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60 Years after the 2nd Five-Year Plan: On Economic Theory, Planning & Policy

Posted by Alex M Thomas on 18th June 2016

Picking up Ajit Dasgupta’s A History of Indian Economic Thought (1993) motivated me to revisit India’s 2nd Five Year plan (1956-61) and the Mahalanobis model in light of the structural changes in India’s economy and developments in economic theory, particularly of demand-led growth theory. Although 60 years have passed since the inception of the 2nd Five Year plan, the ‘Approach to the Second Five Year Plan’ contains ideas which are particularly important today, especially after the closure of the Planning Commission. In its place, we now have the NITI (National Institution for Transforming India) Aayog which assumes that Indian manufacturing and service sectors are currently operating ‘on a global scale’ and what is now needed is ‘an administration paradigm in which the government is an “enabler” rather than a “provider of first and last resort”’ (see Cabinet Secretariat resolution, 1 January 2015).

Why economics?

Economics is the study of commodities – its production, distribution and consumption. Economics provides us with the determinants of aggregate production (GDP), employment, and income distribution. This allows us to understand our economic surroundings better and consequently enables us to improve existing economic conditions. This may be carried out through general economic policies (for example, progressive taxation to reduce income and wealth inequalities and monetary policy to combat inflation) or through targeted economic policies (for example, fertilizer subsidies to improve agricultural productivity and tax concessions to foreign investors). Ultimately, economic interventions are made based on an assumption and several aims. The assumption is that economic theory tells us how economies function. The interventions are carried out to satisfy certain normative aims (for example, equity and freedom). This distinction is made in textbooks by distinguishing between positive and normative economics. For instance, if a particular society is not uncomfortable with unemployment its economic policies would not be aimed at reducing unemployment.

Objectives of the 2nd Five Year Plan

In this section, the economic objectives of the 2nd Five Year Plan are presented. All excerpts from the 2nd Five Year Plan are taken from here.

“The current levels of living in India are very low. Production is insufficient even for satisfying the minimum essential needs of the population….” Therefore, it was imperative to increase aggregate production. But, the economic architects of the plan did not visualize money as an end in itself.

“A rising standard of life, or material welfare as it is sometimes called, is of course not an end in itself. Essentially, it is a means to a better intellectual and cultural life. A society which has to devote the bulk of its working force or its working hours to the production of the bare wherewithals of life is to that extent limited in its pursuit of higher ends.”

Moreover, economic policy was aimed at an increase in activity levels and “also in greater equality in incomes and wealth.”

The Plan Document clearly favours social gain over private gain. In other words, private enterprise was regulated such that the economic yields benefitted all. To put it differently, a recognition of negative externalities was present.

“The private sector has to play its part within the framework of the comprehensive plan accepted by the community. … Private enterprise, free pricing, private management are all devices to further what are truly social ends; they can only be justified in terms of social results.”

More clearly,

“Economic objectives cannot be divorced from social objectives and means and objectives go together. It is only in the context of a plan which satisfies the legitimate urges of the people that a democratic society can put forward its best effort.”

The Plan Document also recognized the dual nature of urbanization – that economies of scale have both positive economic externalities and negative environmental externalities.

The 2nd Five Year Plan on economic inequality

The 2nd Five Year Plan clearly recognized that the gains from economic development are skewed and trickle down is not automatic. For the gains from economic development to be inclusive, two institutions have to be strong: trade unions and the democratic state.

“The gains of development accrue in the early stages to a small class of businessmen and manufacturers, whereas the immediate impact of the application of new techniques in agriculture and in traditional industry has often meant growing unemployment or under-employment among large numbers of people. In course of time this trend gets corrected partly through the development of countervailing power of trade unions and partly through state action undertaken in response to the growth of democratic ideas.”

There is a passage similar to Thomas Piketty’s view on wealth inequalities and the role of progressive taxation in reducing such inequalities in the document.

“The most important single factor responsible for inequalities of income and wealth is the ownership of property. Incomes from work are by no means equal, but in part at any rate, they have some justification in terms of productivity or relative scarcity. Some types of work are, however, remunerated more liberally than others for reasons which are not directly connected with productivity. Differential monetary rewards are often a matter of tradition an existing psychological or social rigidities. It has also to be borne in mind that capacity to work effectively at higher levels depends on a person’s education and training, and these are a matter of the accident of birth or circumstances. A large expansion of general and technical education for all classes of people irrespective of their paying capacity is over a period a potent equaliser. The point is that while inequalities in incomes from work have to be corrected, the case for taxation based specifically on wealth or property needs to be carefully examined.”

India needs to seriously consider a tax on wealth given the wide disparities of income and wealth. The connection between ‘productivity’ and ‘social rigidities’ is noteworthy and requires to be addressed through labour laws, education policy, food policy, employment policy and so on.

The core of the 2nd Five Year Plan: the Mahalanobis model

From the previous paragraphs, we can state the following as the normative economic aims of the 2nd Five Year Plan: (1) expansion of output and employment opportunities, (2) reduction of income inequalities, and (3) inclusive economic growth and development. The economic core of the 2nd Five Year Plan is constituted by the Mahalanobis model. As Ajit Dasgupta writes in A History of Indian Economic Thought, “The purpose of the model was to determine the optimal allocation of investment between different productive sectors so as to maximise long-run economic growth in India” (p. 164). In other words, the aim of this model is to increase the pace of aggregate economic activity in India.

The Mahalanobis model is a two-sector model with a capital goods and a consumption goods sector. The model tells us how the resources are to be distributed between these two sectors such that maximum economic growth is achieved. Note that the then production was insufficient to meet the basic needs of the Indian populace. There are inter-sectoral relations due to which one sector cannot exist (or grow) without the other. To produce consumption goods, capital goods are required. For the workers and capitalists in both sectors, consumption goods are needed. Employing the Mahalanobis model is to some extent vindicated because the model assumes “capital to be the effective constraint on output” and India lacked good physical infrastructure.

Note also that this model assumes that there are no demand constraints. As Dasgupta writes, “The higher the proportion of investment (i.e. of the current output of capital goods) that is allocated to the further production of capital goods, the higher the long-run growth rate of output” (p. 165). The dual character of investment is not clearly understood for investment creates productive capacity and is a component of aggregate demand. Logically, a solution can be found such that the addition to capacity is validated by the demand generated but it is a knife-edge equilibrium as in Harrod.

Dasgupta points out that the Mahalanobis model has been criticized “for being concerned exclusively with investment and for identifying investment with the production of capital goods” (p. 165). Yes, demand constraints and human capital investment are ignored. Another criticism of the model has been its neglect of foreign trade (p. 166). However, the model could be modified easily to account for foreign investment and consumption whereas the incorporation of demand constrains and human capital would not be easy.

Conclusion: the relevance of economic planning

Since the 2nd Five Year Plan, much time has passed and the Indian economy has undergone several changes. Developments have taken place in economic theory too, particularly in the areas of economic growth and development. While the Mahalanobis model has its limitations, the normative aims of the 2nd Five Year Plan are still valuable today. The expansion of employment opportunities needs to be at the forefront of any macroeconomic or growth strategy. As written in the 2nd Five Year Plan, “From the economic as well as from the larger social view point, expansion of employment opportunities is an objective which claims high priority”. However, NITI Aayog, the successor to the Planning Commission works within ‘an administration paradigm in which the government is an “enabler” rather than a “provider of first and last resort”’. The market cannot be expected to provide accessible and good quality education, health, housing and living environments to all. With existing economic and social inequalities, the need for economic planning is even more. Social costs require to be assessed and not ignored in the name of economic efficiency and economic growth.

An economic planner ought to know the implicit assumptions and scope of economic theories and be knowledgeable about legal and institutional constraints of policy implementation. The economic planner must therefore be an excellent economist and an experienced bureaucrat.

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Posted in Development Economics, Economic Growth, Economic Thought, Economics, Employment, GDP, India, Indian Plan Models, Macroeconomics | No Comments »

A Review of Mian & Sufi’s House of Debt

Posted by Alex M Thomas on 31st October 2015

Lawrence Summers, a Professor of Economics at Harvard University and a Financial Times columnist, hailed Atif Mian & Amar Sufi’s book as ‘the most important economics book of the year’. The book was published in 2015 by the University of Chicago Press. This is a very readable book on issues of debt (particularly household debt in America), determination of activity levels, and on how to do good economics.

        Mian & Sufi begin by discussing the leverage ratio – ‘the ratio of total debt to total assets’ (p. 20). For the poorest homeowners, this ratio was near 80% and for the richest 20%, this ratio was only 7%. This is because the poor households borrow to purchase their assets (for example, a house). At the same time, the rich households deposit (credit) money with the banking sector to earn interest. The banking sector mediates the financial needs of the borrowers and the lenders. As Mian & Sufi write:

A poor man’s debt is a rich man’s asset. Since it is ultimately the rich who are lending to the poor through the financial system, as we move from poor home owners to rich home owners, debt declines and financial assets rise. (p. 20)

This observation immediately points to the need for looking at inequalities of income and wealth when studying debt or credit. Indeed, ‘[a] financial system that relies excessively on debt amplifies wealth inequality’ (p. 25). This is because when house prices fall, the decline in net worth for the indebted poor households will be more than proportional (p. 22-3).

       The authors rightly note that ‘the Great Recession was consumption-driven’ (p. 30) for ‘the decline in overall household spending in the third and fourth quarters of 2008 was unprecedented’ (p. 33). However, the dominant view in the US and across the world is what the authors term the ‘banking view’.

According to this view, the collapse of Lehman Brothers froze the credit system, preventing businesses from getting the loans they needed to continue operating. As a result, they were forced to cut investment and lay off workers. In this narrative, if we could have prevented Lehman Brothers from failing, our economy would have remained intact. (p. 31)

The dominant view locates the problem to be the lack of credit in the economy. And, they believe that if credit is made available at cheap rates (low rates of interest), the economy will revive. This view ignores the purpose of credit in an economy. Individual and firms demand money for consumption and investment (in a two-sector economy, aggregate demand is the sum of consumption and investment), and if aggregate demand falls so will the demand for credit. A fall in aggregate demand, as Keynes demonstrated in The General Theory, results in the reduction of activity and employment levels. This is precisely what happened during the Great Recession.

Job losses materialized because households stopped buying, not because businesses stopped investing. In fact, the evidence indicates that the decline in business investment was a reaction to the massive decline in household spending. If businesses saw no demand for their products, then of course they cut back on investment. (p. 34)

In other words, investment is not independent of consumption. This insight is of value in emerging economies like India where actual output is far below the potential output (large presence of disguised unemployment and underemployment), and political campaigns like ‘Make in India’ must be viewed with great caution. The dominant view is based on, what in growth theory is called, the supply-side growth theory. According to this theory, a growth in aggregate supply automatically generates an equivalent growth in aggregate demand. In House of Debt, the authors label this as the ‘fundamentals view’.

The basic idea behind the fundamentals view is that the total output, or GDP, of the economy is determined by its productive capacity: workers, capital, and the technology of firms. The economy is defined by what it can produce, not by what is demanded. Total production is limited only by natural barriers, like the rate at which our machines can convert various inputs into output, the number of working hours in a day per person, and the willingness of people to work versus relax. This is sometimes called the supply-side view because it emphasizes the productive capacity, or supply, of resources. (pp. 47-8)

That is, lower spending in the fundamentals view does not lead to contraction or job loss. Remember, output in the fundamentals view is determined by the productive capacity of the economy, not by demand. In response to a sharp decline in consumption, the economy in the fundamentals view has natural corrective forces that keep it operating at full capacity. These include lower interest rates and consumer prices … Obviously, however, these corrective forces weren’t able to keep the economy on track. (p. 49)

This view ignores the fundamental insight provided by Keynes in 1936. In a sense, the Say’s Law still lives on. And, in this theory, ‘[i]nvoluntary unemployment can only exist … if there are some “rigidities” that prevent wages from adjusting and workers from finding jobs’ (p. 56). These rigidities or frictions may be the following: presence of non-tradable jobs (that is, jobs which only cater to the local economy); wages do not fall; workers do not move; and the costs of reskilling if workers have to reallocate (p. 58, p. 63). For a critique and an alternative, see Thomas 2013.

       The marginal propensity to consume (MPC) varies across classes and therefore the assumption that everyone has the same MPC cannot be admitted. The MPC is high for poor households and low for rich households. ‘The larger the MPC, the more responsive the household is to the same change in wealth’ (p. 39; also p. 44). In fact, ‘the higher the leverage in the home, the more aggressively the household cuts back on spending when home values decline’ (p. 42). Therefore, debt matters. According to Mian & Sufi, ‘[t]he higher MPC out of housing wealth for highly levered households is one of the most important results from our research. It immediately implies that the distribution of wealth and debt matters’ (p. 42). Moreover, ‘[t]he MPC of households is also relevant for thinking about the effectiveness of government stimulus programs for boosting demand’ (p. 41).

       Very often, during recessions, the dominant policy response is the lowering of interest rates via monetary policy. But does the lowering of rates help? Is the problem a lack of availability of funds at cheap rates?

To help answer this, there is evidence from surveys by the National Federation of Independent Businesses (NFIB). Proponents of the bank- lending view are particularly concerned about credit to small businesses. Because small businesses rely heavily on banks for credit, they will be disproportionately affected. Large businesses, however, can rely on bonds or commercial paper markets for debt financing. The NFIB is informative because it surveys exactly the small businesses that should be most vulnerable to being cut off from bank lending. The survey asks small businesses to list their most important concern, where “poor sales,” “regulation and taxes,” and “financing and interest rates” are a few of the options. The fraction citing financing and interest rates as a main concern never rose above 5 percent throughout the financial crisis— in fact, the fraction actually went down from 2007 to 2009. It is difficult to reconcile this fact with the view that small businesses were desperate for bank financing. On the other hand, from 2007 to 2009, the fraction of small businesses citing poor sales as their top concern jumped from 10 percent to almost 35 percent. As indebted households cut back sharply on spending, businesses saw a sharp decline in sales. (p. 128)

As the survey indicated in the passage shows, the problem is a lack of aggregate demand, particularly consumption demand. ‘Companies laying off workers in these hard-hit counties were the largest businesses. This is more consistent with businesses responding to a lack of consumer demand rather than an inability to get a bank loan’ (p. 128). There is another issue here; this has to do with the effectiveness of the monetary policy mechanism. Hence, Mian & Sufi write: ‘[a]n increase in bank reserves leads to an increase in currency in circulation only if banks increase lending in response to the increase in reserves. If banks don’t lend more— or, equivalently, if borrowers don’t borrow more— an increase in bank reserves doesn’t affect money in circulation’ (p. 154) limiting the ‘effectiveness of monetary policy’ (p. 155). And there is no strict connection between interest rates and household spending; at the very least, a strong association cannot be assumed (see p. 161).

       This brings us to the end of this book review. It was noted in the introductory paragraph that this book is also about doing good economics. Mian & Sufi point to the need for have a good theory to make sense of the macroeconomic phenomena. This blog concludes with their view on the role of theory.

The ability to interpret data is especially important in macroeconomics. The aggregate U.S. economy is an unwieldy object – it contains millions of firms and households. … But unless an economist can put some structure on the data, he or she will drown in a deep ocean of numbers trying to answer these questions.

Which brings us to the importance of an economic model. Macroeconomists are defined in large part by the theoretical model they use to approach the data. A model provides the structure needed to see which data are most important, and to decide on the right course of action given the information that is available. (p. 47)

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Posted in Book reviews, Economics, Employment, Financial Economics, Government, Macroeconomics, Supply side economics, Unemployment | 1 Comment »

Summers, Secular Stagnation and Aggregate Demand Deficiency

Posted by Alex M Thomas on 28th February 2015

The foundations of a coherent theory of activity levels were first put forth by Kalecki and Keynes in the 1930s. Their economic theory states that an economy’s output levels are determined by aggregate demand and that there are no economic forces which ensure full employment of labour or the full utilization of capacity. In other words, aggregate supply adapts to aggregate demand. This principle was then extended to the question of economic growth, most notably by Roy Harrod. Subsequent work in this line of enquiry suggests that growth is demand led, as opposed to the mainstream/neoclassical view of economic growth as supply driven.

The idea of secular stagnation, recently articulated and advocated by Larry Summers, will be critically appraised in this blog post amidst the above backdrop. Here, we almost exclusively focus on Summers’ 2014 paper in Business Economics titled ‘U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound’. The principle (also simultaneously a policy prescription) of secular stagnation can be stated as follows: since interest rates have reached their lower bounds and aggregate activity levels are depressed, the solution is expansionary fiscal policy. Why are aggregate activity levels depressed? Secular stagnation suggests that negative fluctuations re-quilibrate the economy to a position characterised by lower output and employment levels. Moreover, ‘the amplitude of fluctuation appears large, not small’ (p. 65).

Macroeconomic equilibrium is characterised by equality between actual and potential output. According to Summers, ‘essentially all of the convergence between the economy’s level of output and its potential has been achieved not through the economy’s growth, but through downward revisions in its potential.’ (p. 66) This is because of aggregate demand insufficiency. ‘The largest part [of the downward trend in potential] is associated with reduced capital investment, followed closely by reduced labor input.’ (p. 66) To put it differently, aggregate demand deficiency leads to the unemployment (and underemployment) of labour and underutilization of capacity.

Despite Summers’ correct identification of the problem, his marginalist conceptualization forces him to connect this with the ‘equilibrium or normal real rate of interest’ which equilibrates saving and investment. As a consequence, he argues that a ‘significant shift in the natural balance between savings and investment’ (p. 69) has occurred. This post will only state that the idea of the rate of interest being sufficiently sensitive to changes in planned saving and investment is one that has been severely criticized and rightly so. [A follow-up post will examine this matter more closely.]

Towards the end of the paper, Summers makes a point which Keynes (and Kalecki) made in the 1930s: ‘We are seeing very powerfully a kind of inverse Say’s Law. Say’s Law was the proposition that supply creates its own demand. Here, we are observing that lack of demand creates its own lack of supply’ (p. 71). However, Summers states this as a contingent principle and not a general proposition as it is in Keynes (or Kalecki). This is not surprising given Summers’ economics being marginalist in nature.

Therefore, since demand creates its supply, Summers advocates public investments and vocally states the counterproductive nature of fiscal austerity. Furthermore, he hypothesises that ‘increases in demand actually reduce the long run debt-to-GDP ratio’ (p. 73). Lastly, he favours policy measures which place ‘substantial emphasis on increasing demand as a means of achieving adequate economic growth.’

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Posted in Economic Growth, Economics, Employment, Government, Keynes, Macroeconomics, Marginalist economics, Michal Kalecki, Neoclassical Economics | No Comments »

An Economic Analysis of the ‘Make in India’ Program

Posted by Alex M Thomas on 7th January 2015

The ‘Make in India’ program webpage states as its objectives the following: (1) to facilitate investment, (2) to foster innovation, (3) to enhance skill development, (4) to protect intellectual property, and (5) to build manufacturing infrastructure. This short blog post focuses of selected aspects of the program as laid out of the webpage and then critically examines them and the economics underlying them.

Selected features of the program from the webpage are outlined in this paragraph.  The process of industrial licensing has become simpler and for some, the validity has been extended. There is an impetus to develop industrial corridors and smart cities. The cap of foreign direct investment (FDI) in defence raised from 26% to 49%, with further easing of FDI norms underway in the construction sector. Labour-intensive sectors such as textiles and garments, leather and footwear, gems and jewellery and food processing industries, capital goods industries and small & medium enterprises will be supported. Further, National Investment & Manufacturing Zones (NIMZ) will be set up. Incentives for the production of equipment/machines/devices for controlling pollution, reducing energy consumption and water conservation will be provided.

To summarize, the government will provide incentives for the construction of green technology while at the same time making it easier for firms to get environmental (land) clearances. Setting up industrial zones is a good idea because it reduces transportation costs and common infrastructure can be better streamlined; also, they should be located at a safe distance from populated areas. Investment by foreign companies is beneficial if they these investments entail the learning of new technology and scientific and managerial collaboration. FDI should not be forthcoming solely to exploit the low wages prevailing in India.

Undoubtedly, India needs to revive its manufacturing sector. Globally, Indian manufacturing products need to be competitive. To achieve these two objectives, the present government’s ‘Make in India’ program is necessary. As always, we need to wait and see how the program works in practice. This program is aimed at improving the supply-side of the economy – improving the capacity to supply manufactured products. Creating of physical infrastructure will also have multiplier effects on agricultural and services sector.

Two related issues need to be raised in this context. Firstly, what about economic ‘reforms’ targeted at the demand-side of the economy? Secondly, isn’t it more prudent to validate the supply of manufactured commodities from domestic demand than foreign demand? Let us take each of them in some more detail. Raghuram Rajan made the second point in his December 12, 2014 Bharat Ram Memorial Lecture. Ashok Desai, in the Outlook, criticises the previous government for their corruption scandals and economic schemes which, according to Desai, primarily benefited the non-poor and due to their consumption raised the industry and services growth rates.

While supply-side measures are important, we must not lose sight of demand-side measures – such as public investment in health and education. The recent cut in public health expenditure by the current government is indeed very alarming. Equally important is a good labour law framework which ensures good working conditions for workers and a decent minimum wage. This will ensure adequate domestic demand, as our workers will earn above-subsistence incomes and be healthy. If the core institutions of health and education (and clean environment) are also strengthened alongside the labour market ones, then domestic demand-led growth will not be difficult to manage.

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Posted in Economics, Education, Employment, India, Industrial sector, Macroeconomics | 1 Comment »