There exist disagreements about the role economic growth plays in socio-economic development. Among economists, a divide exists between those who consider economic growth to be a necessary condition for economic development and those who do not. This blog post tackles this issue from the perspective of the ‘surplus approach’, an approach embedded in the works of economists such as Adam Smith, David Ricardo and Karl Marx, and revived and improved in the 20^th century notably by Piero Sraffa and Pierangelo Garegnani. For our purposes, it is enough to focus on the concept of the social surplus.

Deducting necessary expenses (subsistence wages, raw material costs and depreciation) from the annual gross product of an economy leaves us with the surplus. In the work of classical economists, this surplus consisted of profits and rents. Wages could also contain a ‘surplus’ element when the economy is growing or when collective bargaining favours the working class. Most importantly, the surplus could be utilised freely (or for any purpose) without it affecting the ability of the economy to reproduce itself. Of course, for the economy to grow, some of that surplus will have to be reinvested. This reinvestment of a part of the surplus results in an expansion of productive capacity. When this expansion in productive capacity is matched by an equivalent aggregate demand, there will be economic growth.

In physical terms, the volume of the surplus depends on the methods of production in use and the magnitude of subsistence wages. The methods of production specify how much of output can be produced with a certain combination of inputs (given by the technical know-how and blue prints available with the firms). (To use marginalist terminology, the production function in classical economics is of fixed-coefficients; that is, labour and ‘capital’ cannot be substituted for each other such that the same commodity is produced.)

Leaving rent aside, the distribution of the surplus between capitalists and workers will depend on the strength of the labour unions and other labour market conditions. For instance, in India, it will also depend on the gender and caste determinants. Also, the distribution will vary depending on whether the firm is formal or informal. There exist sectors where productivity gains entirely accrue to the capitalists. Whereas, the distribution of the surplus between private individuals (both workers and capitalists) and the government depends on the prevailing income and corporate tax structure.

The surplus, as mentioned previously, can be used for reinvestment (to produce capital goods) or for luxury consumption (in the production of non-capital goods). Also, the surplus can accrue as taxes to the government. And we have seen that if the surplus is reinvested, there will be economic growth as long as there is adequate aggregate demand. How much of economic growth is good? Are all kinds of economic growth desirable? Are all kinds of economic growth sustainable? By ‘kinds of economic growth’, we refer to several combinations – driven by agriculture; service-led; consumption-driven; debt-induced; foreign trade-driven; or productivity-driven. These issues will not be addressed in this blog post. More precisely, we do not examine the difficulties associated with any of these drivers of growth.

So far, we have not discussed development. Let us define economic development to be the rise in the standard of living of the people in an economy/nation state. An overall increase in real incomes is necessary for an overall improvement in the standard of living. If all workers and capitalists have sufficient (real) incomes to access their as well as their dependents’ educational needs, health needs besides the basic needs of ‘decent’ food, shelter and clothing, we can safely say that the economy is ‘developed’. In an economy where workers do not have sufficient (real) incomes and/or there are socio-cultural impediments to access/consume any of their needs, development needs to take place.

What is the source of (economic) development? There has to be monetary resources available to build the lacking infrastructure or to directly import them where possible. One of the means of generating such resources is through economic growth. But, generating a surplus is clearly not sufficient. The manner in which the surplus is distributed among workers and capitalists as well as redistributed by the government is extremely crucial. There is no predefined way of going about this. It is determined by wider social, cultural and political factors. For example, if trees are felled during the creation of infrastructure, some of the surplus can go towards planting new trees. Or, some of the surplus accruing to the capitalists can be reinvested for improving the working conditions. The important point to note is that there are no automatic mechanisms which ensure such allocations. The market has no such interests or objectives. In short, the decision of ‘development’ is primarily undertaken in the socio-political arena. And, as long as we aspire for better standards of living, economic growth is necessary so that it generates adequate monetary resources in order that our aspirations may be met. But, yes, economic growth by itself cannot guarantee or ensure development.

Wages is the payment made to a labourer for the number of hours worked – sowing seeds, rolling tobacco, developing computer software or providing medical care in a hospital. How are these wages determined? Are they determined in a similar manner as that of commodities? That is, are they determined based on some sort of demand and supply mechanism? Or, are they predominantly set by non-economic forces which are not easily quantifiable? This blog post looks at the dominant neoclassical or marginalist viewpoint and contrasts it with the theoretical approach of classical economics. In this light, the post examines certain characteristics of the Indian economy relating to labour and employment.

The basic principles of neoclassical economics tell us that the price and quantity demanded and supplied of a commodity are determined by the intersection of its demand and supply curves. This is the demand and supply approach to economics. When extended to labour, the intersection of the demand and supply curves of labour is supposed to determine the wages per hour (the price of labour) and the number of hours worked (the quantity of labour). Therefore, an increase in the demand for labour relative to its supply is expected to raise the wage rate and a relative increase in supply of labour (say, from an increase in the working population commonly termed the demographic dividend) leads to a fall in the wage rate.

Classical economics, a distinct theoretical framework in economics, has a very different view of wages. It largely considers wages as an exogenous variable; that is, wages are not determined by market forces – demand and supply of commodities or of labour. Of course, temporary changes can be brought about by market forces. In the theoretical world of classical economics, wages are determined primarily by socio-cultural factors such as trade union strength, the collective notion of minimum wages for different occupations and the society’s views on trust, risk, etc. In this theoretical world, which to me, seems closer to the reality, an improvement in social institutions lead to an increase in subsistence wages. Wages, in this framework, has a subsistence (relatively fixed) component and a surplus (relatively flexible) component. Hence, classical economics allows for an increase in wages, in its surplus component, when GDP is rising on account of higher labour productivity.

A conflict is present in the distribution of GDP between workers and capitalists. Neoclassical economics eliminates this conflict by recourse to marginal productivity theory. By employing logically fallacious concepts (especially of capital), a theory of distribution has been erected where both labour and ‘capital’ are ‘justly’ remunerated. In this framework, trade unions distort the market and causes injustice! According to classical economics, the presence of strong trade unions and fair labour laws ensure that workers get a fair share of productivity gains, which will otherwise entirely go as profits of the capitalists. The Global Wage Report 2012/13 published by the International Labour Organisation (ILO) notes that in several countries wage rises have not matched the increase in employment and productivity (see especially p. 28).

There are enormous disparities in wage rates across the states in India, with Kerala paying relatively high wages. One reason for the high wages is the presence of strong trade unions. As per the Labour Bureau (as part of the Rural Labour Enquiry) report on ‘Wage Rates in Rural India’ for September 2012, the average daily wage rates for men for engaging in sowing in Gujarat is 132 rupees; in Kerala, it is 500 rupees; and in Tamil Nadu, it is 222.02 rupees. A carpenter in Gujarat is paid 233.33 rupees daily; in Kerala, he is paid 514.05 rupees and in Tamil Nadu, he is paid 388.6 rupees. The differences are starker with respect to unskilled labour: a male unskilled worker in Gujarat gets paid 109 rupees; in Kerala, he earns 411.32 rupees; and in Tamil Nadu, he earns 223.54 rupees. The corresponding wages for a female worker are: 101.71 rupees in Gujarat, 266 rupees in Kerala and 159. 76 rupees in Tamil Nadu. Note the gender-wage inequality in Kerala. Also, the economic condition in rural Kerala is significantly better than rural Tamil Nadu; therefore, the statistics will have to be interpreted with some restraint.

Subsistence wage, as a concept, has enormous theoretical and practical significance. In fact, the legislations pertaining to minimum wages in India ought to look at socio-cultural factors too, such as gender, caste, geographic location, kind of labour (formal vs. informal, rural vs. urban) and so on. The enforcement of minimum wages has been beset with difficulties as evident from a recent study (published in 2011) by Patrick Belser and Uma Rani; the proportion of salaried workers and the proportion of casual workers below the minimum wage at the national level is 25.3 and 50.6 per cent respectively. Discussions on and about subsistence wages, and by extension, on minimum wage legislations are much needed. Moreover, discussions surrounding subsistence wages can also result in more dignified definitions of poverty and minimum wages.

Over the years, much has been written about the methods employed in economic theory. The recent financial crisis and the ongoing economic crisis in Europe have resulted in a marked increase in criticisms directed at mainstream economic theory – neoclassical economics (more precisely, marginalist economics). Internal critics of neoclassical economics have been modifying certain assumptions of marginalist economics and have ‘developed’ new forms of economic knowledge such as law and economics, welfare economics, neuroeconomics, new institutional economics and so on. Critics external to marginalist economics, often known as heterodox economics (examples include Classical/Sraffian economics, Post-Keynesian economics and Marxian economics), have provided compelling logical critiques of the theory. Additionally, they also supplement their analysis with empirical and historical details (which is not uncommon in neoclassical economic either). This post is reflective in nature and tries to comprehend the character of economic theory along with a commentary on its contemporary function in the form of questions, thereby reinforcing the reflective nature of this blog post.

First, the definition adopted has a critical influence on the aims and scope of economic theory. For instance, the definition of economics as a study of reproduction and accumulation of wealth/income (characteristic of the heterodox economic theories mentioned above) is qualitatively different from a definition which views economics as a study of allocating scarce resources among competing ends (characteristic of neoclassical economics). The former definition is more modest in scope and seeks to provide answers to a limited number of questions vis-à-vis the latter one which encompasses any and every issue where human decisions are involved. Examining the causes of accumulation and growth warrant the following theories: a theory of value and distribution; a theory of activity-levels (at times, this is absent); and a theory of economic growth. While examining the causal connections within these theories, some features of human behaviour are taken as given. The most important, perhaps, is the human propensity for self-betterment in material terms. Such a limited domain enables these economic theories to be more specific and definite thereby improving their explanatory power in the analysis of economic growth, unemployment, technical progress, wage dynamics and so on. An extremely wide scope is entailed by the definition of economics present in neoclassical economics; consequently, we see the emergence of sub-fields such as: cognitive economics, neuroeconomics, economics of philosophy, experimental economics, evolutionary economics, cliometrics, etc. The questions addressed in many of these sub-fields often have nothing to do with the generation of income or its distribution. The questions being asked are different, and quite relevant in understanding various aspects of human behaviour and institutions. However, if the aim of economic policy and economists is to improve material well-being, neoclassical economics and its sub-fields are not entirely satisfactory, primarily for logical reasons. The two most dangerous tenets of marginalist economics are the marginal productivity theory and the tendency to full employment.

Second, economic theory, I think, has two broad functions. One is to explain the logically necessary connections which exist between various economic variables, and the direction of causation. Usage of terms such as exogenous, endogenous, dependent and independent variables convey the direction of causation. For example, classical/Keynesian theory argues that activity levels and economic growth is demand-led whereas marginalist economics posits that activity levels and economic growth is supply-driven. This is a theoretical debate, which cannot be resolved by recourse to empirical data given the high degree of correlation present among (macro)economic variables such as income, investment, saving, etc. Another reason for the debate being unresolved in the incommensurability of the two kinds of economic theory involved – classical/Keynesian vs. marginalism. The other broad function of an economic theory is to provide an explanation for the manner in which these (marco)economic variables grow over time; strictly speaking, the dominant economics influences the way in which data is collected and presented and the explanation for the data is also provided by the dominant economics. (A chief, although not very reliable, exception to this is the econometric technique known as VAR which attempts to undertake ‘measurement without theory’.) Much of these numbers will need to be supplemented with contextual and historical details. Also, in economics, one needs to be careful about assigning too much ‘reliability’ to data so much so that they are considered ‘adequate’ to overturn a particular economic theory. This is not to say that data does not matter, but that it should be treated with significant caution.

Third and finally, it is of great practical importance to know what economic policies can be advanced based on economic theory, supplemented by data or not. In other words, what conditions must a particular theory fulfil in order for it to be reliable? Is an empirical assessment necessary or is it sufficient? How sound must the logic be? To what extent must the assumptions be scrutinised? Can econometric analysis provide conclusive evidence?

As the title suggests, this blog post examines a couple of policy recommendations made in Chapter 2 (Micro-foundations of Macroeconomic Policy) of the Economic Survey 2011-12. This examination is carried out in conjunction with Kaushik Basu’s economic methodology which is scattered across the Economic Survey and very visible in his 2011 book Beyond the Invisible Hand: Groundwork for a New Economics (Princeton and Oxford: Princeton University Press). Note that we are making an assumption, albeit very plausible, that Basu authored and/or significantly influenced the contents of Chapter 2 of the Economic Survey. On the basis of these two texts – Chapter 2 and his 2011 book, this blog post evaluates (1) Basu’s method of doing economics, (2) his affinities towards the micro-foundations approach and (3) his (select) macroeconomic recommendations. The blog post concludes with a critical look at the role of economics as espoused by Basu.

Basu writes in the Economic Survey that ‘monetary and fiscal policies are part science and part intuition and common sense’ (p. 24). This statement reflects the openness to knowledge possessed by the author. However, owing to his role as the Chief Economic Advisor of India, he is an economic architect. Therefore, at a deeper level, one wonders whether he is talking about the ‘intuition and common sense’ of a particular individual (himself?) or a certain group of individuals. We get to read more of his thought on ‘intuition’ in his 2011 book. Some priceless extracts are reproduced below:

‘My view is that in economics, the need for intuitive understanding is much greater than most economists would have you believe. Good economic policy requires a “feel” for things over and above the knowledge of theorems and regression coefficients’ (p. 14).

‘Both interventions and noninterventions have too often been left to the ideological whims of believers. They need to be founded on analysis and reason, not faith’ (p. 23).

‘What we so often take to be features of the world are actually propensities of the mind’ (p. 51).

‘My belief about the puzzle of knowledge lies somewhere between the skeptical and evolutionary claims. I have faith in our intuition’ (p. 53).

‘Causality lies in the eyes of the beholder’ (p. 54).

‘To sum up, scientific knowledge has to be combined with intuition and a shot of skepticism for it to be useful’ (p. 54).

On p. 23, he argues that policy interventions should be based on reason and not faith. However, on p. 53, he asserts that he has faith in (his?) intuition. Most of his comments seem to indicate a certain sense of confusion on what the scientific method entails and the role of economic theory in particular. This is quite unfortunate, since it comes from the pen of the current Chief Economic Advisor of India. If it is not confusion then it seems to be a proposal that ‘any idea goes’ wherein obviously the ‘idea’ is decided by those in power. Whatever happened to reason? At the risk of repetition, let me state that this is an extremely dangerous outlook to possess because bad economic policies have devastating implications for majority of the population.

Basu rightly points out in his 2011 book that ‘the economy must be viewed as embedded in society and politics’ (p. xi). No one disputes this fact of reality. A worthwhile digression follows. Classical economists such as William Petty, Adam Smith, David Ricardo and Karl Marx in their contributions to political economy, as it was called then, never said otherwise. They stressed the need for proper social and political institutions. Coming back to Basu, he further writes: ‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104). Based on this premise, he criticises neoclassical microeconomics for restricting individual choice to their budget sets for, in reality, they make choices outside their budget sets. In other words, there is a wide range of behavioural options which cannot be captured by the budget set and therefore Basu arrives at the conclusion that traditional microeconomic theory is very unqualified to deal with human behaviour. But, isn’t the aim of microeconomics to explain (economic) prices and quantities? Or, should we consider microeconomics as the study of human behaviour? Basu seems to think of the latter when he discusses economics. For him, economics is primarily the study of human behaviour and actions and not primarily a study of incomes and prices (on this, see Economics: The Study of Commodities). It also must be kept in mind that Basu’s scientific strengths lie in game theory, behavioural economics and related fields. In his 2011 book, he himself states that his analysis ‘belongs predominantly to positive social science’ (p. 98).

Since his objective is to study human behaviour, he proposes that we expand the scope of economics. This proposal, as we all know, has important repercussions on economic theory and eventually on economic policy. As Malthus pointed out, to study wealth and its distribution, one needs depth and not breadth; in short, the boundaries or scope of economics must be clearly outlined, however limited they might seem. Introducing several aspects of culture as Basu suggests will only make the explanatory and causal content of economic theory very weak. In fact, it might make economic theory too open that it can be used to explain everything. This must be resisted at all costs for it is knowledge that is at stake here (see also Malthus: The Scope of Political Economy). Basu therefore hopes to expand the scope of economics by altering and widening its foundations in order to usher in the micro-foundations approach in macroeconomic theory as well as in policy making. One glance at the title of Chapter 2 of the previous three Economic Surveys is sufficient for this purpose – 2009-10: Micro-Foundations of Inclusive Growth; 2010-11: Micro-foundations of Macroeconomic Development and 2011-12: Micro-foundations of Macroeconomic Policy. The mark of Kaushik Basu is indelible.

Basu seems to be doing exactly what Gary Becker did when he applied microeconomic tools to a variety of human behaviour around the 1970s. Although, things have improved since then and research in game theory and behavioural economics have been reasonably successful in dispelling the very nice-to-hear qualities of the individual/agent in the economy. Cooperation, reciprocity, trust, etc have once again (Adam Smith talked about a lot of this in his Theory of Moral Sentiments; although he believed that it was necessary to assume certain behavioural propensities when studying the generation and distribution of wealth) begun to play an important role in economics. Basu does provide the reader with many such insights in his 2011 book by drawing upon his earlier research. As a consequence, he criticises the manner in which mainstream neoclassical/marginalist economics employs methodological individualism, especially the textbook version of it. Basu is unhappy because the agent in mainstream economics still does not carry out identity-based behaviour (p. 49). He demands an agent who is more social which does not imply a complete rejection of methodological individualism. Basu is candid about this: ‘It is not within my ability to break away from methodological individualism to the extent that we will eventually need to in order to have a more powerful social science and at the same time retain rigor’ (p. 101). He wants an increased role for identities in economic theory – caste, gender, race, language, etc. As pointed out earlier, bringing too many variables when studying a specific problem often muddies and obfuscates the phenomenon under study. Moreover, the cognizance of such identity-based behaviour can easily be taken into account while formulating policies without having to call for an overhaul of economic theory. Therefore, Basu calls for widening the scope of economics:

‘A fundamental step in broadening the scope of economics is to recognise that the feasible set of actions open to individuals is much larger than our models make it out to be’ (p. 27).

‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104).

‘How a nation functions at the level of macroeconomic aggregates depends a lot on the nuts and bolts of the economy. In our concern with managing the large and attention-catching variables, it is easy to let attention slip on the small, which may be vital’ (p. 39, Economic Survey 2011-12 ).

Given Basu’s view about the scope of economics, it is easy to understand why he promotes the micro-foundations approach in macroeconomics. This is undertaken in a manner which shows complete disregard for alternative/heterodox macroeconomic schools such as the Post-Keynesians, the Sraffa inspired Classical/Keynesians, the Marxians or the Kaleckians. These schools of thought are built on the belief that the economy is a system which has a logic and working distinct to itself. They criticise the neoclassical/mainstream economists of committing the fallacy of composition when they conceptualise the economy as an aggregation of individuals (see Some Logical Fallacies in Economics). Basu strongly advocates using the micro-foundations approach to macroeconomic issues in the Economic Survey. He writes:

‘The error has usually been in misreading the incentives and behavioural traits of the individuals who are to benefit from the policies and those who are supposed to carry out their day-to-day functioning. Fortunately, this is beginning to change both in the discipline of economics as well as in the design of policies in India. There is increasing recognition that flawed micro-foundations can devastate the best of macro intentions’ (p. 24).

‘Macroeconomic policymaking entails a mix of science and intuition. To ignore either of these would be a mistake. We need to marshal the best scientific knowledge available and study the microeconomic foundations of these macroeconomic concerns and then blend them with intuition and commonsense to craft policy’ (p. 25).

In short, according to Basu, micro-foundations is THE way forward both of economic theory and for policy.

His macroeconomic policy recommendations are problematic because of two reasons. First, his method of doing economics seems to be lack focus on the issues at hand – unemployment, poverty, inflation, agricultural growth and so on; instead, his entire focus is on human behaviour and micro-foundations. Second, he appears to lack a solid understanding of macroeconomics, especially its alternative schools. In any case, let us take a look at two of his major macroeconomic proposals – on fiscal deficit and Government as an enabler.

‘In the interest of medium- to long-term growth, it is important for us to bring the fiscal deficit down. While an expanded deficit can boost consumption and economic growth, this is medicine akin to antibiotics. It is very effective if properly used and in limited doses, but can cause harm if used over a prolonged period. Hence, government’s aim must be to effect rapid fiscal consolidation. A large deficit over a long period tends to squeeze out the private sector from the credit space. This dampens private investment and productivity and, more significantly, worsens the options of the inflation-growth mix available to government’ (p. 27).

‘This is what is meant by the enabling role of government. It should create a setting where it is in the interest of private agents to deliver on what needs to be delivered’ (p. 28).

As long as the economy is not at the full-employment level of output, crowding-out can never happen. Moreover, Basu forgets that the economy is not a stagnant organism; instead it is a growing one. The idea that government investment crowds-out private investment precariously hinges on the notion of scarcity in the economy. In a setting where the Central Bank controls interest rates so as to maintain price stability, it is difficult to see how crowding-out occurs as a result of government expenditure (see Introductory Macroeconomics: On Crowding Out). As for the enabling government, Basu seems to forget that India requires significant government expenditure/intervention in the form of Right to Food, Right to Education, Right to Employment, Right to Information, etc so that a dignified ‘setting’ can be constructed for everyone.

To conclude, it appears that as a game theorist who has important socially relevant insights, Basu is well on the mark. However, his macroeconomics, unfortunately, is grounded on extremely weak foundations and therefore is well off the mark.