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 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. [Given the length of this post, I chose not to elaborate on crowding-out. I hope to do that soon, in a future post.] 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.

Although J.-C.-L. Simonde de Sismondi (1773-1842) lived in Geneva and wrote on economics, history and public policy, his concerns about the role of political economy is valid even today, especially for India. Marx considered Sismondi to be the last classical economist. Sismondi engages with the economics of Adam Smith, David Ricardo and J B Say in his 1819 work New Principles of Political Economy: Of Wealth In Its Relation to Population. This work has been translated into English by Richard Hyse in 1991 (available at Google Books). According to Sismondi, the objective of Political Economy is to ensure that majority of the population live a happy life.

Indian realities

Sainath informs us that India has seen over a quarter of a million farmers’ suicides between 1995 and 2010. The total figure according to National Crime Records Bureau (NCRB) is 256,913. And, since 1998, at least 15,000 farmers have committed suicide very year. More unsettling is that fact that the total number of farmers have been declining significantly. In Andhra Pradesh, it is alleged that 90 farmers committed suicide, that too, in rain-fed areas, in the last few weeks.

The inflation of food articles has reached double digits. Food inflation doubly affects the actual cultivators. Since, the prices are fixed by the Government (minimum support prices), the price rise does not benefit the actual cultivators. Secondly, their ability to purchase their usual consumption basket also falls when price rise. It is in this context that M S Swaminathan’s reminders need to be understood. He rightly asserted: “If agriculture goes wrong, nothing else can go right for this country.”

Very recently, Dreze and Sen pointed out the nature of the asymmetrical growth that is driving India with a majority of the population living without access to basic amenities. They concluded their article in the Outlook by stating that one of the ways forward is to have a “radical broadening of public discussion in India to development-related matters—rather than keeping it confined to simple comparisons of the growth of the gnp, and naive admiration (implicit or explicit) of the high living standards of a relatively small part of the population. An exaggerated concentration on the lives of the minority of the better-off, fed strongly by media interest, gives an unreal picture of the rosiness of what is happening to Indians in general, and stifles public dialogue of other issues.” In other words, how much has the socio-economic condition of majority of the Indian populace (who happen to be farmers and weavers) improved?

Sismondi

In the hurry to build sophisticated DSGE models and while working out monetary and/or fiscal solutions to inflation and economic growth, it is often forgotten that actual human livelihood is at stake. How can Indian agriculture not be a necessary component of the curriculum in economics? Within economics, steep walls which cannot be crossed exist between agricultural economics, macroeconomics, monetary economics, labour economics, development economics, etc. The so-called specialization in these fields (to be understood as literature which is not easily accessible or comprehensible to an economist from another field) has reached alarming levels. Sismondi says the following on the nature of economic inquiry:

However, I believe I should protest against the manner, so often superficial, so often false, in which a work on the social sciences is judged in the world. The problem which they offer to resolve is tangled in quite another way than those that arise from the natural sciences; at the same time it appeals to the heart as well as to reason. The observer is called upon to recognize unjust sufferings that come from man, and of which man is the victim. We cannot consider them coldly and pass them over, without seeking some remedy (Sismondi 1819: 13).

Maybe, the idea of modern science does not allow investigators to be moved by the ‘object’ under study. Nevertheless, as Sismondi reminds us, economic problems and their solutions affect people (who are not ‘objects’) in a significant manner. The state of Indian farmers and weavers is certainly to be given attention, especially in terms of livelihood building, through providing employment and incomes in a dignified manner.

The following lines from Sismondi echoes what Dreze and Sen recently pointed out as regards Indian growth:

If they find a tremendous accumulation of riches, an improved agriculture, a prosperous business community, manufactures which multiply without end all products of human industry, and a government that disposes of almost inexhaustible coffers, as in England, they call the nation opulent that has all these things, without stopping to inquire whether all those who work with their hands, all those who create this wealth, are not reduced to mere subsistence; whether every tenth member among them must not apply each year to the public welfare; and whether three-fifths of all individuals, in a nation that is called rich, are not exposed to more privation than an equal proportion of individuals in a nation called poor (Sismondi 1819: 22).

In India, the wealth creators, the farmers, are forced to live below even ‘subsistence levels’ as Sainath’s commentary on farmer suicides indicate. Even though we have 53 agricultural universities in India, their contribution to the farming population is circumspect. Three to four decades before, working on agricultural economics and debating issues related to agriculture was fashionable and ‘important’. Today, it is even more important but, perhaps, not very attractive. In fact, the Government admits that the farm sector has been neglected.

Admitting that the government is neglecting research in the farm sector, the agriculture ministry has sought more funds in the next Five Year Plan (2012-2017) for significant jump in food grain production.

But, focussing on aggregate food grain production is clearly insufficient. One needs to look at the ‘production conditions in Indian agriculture’. As Sismondi points out very clearly

Commercial wealth is augmented and distributed by exchange; and even the produce of the ground, so soon as it is gathered in, belongs likewise to commerce. Territorial wealth, on the other hand, is created by means of permanent contracts. With regard to it, the economist’s attention should first be directed to the progress of cultivation; next to the mode in which the produce of the harvest is distributed among those who contribute to its growth; and lastly, to the nature of those rights which belong to the proprietors of land, and to the effects resulting from an alienation of their property (Sismondi 1819: 133).

In 1974, Krishna Bharadwaj published a book Production Conditions in Indian Agriculture. In the same period, economists such as Amit Bhaduri, Ashok Rudra, Amartya Sen, K N Raj, C H Hanumantha Rao, Pranab Bardhan, etc wrote extensively on various aspects of Indian agriculture. The issues Sismondi pointed out were discussed and debated. Bharadwaj points out the significance of examining property relations, technology, local patterns of power, etc. Moreover, she notes that non-economic variables such as tradition, customs, caste and religion determine the economic position of a farmer and thereby determines their income and asset levels. The rise in food inflation has prompted many commentators to hold employment guarantee schemes (NREGA) responsible. If agriculture generated adequate incomes (to maintain a decent and dignified life) employment guarantee would not be necessary. In other words, employment on and off farm cannot be treated as independent of each other. Further, in India, markets are interlocked through both price and non-price links (with the Government playing an ambiguous role). These interlocked markets are exploitative as it denies the following freedoms to the agricultural farmer, who is very much an entrepreneur.

(1)   What to produce?

(2)   How much to produce?

(3)   For whom to produce?

(4)   When to sell the produce?

Conclusion

As Sismondi reminds us, we cannot ignore the majority of the Indian population who do not have access to the basic necessaries of life. Agriculture provides livelihood to more than half the Indian workforce. A farmer is an entrepreneur who produces food, the most basic of all commodities. Although, it might not be academically fashionably and profitable to study Indian agriculture but as Sismondi notes: “We cannot consider them coldly and pass them over, without seeking some remedy.”

Inflation has been portrayed as the biggest challenge faced by Indian policy makers and its Central Bank, Reserve Bank of India, in recent times. The Chief Economic Advisor to the Government of India and Professor of Economics at Cornell University, Kaushik Basu, recently presented his professional views on inflation – understanding and management, at the First Gautam Mathur Lecture on 18 May 2011. This is currently available for download as a working paper at the Ministry of Finance website. Various excerpts from this paper have made its way in some English newspapers and TV media. I will comment on this paper at length on a later date. Reading Basu’s paper makes me wonder whether monetary economists or other policy makers know what India is, who Indians are and what Indians actually do. In more abstract terms, do economists know the structure of the Indian economy? Do they know what motivates Indians? Is it primarily region, class, caste, religion, gender, education, self-interest, compassion, sympathy, fame, status? Although, to be fair to Kaushik Basu, he asks the RBI not to experiment and not to put up a façade of knowledge (which he frequently does). Without having a clear understanding of, what the 18^th century economist James Steuart calls, “the spirit of a people”, it is impossible to formulate effective policies. Moreover, the focus on employment generation has completely given way to inflation stabilisation, using sophisticated econometric techniques. Therefore, this blog post revisits James Steuart’s views on how “the spirit of a people” influences economic engineering. In the Indian context, the consequences of monetary intervention might not be those which are depicted in conventional models of inflation.

Sir James Steuart (1713-1780) published An Inquiry into the Principles of Political Oeconomy in 1767 which was and has been overshadowed by Adam Smith’s Wealth of Nations published in 1776. Steuart acknowledged the importance of devising context-specific economic policies. However, we must realise that context-specific economic policy is not antithetical to general economic theories. In other words, proposing economic theories and models of a general nature is not inherently a problem; but, when applied blindly, they cause havoc, which is often supressed in very clever ways. Steuart writes:

“Every operation of government should be calculated for the good of the people. . .that in order to make a people happy, they must be governed according to the spirit which prevails among them” (p. 21).

An ignorance or lack of understanding of this “spirit” can have disastrous consequences. We see some of them in the worsening urban-rural inequality, falling of inflation-adjusted per capita incomes in interior villages [EPW, 2011], agricultural distress and forced migration [P Sainath, The Hindu, 2011]. One of reasons why such skewed policies are implemented is because of the rationale provided by “pure economic theory”, which Basu seems to praise for its scientific rigor and [semblance of] truth. To be clear, “pure economic theory” is something which Steuart was against because it assumed a certain “spirit” and claimed to be universal thereby neglecting important specificities and characteristics pertaining to individual economies.

For Steuart, “the spirit of a people is formed upon a set of received opinions relative to three objects; morals, government and manners: these once generally adopted by any society, confirmed by long and constant habit, and never called in question, form the basis of all laws, regulate the form of every government, and determine what is commonly called the customs of a country” (p. 22). That is, education, religion, region, caste, gender, etc would significantly affect the “spirit” of India. Also, important characteristics such as the percentage of Indians employed in agriculture, in unorganised manufacture, in self-employment, in rural areas, using informal sources of finance, who are socially poor (less than 100 rupees a day), who actually invest in stock markets, who read English newspapers and so on affect the outcomes of economic engineering. Not paying heed to these significant characteristics is the same as formulating an inappropriate policy. Let me highlight once instance. The RBI conducts Inflation Expectations Survey to estimate how the expectations of the Indian populace change over time and this result forms an input into monetary policy making. Despite this, the RBI did not survey any Indian living in rural areas; they seem to neglect and forget the fact that the main producers live in rural areas and their chief occupation is agriculture! This certainly deserves to be questioned. Policies should not be formulated “at any point which regards the political oeconomy of a nation, without accompanying the example with some supposition relative to the spirit of the people” (p. 23). If the “spirit of the people” is not taken into account, as the example above indicated, such policies could prove to be harmful. This also calls for greater dialogue between economists and other social analysts (sociologists, cultural theorists, political scientists, anthropologists, social workers, etc) when engineering nation-wide socio-economic policies. Hence, Steuart writes that “in every step the spirit of the people should be first examined” (p. 25).

Often, the attitudes of policy makers indicate how much their academic knowledge is irrelevant for practical economic and social problems. The reliance on “pure economic theory” is nothing but an intellectual looking, mathematically replete and made-difficult-to-understand version of free markets, because efficiency and rationality are our new gods! As Keynes writes in his preface to The General Theory, “the difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds.” Today, these “old ideas” are not only fashionable and ‘scientific’ (and often unsuited to India), but they are also communicated relentlessly to the new generations through schools and universities. In conclusion, it is scary to realise that India’s policy making is done by those who are “strangers” to the Indian realities. Steuart warns us that “when strangers are employed as statesmen, the disorder is still greater, unless there be extraordinary penetration, temper, and, above all, flexibility and discretion” (p. 27).

Ever since political economy became economics, the role of ethics has continually diminished in the learning of economics. This is because economists want(ed) their discipline to be scientific. To serve this purpose, economics has been divided into normative economic and positive economics. Normative economics deals with questions such as “what ought to be the price configuration” whereas positive economics deals with questions such as “what is the configuration of process”. In other words, there is no room for debate in positive economics; at least, that is the impression one gets from reading the mainstream textbooks. Amartya Sen tried to remedy this situation by strengthening the area of welfare economics; however, methodologically, it still adopts a ‘positive economics’ framework. In any case, this development motivated economists to ask humane and ethical questions. This post raises some issues concerning the role of ethics in economics.

Adam Smith, the father of economics, did not only write Wealth of Nations; being a moral philosopher and an acute observer of society also published a book titled Theory of Moral Sentiments. This book talks of sympathy, passion, ambition, justice, duty, utility, custom, virtue, self-command, etc. Often, proponents who favour utility maximization cite Adam Smith as the first one to do so effectively. As much as one glance at the table of contents of Theory of Moral Sentiments will say otherwise.

This brings us to the following pertinent, yet very difficult questions. What is the objective of economic policies or economic engineering? What role does economic theory play in policy making? Does economic theory provide tools, methods and concepts that aid policy formulation? The final objectives of economic policy invariably happen to be poverty elimination, reduction of unemployment, inflation control and provision of a good standard of living to all the inhabitants. Hence, various kinds of policies are undertaken to achieve these broad objectives. Very often, economic theory aids such policy making exercise in a significant manner. Now, we come to a very startling observation. Economic theory (which is positive in nature) has no room for conflicts, ethics or values. Instead, the major criterion which dominates most economic theorization is that of economic efficiency – free markets achieve efficiency. So what? The goals of economic policies are not to make markets efficient or free; instead, it is to provide the inhabitants with a good standard of living. In India, how can markets take care of the diversity in caste, language, region, income, etc? Economists must do away with their arrogance and admit that policy making is a serious and complex matter, which cannot be solely guided by macroeconomic models of the general equilibrium variety!

For instance, the variables which the government tries to engineer affect people in different and often opposite ways. Alterations in interest rates affect lenders and borrowers differently. Also, movements in exchange rates affect exporters and importers in exactly opposite ways. More importantly, changes in prices of goods and services affect those who cannot afford it very adversely. Given such differential effects of policy variables, economics must incorporate ethical discussions into its fold. Perhaps, a reading of Theory of Moral Sentiments will be of great help!