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

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.

Model Building and Planning in India

Ever since the First Five Year Plan, we have utilised models in order to channel resources for achieving objectives of higher growth, establishing strong capital base, strengthening import substitution, reducing poverty, increasing foreign exchange resources and so on. The early plans made use of Harrod-Domar model and the Feldman-Mahalanobis models. The models used for planning purposes were largely taken from economic theory, which were then adapted (hopefully) by the Planning Commission. Owing to changes in the structure of the Indian economy, the nature of modelling has also undergone various alterations. This post highlights certain issues in the macro-modelling that was done for the 11th Five Year Plan, chiefly based on the publication by the Planning Commission Macro-Modelling for the Eleventh Five Year Plan of India edited by Kirit S Parikh.

It is incorrect to argue that planning in India has become redundant after the 1991 reforms. These reforms provided freedom to the firms with respect to what to produce and how to produce them. As the recent global financial crisis has shown, unregulated finance can lead to unfavourable outcomes for the financial as well as the real sectors of the economy. Also, significant divergences in income and wealth are being reported. This is the case, especially in India which is home to some of the richest and poorest people in the world. As Parikh writes, ‘As long as disparities in income, endowments and wealth persist, access to public goods and services is uneven and infrastructure paucity is there, we need active government policy. We need planning.’ [Planning Commission 2009, 16]

The 11th Five Year Plan’s goal is to have ‘Faster and More Inclusive Growth’. The basis of this goal is that the growth of GDP is treated as a necessary and almost sufficient condition for improving livelihoods. We know that markets exclude those without adequate purchasing power. And growth in GDP mainly results in an increase in the extent/size of the market. Unless appropriate systems are in place, ‘trickle down’ does not take place. Hence, an outline of how ‘inclusive growth’ can take place needs much greater attention. And it is disappointing to see that employment generation is not considered as a central objective. For the first time, the inputs of the 11th Five Year Plan have been provided by a ‘modelling forum’. The forum consists of researchers from NCAER, IGIDR, IEG and ISI Bangalore apart from the in-house team of the Planning Commission.

A formal model is constructed for the purposes of planning because it makes the assumptions transparent, ensures consistency and provides insights into the inter-relationship between various actors and sectors in the economy. These models in turn borrow concepts, categories, functional relationships and links from the paradigms in economics. The paradigms that have influenced modellers, according to Parikh are Input-Output, Walrasian, Neoclassical, Keynesian, Structuralist, Vector Auto Regression/Error Correction, New Neoclassical and Dynamic Stochastic General Equilibrium. The most obvious drawback of this classification is the mix-up of paradigms with tools of economics. For instance, IO framework, VAR models and DSGE models are only tools. For our later exposition, it would be helpful to point out the important characteristics of each of these paradigms/tools.

Input-Output: Usage of inputs in fixed proportion

Walrasian: Optimising behaviour of economic agents

Neoclassical: Pricing through supply and demand mechanism and full employment at prevailing wage rate

Keynesian: Underemployment equilibrium

Structuralist: Imperfect markets and incomplete monetization of the economy

Vector Auto Regression: All variables depend on lagged values of all variables and data speak for themselves

New Neoclassical: Microeconomic foundation of macroeconomics- importance of information, expectations and contracts

DSGE: Forward looking and optimising economic agents

In the modelling for the 11th Five Year Plan, six different models with different analytical approaches have been used. The models are a) Perspective Planning Division’s In-house Model, b) A VAR/VEC Model from ISI, Bangalore, c) A General Equilibrium Model from IGIDR, d) An Econometric Model from IEG and e) Macro-Econometric Model of NCAER. The various model scenarios show that the direction of policy shocks are similar ‘though the structure and philosophy of the models are different’. However, this is not such a shocking or an interesting revelation. For everybody knows that oil price shocks have a negative impact on the GDP growth rate and that the global slowdown affects the GDP adversely. The only result of interest is that of an increase in NREGs by 1% of GDP. This will result in an increase of around 0.35 to 0.5 GDP percentage points. However, it must be noted that this is based on ‘a general equilibrium model in which it is assumed that the adjustments to the new equilibrium are completed in one year. Thus, the impacts may be overstated as in reality this may not be the case’.

Overall, it seems that the assumptions of the various models are far from our Indian reality. There is no attempt at including the unorganised sector. And it is very clear, from the recent evidences from neuroeconomics, experimental economics and game theory that individuals are not rational optimizing machines. Instead, we are more moved by social concerns and we exhibit a pro-social behaviour which is norm-based. There is no explicit move to analyse employment generation. Nor is there the necessary focus on agriculture. It is stated that agriculture needs to grow by 2.4 % to 4 % so as to achieve 9% GDP growth rate. One cannot help but wonder whether the objective of economic planning in India is only about the GDP growth rate! And as to the use of VAR models, the generators of the model argue that since there is ‘no real basis to say which variable is endogenous and which is exogenous’, they adopt a ‘general equilibrium approach, where everything (except rainfall, of course) depends on everything else.’ [Planning Commission 2009, 88] An easy route indeed!

This publication by the Planning Commission is a must read for all those who are interested in understanding the Indian policy making. Also, it provides the crucial link between policy and theory. Hence, making the study of economic theory very significant, especially for policy makers. It will also be of interest to students and practitioners of time series methods using the VAR framework.


Planning Commission (2009), Macro-Modelling for the Eleventh Five Year Plan of India, edited by Kirit S Parikh, Academic Foundation: New Delhi.