of the conceptual basis of economic thinking and expression? All theory ultimately is, or ought to be, “Critique of Language”. When we are faced with a particular and concrete problematic situation, the theorist is to whom we turn for conceptual guidance and criticism. If instead you take the role of the theorist to be one of searching the universe for grand and general and absolute and abstract truths, which need to be discovered before we can say anything about some concrete set of particulars, then it seems to me you will be either struck dumb by a total and debilitating scepticism or become very shrill in your dogmatism or alternate wildly between the two. To me it seems unimportant ultimately to whose flag one shows allegiance, or indeed that allegiance to any flag must be shown.

STRANGER It seems again I will not disagree. But you have sketched the critique of Friedman and Lucas and indeed the ghost of Wicksell addressed to the dogmas of the keynesian orthodoxy. And I have agreed with you this has been a healthy criticism of the sort we should expect economists to provide. But there has been serious question too of the framework used by Friedman and Lucas, hasn’t there? I am thinking especially of Tobin and Hahn.

ATHENIAN Tobin has done much to add clear and reasonable thinking about Keynes — his suggestion that a certain amount of inflation may be the only way to bring down real wages towards their walrasian rates in complex monetary economics is especially interesting; it shows how wide the common ground can be upon which the debate may occur. But you will have to tell me what Hahn’s criticisms have been. I have always found them too abstract and too caustic.

STRANGER That they tend to be, but don’t let that deter you. As I see it, Hahn argues somewhat as follows. We should grant Friedman and Lucas two important points: first, the government is itself a large economic agent whose actions and announced plans enter the calculations of private agents; secondly, erratic changes in monetary policy away from a steady k% rule may have perverse effects “by confusing signals of relative scarcity with those that arose from the monetary policy”. Also, we may accept that the assumptions sufficient for a full walrasian equilibrium with rational expectations suffice for the absence of any persistent involuntary unemployment by Keynes’s definition. But Hahn would say this may not be the relevant empirical description.

ATHENIAN In what way?

STRANGER Well for one thing the pricing axiom or the recontracting assumption of stability theory remains unexplained. It is possible traders will face quantity constraints, and this often seems so in markets for labour and credit. We may simply find prices not moving in the direction of excess demand even when a quantity constraint happens to be binding. The structure of wages may be “neither fixed, nor arbritrary, nor inflexible; it is what it is because given conjectures, no agent finds it advantageous to change it.” Moreover, it may not be plausible to suppose there will be convergence after arbitrary displacements back towards a stable equilibrium, because the conditions for stability are very stringent and uniqueness of equilibrium may also need to be postulated. Furthermore, it may be quite unsatisfactory to treat money in models which are isomorphic to the Arrow-Debreu model, because in such a world there is no logical use for money, so there must be some essential features of reality which have failed to be features of the model.

ATHENIAN You don’t think Patinkin’s integration was adequate?

STRANGER For many practical purposes perhaps, but certainly not to full logical satisfaction. If you put real money balances into the utility function and treat money just about like any other good, you have to be prepared to accept a possible equilibrium in which the price of money is zero. Lastly, if there are internal debts denominated in money as there are in fact, you may not assume equiproportional changes in all prices will not have real effects, unless you are prepared to assume away redistributions between creditors and debtors, which you can do only under another assumption that all households have parallel and linear Engel curves through the origin. Hahn’s line of argument is admittedly abstract, but you will have to admit it raises some fundamental questions.

ATHENIAN Another example we might say of the healthy scepticism of the theorist. It seems my turn to agree with you. But we can imagine replies too can we not?

STRANGER What do you have in mind?

ATHENIAN Well to argue there can be unemployment which is involuntary is not to have argued that an employment policy can be expected to remove it. This seems a premise and conclusion too frequently confounded by both keynesians and their critics, with disastrous consequences. Then, Buchanan would argue that a more thorough characterization needs to be given of the making of government policy, especially when it is proposed to supplant the market outcome. Policies are after all proposed, enacted, and put into effect by actual people — all of whom may need to be assumed to be pursuing private rewards as well in the course of their public duties. The relevant description for the economist needs to be one including this further fact that actual proposals of public policy can embody the private interests of the proposers too.

STRANGER Making it that much more difficult to determine what is in the public interest in a given case.

ATHENIAN Exactly. And so reinforcing the case for predictability and an orderliness in the framework of government.

STRANGER But we have been talking now for quite long enough my friend. I seem to feel a fear too that we have not gained anything at all in our discussions.

ATHENIAN Don’t be so pessimistic! Surely the point of reconstructing such conversations as we have done is not to hold absolutely to the matters raised in them. You and I after all have been making summary and highly simplified and unauthorized interpretations. I take the point of it to have been clarifying our thoughts, and perhaps to show ourselves how discussion can proceed between economists of different schools of thought. Arguments might come to a halt for any of a number of reasons, but they needn’t be supposed to have any logical or necessary end. Too often we let people retreat into different dogmatic positions, fostering the belief that each is starting from some set of absolute axioms ultimately irreconcilable with those of the other. We may need to keep insisting instead that the pursuit of knowledge and understanding is an open-ended activity with potentially indefinite limits. It yields conclusive results but has no absolute end. You or I might call a halt and retire from it, but that will not mean it cannot or will not continue without us.

STRANGER Perhaps so. But you are younger than I, and I have become tired by all these thrusts and parries. Besides, there has been the enjoyment of conversation itself.”

II

October 1929? Not!  by Subroto Roy / First published in Business Standard September 18, 2008

“Lehman Brothers filing for bankruptcy protection, Merrill Lynch taken over by Bank of America, Fannie Mae and Freddie Mac and now AIG being nationalised by the US Government, Bear Stearns getting a government bailout, many thousands of low-quality loans going bad … Does it all add up to an American financial crisis in the autumn of 2008 comparable to that in the autumn of 1929? Even Alan Greenspan himself has gone on record on TV saying it might.

But there are overriding differences. Most important, the American economy and the world economy are both incomparably larger today in the value of their capital stock, and there has also been enormous technological progress over eight decades. Accordingly, it would take a much vaster event than the present turbulence — say, something like an exchange of multiple nuclear warheads with Russia causing Manhattan and the City of London to be destroyed — before there was a return to something comparable to the 1929 Crash and the Great Depression that followed.

Besides, the roots of the crises are different. What happened back then? In 1922, the Genoa Currency Conference wanted to correct the main defect of the pre-1914 gold standard, which was freezing the price of gold while failing to stabilise the purchasing power of money. From 1922 until about 1927, Benjamin Strong of the Federal Reserve Bank of New York adopted price-stabilisation as the new American policy-objective. Britain was off the gold standard and the USA remained on it. The USA, as a major creditor nation, saw massive gold inflows which, by traditional gold standard principles, would have caused a massive inflation. Governor Strong invented the process of “sterilisation” of those gold inflows instead and thwarted the rise in domestic dollar prices of goods and services.

Strong’s death in 1928 threw the Federal Reserve System into conflict and intellectual confusion. Dollar stabilisation ended as a policy. Surplus bank money was created on the release of gold that had been previously sterilised.

The traditional balance between bulls and bears in the stock-market was upset. Normally, every seller of stock is a bear and every buyer a bull. Now, amateur investors appeared as bulls attracted by the sudden stock price rises, while bears, who sold securities, failed to place their money into deposit and were instead lured into lending it as call money to brokerages who then fuelled these speculative bulls. As of October 22, 1929 about $4 billion was the extent of such speculative lending when Chase National Bank’s customers called in their money.

Chase National had to follow their instructions, as did other New York banks. New York’s Stock Exchange could hardly respond to a demand for $4 billion at a short notice and collapsed. Within a year, production had fallen by 26 per cent, prices by 14 per cent, personal income by 14 per cent, and the Greatest Depression of recorded history was in progress — involuntary unemployment levels in America reaching 25 per cent.

That is not, by any reading, what we have today. Yes, there has been plenty of bad lending, plenty of duping shareholders and workers and plenty of excessive managerial payoffs. It will all take a large toll, and affect markets across the world.

But it will be a toll relative to our plush comfortable modern standards, not those of 1929-1933. In fact, modern decisionmakers have the obvious advantage that they can look back at history and know what is not to be done. The US and the world economy are resilient enough to ride over even the extra uncertainty arising from the ongoing presidential campaign, and then some.”


III

America’s divided economists by Subroto Roy First published in Business Standard October 26, 2008

“Future doctoral theses about the Great Tremor of 2008 will ask how it was that the Fed chief, who was an academic economist, came to back so wholeheartedly the proposals of the investment banker heading the US Treasury. If Herbert Hoover and FDR in the 1930s started something called fiscal policy for the first time, George W Bush’s lameduck year has marked the total subjugation of monetary policy.

In his 1945 classic, History of Banking Theory, the University of Chicago’s Lloyd Mints said: “No reorganisation of the Federal Reserve System, while preserving its independence from the Treasury, can offer a satisfactory agency for the implementation of monetary policy. The Reserve banks and their branches should be made agencies of the Treasury and all monetary powers delegated by Congress should be given to the Secretary of the Treasury…. It is not at all certain that Treasury control of the stock of money would always be reasonable… but Treasury influence cannot be excluded by the creation of a speciously independent monetary agency that cannot have adequate powers for the performance of its task…” Years later, Milton Friedman himself took a similar position suggesting legislation “to end the independence of the Fed by converting it into a bureau of the Treasury Department…”(see, for example, Essence of Friedman, p 416).

Ben Bernanke’s Fed has now ended any pretence of the monetary policy’s independence from the whims and exigencies of executive power. Yet Dr Bernanke’s fellow academic economists have been unanimous in advising caution, patience and more information and reflection upon the facts. The famous letter of 122 economists to the US Congress was a rare statement of sense and practical wisdom. It agreed the situation was difficult and needed bold action. But it said the Paulson-Bernanke plan was an unfair “subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.”

Besides, the plan was unclear and too far-reaching. “Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards…. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.”

The House’s initial bipartisan “backbench revolt” against “The Emergency Economic Stabilisation Act of 2008” (ESSA) followed this academic argument and rejected the Bernanke Fed’s advice. Is there an “emergency”, and if so what is its precise nature? Is this “economic stabilisation”, and if so, how is it going to work? The onus has been on Dr Bernanke and his staff to argue both, not merely to assert them. Even if the House “held its nose” and passed the measure for now, the American electorate is angry and it is anybody’s guess how a new President and Congress will alter all this in a few months.

Several academic economists have argued for specific price-stabilisation of the housing market being the keystone of any large, expensive and risky government intervention. (John McCain has also placed this in the political discussion now.) Roughly speaking, the housing supply-curve has shifted so far to the right that collapsed housing prices need to be dragged back upward by force. Columbia Business School economists Glenn Hubbard and Chris Mayer, both former Bush Administration officials, have proposed allowing “all residential mortgages on primary residences to be refinanced into 30-year fixed-rate mortgages at 5.25 per cent…. close to where mortgage rates would be today with normally functioning mortgage markets….Lower interest rates will mean higher overall house prices…” Yale’s Jonathan Koppell and William Goetzmann have argued very similarly the Treasury “could offer to refinance all mortgages issued in the past five years with a fixed-rate, 30-year mortgage at 6 per cent. No credit scores, no questions asked; just pay off the principal of the existing mortgage with a government check. If monthly payments are still too high, homeowners could reduce their indebtedness in exchange for a share of the future price appreciation of the house. That is, the government would take an ownership interest in the house just as it would take an ownership interest in the financial institutions that would be bailed out under the Treasury’s plan.”

Beyond the short run, the US may play the demographic card by inviting in a few million new immigrants (if nativist feelings hostile to the outsider or newcomer can be controlled, especially in employment). Bad mortgages and foreclosures would vanish as people from around the world who long to live in America buy up all those empty houses and apartments, even in the most desolate or dismal locations. If the US’s housing supply curve has moved so far to the right that the equilibrium price has gone to near zero, the surest way to raise the equilibrium price would be by causing a new wave of immigration leading to a new demand curve arising at a higher level.

Such proposals seek to address the problem at its source. They might have been expected from the Fed’s economists. Instead, ESSA speaks of massive government purchase and control of bad assets “downriver”, without any attempt to face the problem at its source. This makes it merely wishful to think such assets can be sold for a profit at a later date so taxpayers will eventually gain. It is as likely as not the bad assets remain bad assets.

Indeed the University of Chicago’s Casey Mulligan has argued there is a financial crisis involving the banking sector but not an economic one: “We’re not entering a second Great Depression.” The marginal product of capital remains high and increasing “far above the historical average. The third-quarter earnings reports from some companies already suggest that America’s non-financial companies are still making plenty of money…. So, if you are not employed by the financial industry (94 per cent of you are not), don’t worry. The current unemployment rate of 6.1 per cent is not alarming, and we should reconsider whether it is worth it to spend $700 billion to bring it down to 5.9 per cent.”

Dr Bernanke has been a close student of A Monetary History of the United States in which Milton Friedman and Anna J Schwartz argued that the Fed inadvertently worsened the Great Contraction of 1929-1933 by not responding to Congress. Let not future historians find that the Fed, at the behest of the Treasury Secretary, worsened the Great Tremor of 2008 by bamboozling Congress into hasty action.”

IV

Would not a few million new immigrants solve America’s mortgage crisis?
October 10, 2008 — drsubrotoroy | Edit

America was at its best when it was open to mass immigration, and America is at its worst when it treats immigrants with racism and worse (for seeming “uppity”).

All those bad mortgages and foreclosures could vanish within a year or two by playing the demographic card and inviting in a few million new immigrants into the United States.  They would pour in from China, Vietnam, Thailand, Philippines, Indonesia, Mexico, South America,  South Africa, Nigeria, Egypt, Israel, Poland, Romania, Hungary, Belarus, Ukraine, Russia, Uzbekistan, Kazakhstan,  India, Sri Lanka, Bangladesh, and yes, Pakistan too, and more.  They would happily buy up all those empty houses and apartments, even in all those desolate  dismal locations.  If the USA’s housing supply curve has moved so far to the right that the equilibrium price has gone to near zero, the surest way to raise the equilibrium price would be by causing a  new wave of  immigration leading to a new demand curve arising at a higher level.   But yes, nativist feelings of racism towards the outsider or the newcomer would have to be controlled  especially in employment — racists after all are often rather “sub-prime” themselves and hence unable to accept characters who may be “prime” or at least less “sub-prime” from foreign immigrant communities.   Restoring a worldwide idea of an American dream fuelled by mass immigration may be the surest way for the American economy to restore itself.

V

122 Sensible American economists

September 26, 2008 — drsubrotoroy | Edit

“$700 billion comes to more than, uhhhm, $6,000 per income taxpayer in the USA.

I was glad to see the sensible letter of 122 American economists to US legislators regarding the Paulson-Bernanke plan to address America’s financial crisis.

Somehow, I have an inkling that foreign central banks have been left holding more bad US debt than might be remembered — which would explain the embarrassment of Messrs Paulson and Bernanke vis-a-vis their foreign counterparts… Dollar depreciation and an American inflation seem to be inevitable over the next several years.”

Pump-priming for car-dealers: Keynes groans in his grave (If evidence was needed of the intellectual dishonesty of New Delhi’s new macroeconomic policy, here it is)

Pump-priming for car-dealers: Keynes groans in his grave

(If evidence was needed of the intellectual dishonesty of New Delhi’s new macroeconomic policy, here it is)

by

Subroto Roy

I have said the  Government of India’s new macroeconomic policy announced on Sunday by Dr Manmohan Singh’s main economic policy aide has no economic models or data to support it, and may as likely worsen rather than dampen any business-cycle India might be on for the simple reason that no one has a clue where we are in the cycle, or indeed even if such a cycle exists. (See https://independentindian.com/2008/12/07/will-the-government-of-indias-economic-policy-dampen-or-worsen-the-business-cycle-if-such-a-cycle-exists-at-all-no-one-knows-%E2%80%9Cwhere-ignorance-is-bliss-%E2%80%98tis-folly-to-be-wise/)

The policy appears to be the result of the usual intense lobbying by organised  capital and organised labour with the Government’s Ministries in New Delhi.

If evidence was needed of this root intellectual dishonesty, one need look only as far as “Highlights of India’s fiscal stimulus package” (Daily News and Analysis, December 7 2008) and note the item:

” Norms for government departments to replace vehicles relaxed”.

Dr Singh’s aide, after announcing the policy, openly spoke of how private automobile manufacturers had accumulated a lot of unintended inventory due to falling sales, and how they needed, in his opinion, to lower prices.  Evidently, the Government has also decided to itself  buy a lot of that unintended inventory too, using  the very scarce  public  resources of India’s ordinary people.  Pump-priming for car-dealers — JM Keynes groans in his grave!  Watch out for those fancy  fast new cars carrying India’s bureaucrats, politicians and their friends and family!

Bengal’s Finances

BENGAL’S FINANCES

First published in The Sunday Statesman February 25 2007, Editorial Page  Special Article, www.thestatesman.net

There is urgent need for calm, sober thought, not self-delusion. Foreign trade, world politics are not what State Governments are constitutionally permitted to do.

By SUBROTO ROY

Mr Buddhadeb Bhattacharjee is fond of saying his hoped for industrialization plans will lead to jobs for “thousands” of unemployed young men and women emerging from West Bengal’s many schools, colleges and universities.

Now ever since JM Keynes’s time, economists have understood the phenomenon of unemployment quite well. Some unemployment is voluntary: where someone declines to accept a job at the prevailing wage or chooses leisure instead, e.g. withdraws from the labour-force in order to go to college or care for children or family or be involved in search for a better job. Some unemployment is seasonal, as in agriculture ~ where there often is “overfull” employment at harvest-time. Some unemployment may be frictional or structural, depending on dynamic unpredictable industrial or technological changes. In none of these cases is any large role defined for government investment using public resources, though there can be smaller roles like providing job-information, advice and training.

Keynes himself was concerned with systematic “involuntary” unemployment, where masses of people are willing but unable to find work at the going wage because there has been a general collapse of the market economy, as arguably happened in the 1930s in the Western countries. There has been no such situation in independent India.

And it is important to remember our labour markets are mostly unrestricted by State boundaries: unlike totalitarian China, we do not have internal passports in the country, and Indians are mostly free to work anywhere they wish to. Talk from CPI-M, Congress, BJP or other politicians of alleged Keynesian “multiplier” effects arising from government expenditure is mostly talk. And as for Sonia Gandhi’s “National Rural Employment Guarantee”, to the extent it was argued for at all by Amartya Sen’s disciples like Jean Drèze, the argument was not on Keynesian grounds but of a purportedly more equitable distribution of government expenditure.

What then is the Bhattacharjee Government supposed to be doing?

Chandrababu Naidu started a trend among Chief Ministers flying off to exotic foreign vistas, addressing international conferences and signing memoranda with foreign businessmen. But world politics, international relations and foreign trade are not what Indian State Governments are permitted by our Constitution to be engaged in doing. Nelson Mandela is a great man of history but Jyoti Basu’s Government had no constitutional right or business to gift him five million American dollars of West Bengal public money after he was released from jail in South Africa in 1990 by De Klerk.

Our Constitution is crystal clear that the legitimate agenda of India’s State Governments is something very mundane and wholly unglamorous: State Governments are supposed to be managing Courts of Law; the Police, Civil Order, Prisons; Water, Sanitation, Health; State Debt Service; Intra-State Infrastructure & Communications; Local Government; Liquor & Other Public Sector Industry; Trade, Local Banking & Finance; Land, Agriculture, Animal Husbandry; Libraries, Museums, Monuments; State Civil Service & Administration. In addition, “concurrent” with the Union Government are Criminal, Civil & Family Law, Contracts & Torts; Forests & Environmental Protection; Unemployment & Refugee Relief; Electricity; Education. It is relative to that explicit agenda that State Government performances around the country must be evaluated.

The finances of the West Bengal Government and those of every other State of the Union appear in a condition of Byzantine confusion. Even so, it is not impossible for any citizen to understand them with a little serious effort. The State receives tax revenues, income from State operations (like bus fares, lottery tickets etc), and grants transferred from the Union. Of the State’s total revenues, more than 80% arise from taxation. Of those taxes, about 30% is collected by the Union on behalf of the State in accordance with the Finance Commission’s formulae; 70% is collected by the State itself, and about 60% of whhat the State collects is Sales Tax. On the expenditure side, more than 60% goes in repaying the State’s debts as well as interest owed on that debt. The remainder gets distributed as summarily shown in the table. (What would be revealed at a higher level of detail is that e.g. Rs. 2.63 Bn is spent in collecting Rs. 9.93 Bn of land revenue!) The wide difference between the State’s income from all sources and its expenditures implies the State must then issue new public debt. That typically has been a larger and larger sum every year, greater than the amount of maturing debt being amortised or extinguished. The potentially grave consequence of this will be obvious to any householder, and makes it imperative that calm, sober thought and objective analysis occur about the State’s financial condition and budget constraint. There is no room for self-delusion, especially on the part of the Bhattacharjee Government. We are still paying interest on the money we borrowed to make Nelson Mandela a gift seventeen years ago.

Govt. of W. Bengal’s Finances 2003-2004
Rs Billion (Hundred Crore)
EXPENDITURE ACTIVITIES:
government & local government 8.68 1.68%
judiciary 1.27 0.25%
police (including home guard etc.) 13.47 2.61%
prisons 0.62 0.12%
bureaucracy 5.69 1.10%
collecting land revenue & taxes 4.32 0.84%
government employee pensions 26.11 5.05%
schools, colleges, universities, institutes 45.06 8.72%
health, nutrition & family welfare 14.70 2.84%
water supply & sanitation 3.53 0.68%
roads, bridges, transport, etc. 8.29 1.60%
electricity (mostly loans to power sector) 31.18 6.03%
irrigation, flood control, environment, ecology 10.78 2.09%
agricultural subsidies, rural development, etc. 7.97 1.54%
industrial subsidies 2.56 0.50%
capital city development 7.29 1.41%
social security, SC, ST, OBC, labour welfare 9.87 1.91%
tourism 0.09 0.02%
arts, archaeology, libraries, museums 0.16 0.03%
miscellaneous 0.52 0.10%
debt amortization & debt servicing 314.77 60.89%
total expenditure 516.92

tax revenue 141.10
operational income 6.06
grants from Union 18.93
loans recovered 0.91
total income 167.00
INCOME SOURCES:

GOVT. BORROWING REQUIREMENT
(total expenditure
minus total income ) 349.93

financed by:
new public debt issued 339.48
use of Trust Funds etc 10.45
349.93
From the author’s research and based on latest available data published by the Comptroller & Auditor General of India

India in World Trade & Payments

Our Trade & Payments

by

SUBROTO ROY

First published in The Sunday Statesman, Feb 11 2007, The Statesman, Feb 12 2007

Editorial Page Special Article

 

 

TWO and a half millennia ago, the Greeks described how brightly coloured textiles imported from India were popular among the Persians. Five centuries later, the Roman historian Pliny complained that India every year “took from Italy a hundred million sesterces in return for spices, perfumes and ornaments”. Montesquieu observed in 1748: “All peoples who have traded with India have always taken metals there and brought back commodities. Indians need only our metals, which are the signs of value. In all times those who deal with India will take silver there and bring back none”.

During the British period, India remained a great trading nation. JM Keynes found Britain, the world’s largest exporter in 1913, exporting more to India than anywhere else, and Germany, the world’s fastest growing economy in 1913, receiving 5 percent of its imports from India and sending it 1.5 percent of exports, making India the sixth largest exporter to Germany (after the USA, Russia, Britain, Austria-Hungary, France) and eighth largest importer from it (after Britain, Austria-Hungary, Russia, France, the USA, Belgium, Italy). India’s share of world exports during 1870-1914 may have been about 3-4 per cent. As of 1917-1918, India’s balance of payments and fiscal budget appear idyllic: an export surplus of £61.42 million, official reserves of £66.53 million, total claims on the rest of the world of £127.5 million (or 32.85 million troy ozs of gold), and a 1916-1917 budget surplus of £6,594,885.

Even at mid-20th Century, India was still a trading power with 2 percent of world exports and a rank of 16 in the world economy after the USA, Britain, West Germany, France, Canada, Belgium, Holland, Japan, Italy, Australia, Sweden, Venezuela, Brazil, Malaya and Switzerland.

Yet during the second half of the 20th Century, the Indian subcontinent collapsed to near insignificance in world trade and payments. The traditional export surplus implied a high “treasure” demand for precious metals on capital account; this was reversed and the new India became a chronic trade-deficit country dependant on foreign borrowings and grants. Of world merchandise exports, the subcontinent’s share today is 0.8 of 1 per cent, and of Asia’s 6 percent (India accounting for two thirds); by contrast, Malaysia alone accounts for 0.9 of 1 percent of world exports and 6.5 percent of Asia’s. Most poignantly, among 11 major developing countries (Korea, Taiwan, Singapore, Hong Kong, Argentina, Brazil, Chile, Mexico, Israel, Yugoslavia), India’s share of manufactured exports to the world fell from 65 per cent in 1953 to 51 percent in 1960 to 31 per cent in 1966 to 10 per cent by 1973. Our legendary textiles lost ground steadily. As of 1962-1971, India held an average annual market-share of almost 20 percent of manufactured textile imports into the USA; this fell to 10 percent by 1972-1981 and less than 5 percent by 1982-1991. India’s share of Britain’s imports of textile manufactures fell from 16 per cent in the early 1960s to less than 4 per cent in the 1990s. India and Sri Lanka once dominated world tea exports but lost rapidly to Kenya, Indonesia and Malawi. Of total British tea imports, Sri Lanka’s market-share fell from 11 percent in 1980 to 7 per cent by 1991 while India’s fell from 33 percent in 1980 to 17 per cent by 1991. Today India may not be in the top thirty largest merchandise exporting countries of the world.

Several causes may be identified for our historical collapse in world trade and payments. These include Western protectionism e.g. of domestic textiles between 1965-2005, and emergence of new technologies like synthetic fibres, plastics, tea-bags etc as well as new competitors in the world marketplace willing to use these. Successful commerce depends on intangible quantities like trust, reliable information and contacts between individual contracting parties. Decline in our shares of world exports led to wastage of such informational capital and commercial trust. Foreign importers established new relations with India’s competitors, and for Indian entrepreneurs (now facing lessened foreign protectionism or newly liberalized domestic policies) to win new customers or win back old ones becomes doubly difficult.

But the most important cause of the decline was undoubtedly the political discord and trauma leading to economic disintegration of Old India into modern India, Pakistan, Sri Lanka and Bangladesh. Partly as a result of their conflict, independent India and Pakistan deepened government requisitioning and rationing of foreign exchange purportedly as part of pseudo-socialist “planning”.

Trade policy followed the British pattern of import quotas imposed to conserve hard currency and save shipping space during war. Discretionary controls were in place by 1942 on grounds of “essentiality” and non-availability from indigenous sources. War needs over-rode others, and consumer goods banned ~ favouring their production by domestic business houses. In 1945 consumer goods were placed on open general license, as “the pattern of post-war trade should not be dictated by perpetuation of controls set up for purely war-time purposes”, and in 1946 there was further liberalization in view of India’s enormous sterling balances. But by March 1947 this ended, and import of gold and 200 “luxury” goods were banned. Only a few “essential” goods remained on the open list.

After the British left, political/bureaucratic control of imports and foreign exchange were extended, not removed. Intricate restrictions, subsidies, barriers and import-licensing (based on obsolete war-time “essentiality” and “actual user” criteria) continued, now in name of “import-substitution” and “planning”. Major industries were nationalized, and these became leading consumers of imports obtained by administrative rationing of the foreign exchange earned by export sectors. As consumer goods’ imports were most restricted, Indian businesses predictably diverted to produce these in the large highly protected domestic markets that resulted, causing monopolistic profits and financing of a vast parallel or “black” economy with its thriving hawala sector. Restriction of consumer goods’ and gold imports also caused smuggling and open corruption in Customs. The international price of the rupee was viewed not as reflecting demand for foreign relative to domestic moneys but as just another administered price to be used by politicians and bureaucrats. Foreign exchange earnings of exporters were confiscated in exchange for rupees at the administered rate. Foreign currency thus requisitioned was (and still mostly is) disbursed by rationing in the following order of precedence: first to meet Government debt repayments to international organizations, and Government expenditures abroad like maintenance of embassies and purchase of military imports, plus politicians’ and bureaucrats’ foreign travel etc; secondly, for import of food, fertilizers, petroleum; thirdly, for imported inputs required by Government firms; fourthly, for import demands of those private firms successful in obtaining import licenses; lastly, to satisfy demands of the public at large for purposes like travel or study abroad.

After devaluing with sterling in 1949, the rupee was maintained at the same value for 17 years despite weakening reserve positions and numerous shocks to the economy like the 1962 war with China, 1965 war with Pakistan, and droughts and food crises. Devaluation on June 6 1966 to Rs. 7.50 per US dollar met political opposition and contributed to Congress Party losses in the 1967 elections. The rupee did not respond to sterling’s devaluation in November 1967 and was not adjusted downwards though the economy continued to suffer shocks like the rise in petroleum prices, refugees from the Pakistan civil war, and domestic strikes and political instability. In August 1971, India pegged to the dollar and devalued with the dollar’s depreciation but in December again linked to sterling at Rs 18.97. When sterling depreciated after floating in June 1972, the rupee effectively devalued with it, and until July 1975 there were three small devaluations against sterling. In September 1975, India pegged (within margins) to an undisclosed basket of hard currencies including the dollar, yen and deutschmark, and between 1981-1985, the rupee was slowly managed downwards, without political resistance. From September 1985-July 1991, it followed a more rapid downward course depreciating 40 per cent, while the dollar depreciated as well against major currencies, suggesting the dollar weighed heavily in the basket to which the rupee was pegged.

1991 reforms

Narasimha Rao, P Chidambaram and others received from Rajiv Gandhi in his last months the results of a “perestroika-for-India” project, and started a process of economic liberalisation. Chidambaram said at the time the reforms “were not miraculous” but based on rewriting the Congress manifesto: “We were ready when we came back to power in 1991”.

On July 1 1991, the rupee devalued 9 percent and on July 3 a further 11 percent. The new Government’s March 1 1992 Budget placed the rupee experimentally on a dual rate, implicitly taxing exporters who had to surrender 40 percent of their forex at an officially determined rate and could sell 60 percent in an open market. On March 1 1993, the rupee began to be made convertible for current account transactions, i.e. for import and export of goods and services. Trade reforms included removing many import quotas and some export subsidies. But grave fiscal and monetary problems were not (and have never been) addressed with any seriousness.

Balance of payments

The “balance of payments” sums a country’s current and capital accounts. In Western countries, the capital account consists of net trading in long and short-term securities like private stock and government debt ~ domestic securities being bought and sold freely by foreign residents and foreign securities by domestic residents. Prices determined by competitive trading are very sensitive to interest-rate differences. In India (and Pakistan etc) genuine capital account transactions have not existed since the 1930s, and do so only in highly distorted form even today. The traditional export surplus and positive current account, balanced by net inflow of precious metals, had been wiped out and current account deficits were coupled with overvalued currencies and closed capital markets – along with repressive financial policies causing capital flight of an elite nomenklatura. The inherent risk of unproductive use of funds by borrowers and consumers of forex (mostly Government) were shifted to export and other hard-currency earning sectors.

In particular, a severe trade-deficit had followed petroleum-price rises in the late 1970s, which continues today. There has been some exploration, discovery and extraction of domestic supplies of oil and gas, but no significant move to conserve or find economical alternatives to use of imported energy. (Indeed a coal-exporting petroleum-importing nation with the most heavily used railways in the world made an unprovoked decision to abolish steam-locomotives in favour of diesel and electric. And now, very expensive foreign nuclear plants are planned to be imported on a turnkey basis under a false assumption these will help India’s energy sector.)

India gained from exporting temporary workers to the Gulf since the 1970s but that could hardly finance the increased oil bill. Instead there has been large growth of foreign debt since the 1970s, mostly owed by the Government (and recently by large private businesses) to Western financial markets via brokerage of Western governments and organizations they control. India’s foreign debt amounts to more than $100 being owed by each of our one billion citizens, each of us having to earn five or six dollars every year on average just to meet interest payments due to foreign creditors.

This has been accompanied in the last few years by foreign exchange reserves (the residual in the balance of payments) seeming to grow rapidly, and rising reserves have been perceived as a sign of optimism. Just as bad luck came by way of large oil-price increases, we have seen windfall gains from spread of American “information technology” ~ causing an even larger surplus on services as Indian computer-workers are exported, or new foreign investment is lured by low costs of “business process outsourcing” using our “reserve army” of labour and seemingly cheap real estate.

Rising forex reserves may or may not indicate a better financial position just as rising debt may or may not indicate a weaker financial position. A cash-rich person or company or country may have enough liquid resources to meet an immediate payments’ crisis ~ but may have become cash-rich merely by having borrowed more. A country’s forex reserves may be rising because foreigners have lent it more or have been exploiting arbitrage opportunities presented by multiple exchange-rates or interest-rates or other capital market inefficiencies, or even because reserve-assets have appreciated in world markets due to currency movements.

Similarly, it is not the absolute size of a debt that matters but productivity of the use to which it has been put. At a conference on a “perestroika-for-India” in May 1989 at the University of Hawaii, the late Milton Friedman remarked that one man can be heavily indebted yet have used his debt for investment in capital and hence real growth, while another man can be less heavily indebted but have used borrowed money for debauchery or other wasteful consumption.

For countries too, it is the use to which debt has been put ~ the nature of assets that have been created with the debt ~ that is fundamental. If our foreign debt has been used by Government to create roads and bridges or improve agricultural productivity, fertile capital assets have been invested in, which lead to economic growth and well-being.

If borrowed foreign money has been mostly spent on fancy tanks and bombers (or even passenger aircraft, which mostly earn domestic and not foreign currency) or on foreign trips for politicians and bureaucrats, it has likely gone on sterile consumption goods for the elite. Since Pakistan and India are armed with foreign weapons intended to be used mainly against one another, the arms’ merchants on both sides have been laughing all the way to their Swiss banks for decades. Pakistan and India’s weapons’ imports have been effectively paid by their Governments having borrowed what now constitutes the bulk of their enormous sovereign debts. Requisitioning forex has permitted military generals, politicians, bureaucrats and other lobbies to spend as they wish foreign monies earned by relatively meagre export sectors under conditions of severe international competition.

False convertibility

The RBI is presently engaged in a false convertibility whereby the organised private sector can purchase foreign assets, and the elite can transfer $50,000 annually to their adult children already exported abroad. Truly freeing the rupee today would involve allowing, overnight, any Indian to hold gold, foreign currency and foreign exchange bank accounts freely at his/her local bank (just like those glamorous NRIs). But some 50% or more of public expenditure is being financed by debt compulsorily held by nationalized banks, and this would leave Government with the problem of finding real resources to pay interest and amortisation on the sovereign debt. Moving towards convertibility may induce severe inflation and instability caused by exposure of the weakness of the banks, as their assets (especially Government debt) come to be valued at international prices. Yet without a convertible rupee, proper valuation at world prices is not possible of any paper assets in India (including shares), nor is there any incentive for a responsible fiscal and monetary policy to emerge, even while the nomenklatura continue in capital flight, and India’s masses unknowingly inherit large accumulating rupee and dollar-denominated public debts.