Category: Macroeconomics

On the Capital/Output Ratio

A post on the capital output ratio was perhaps inevitable given my teaching and research engagements with macroeconomics, growth theory, and capital theory. This blog post seeks to critically discuss some of the manifestations of the capital-output ratio (K/Y ratio henceforth) in economics. 

K/Y ratio in Macroeconomics

The K/Y ratio captures a technological characteristic of the economy as a whole. It conveys to us the amount of capital required to produce one unit of output. A reduction in it therefore implies we require less capital to produce one unit of output. 

Since capital refers to the stock of produced means of production, which are of a heterogenous nature, K for the economy as a whole requires aggregation via prices: k1p1+k2p2+…+knpn=K. That is, K refers to, as H. G. Jones puts it (p. 17) in his 1975 book An Introduction to Modern Theories of Growth, “an index of aggregate capital.” Of course, Y too requires aggregation via prices.

Roy Harrod, in the chapter ‘Capital Output Ratio’ in Economic Dynamics (1973) treats K/Y ratio as a “kindred concept of the capital-labour ratio” (p. 46). Subsequently, he outlines the scope of the capital-labour ratio in economic studies. 

“It is to be stressed that the capital-labour ratio is a useful weapon for comparing alternative methods of producing a given object, for comparing methods of producing different objects or for comparing the changes through time of methods of producing a given object. It is on the whole an unserviceable tool in relation to national income as a whole, but it can be employed in a very rough sort of way for comparing different countries” (p. 48, emphasis added). 

Similarly, Harrod writes that “the concept of the capital labour ratio is not very helpful, if applied to the economy as a whole, owing to the difficulty of assessing the value of K, namely capital as a whole” (p. 50). 

Additionally, I think that such an aggregate conceptualization conceals more than it reveals. For instance, it conceals the nature of interdependence of production in an economy. What if K/Y changes because of a change in the nature of structural interdependence? Or, what if it changes because of a change in the volume and composition of aggregate consumption demand? After all, the volume of investment influenced by consumption. As Keynes rightly writes in Chapter 8 of The General Theory, “capital is not a self-subsistent entity existing apart from consumption”. 

K/Y ratio in Growth Theories

The K/Y ratio is used as an argument in Kaldor’s (1957) stylized facts: ‘steady capital-output ratios over long periods’. Here too, what is it saying about the structural nature of production and consumption in the economy? 

While Kaldor is talking about ex-post K/Y ratios, the ex-ante K/Y ratio plays a crucial role in Harrod’s growth equation g=s/v. Here, s refers to the marginal propensity to save and v refers to the desired or normal K/Y ratio. A decrease in v raises g, or more accurately, the ‘warranted rate of growth’. 

In the super abstract setup of the corn model (as in Ricardo) or the single-commodity model (as in Solow), since the input and the output are the same commodity, aggregate K is a homogenous set. This assumption allows us to sidestep the problems associated with the measurement and aggregation of ex-ante K. 

One cannot help but wonder how Solow’s single-commodity growth model (expressed via the aggregate production function) continues to be applied in growth accounting exercises on actual multi-commodity economies. We had noted some of the theoretical and empirical problems with one such exercise on the Indian economy in a short note in Economic & Political Weekly.  

K/Y ratio and Capital Theories

Capital theories are concerned with the conceptualization, measurement, valuation, determination, and aggregation of capital. Owing to the central role capital plays in production, the choice of the capital theory has a significant impact on both microeconomics and macroeconomics. Moreover, since capital accumulation is central to growth theory, the choice of the capital theory has a significant impact on development theories too. Similarly, on international trade theories; on this subject, you can consult the 1979 book Fundamental Issues in Trade Theory edited by Ian Steedman. 

In sum, while mathematization of the growth models gives us a better sense of its grammar, capital theory helps us understand its epistemology. And it is the latter which can better guide the use of K/Y ratio in economic theories, empirics, and policies.  

The Political Economy of GST

India welcomed the Goods and Services Tax (GST) on 1st July 2017, sixty-three years after France first adopted it. In his parliament speech, Prime Minister Narendra Modi said that ‘GST marks the economic integration of India.’ It is expected to unify India through the creation of a single market for goods and services as the GST slogan aptly captures: ‘one nation, one market, one tax’. Moreover, it is expected to increase the tax base in India where less than 1 per cent of people pay income tax and close to 90 per cent of the workers are in the informal sector. Both these perceived benefits, according to the government, are expected to accelerate India’s economic growth by making it easier to do business and increasing public investment (financed through increased tax revenue).

The second volume of Economic Survey 2016-17 released earlier last month ‘ another first for India ‘ argues that the introduction of GST partly contributed to ‘optimism about the medium term’. One hopes that the optimism is well founded and not ‘irrational exuberance’, to borrow Robert Shiller’s phrase. Was the introduction of GST aimed at raising tax compliance by simplifying the indirect tax structure with the aid of information technology’ Or, did it aim to structurally reform the Indian economy with a view of increasing employment and reducing inequalities’ There is also another important question to pose: is a uniform tax a good policy move in an economy like India where the intra-state and inter-state differences are significant’

Amidst his discussion on inequality, Thomas Piketty rightly writes in Capital that ‘Taxation is not a technical matter. It is preeminently a political and philosophical issue, perhaps the most important of all political issues.’ Hence, it is important that the political economy of GST is rendered transparent. After the introduction of GST, several Indian states have lost their autonomy in public policy owing to a reduction in their tax revenue because the GST subsumes state taxes such as the value added tax (VAT), sales tax, and luxury tax. [The service tax belonged to the centre.] In fact, as GST is a destination tax, Tamil Nadu, a manufacturing state, had opposed it because of a potential revenue loss of around Rs. 9,270 crore. Additional reforms are necessary to ensure that the state’s economic policies are not throttled.

If simplification of the tax structure was a central goal, the four tax slabs of 5%, 12%, 18%, and 28% do not make sense. However, if the government has an additional goal of influencing consumer choices, different tax slabs make sense. Yet, our current GST tax structure eludes easy interpretation. For instance, why should pens be taxed at 18% and now cost more’ And why should sanitary napkins be taxed at 18% and now cost more’ There appears to be no obvious economic or social logic behind this classification.

On looking closer, the GST classification for goods and services appears to be based on the ‘ability to pay’ principle and therefore progressive in spirit. Hence, non-AC train travel is GST exempt while AC train travel is taxed at 5%. Similarly, while non-AC hotel services are taxed at 12%, the services in AC hotels attract a tax of 18%. From the perspective of the consumer, it is indeed the case that those who consume ‘luxuries’ (e.g., services in Five-star hotels and restaurants) have to pay a higher GST than those who consume ‘necessaries’ such as education and health services. But how are the producers affected’

During the VAT regime, handmade products were tax exempt but they are now taxed at different rates in the GST regime. If one adopts the sole principle of ‘ability to pay’ in the matter of taxation, taxing handmade products might not seem to economically unjust. As a government official put it, ‘a machine-made shawl is priced at Rs 500 and a handmade one at Rs 5,000. If a person can shell out so much for a handmade item, they might as well pay a higher’tax’on it.’ This is a good example of myopic thinking because we need to ask what happens to the handloom sector (employment and wages) once the market price rises.

As I write this, a meeting has been organised to protest the taxing of handmade products. The problem is aptly captured in this statement by one of its organisers:”Handmade products such as khadi saris are already expensive as compared to machine-made products. With imposition of GST, a khadi sari has become costlier.”It is elementary economics that this can lower demand for handmade goods and negatively affect employment in this sector. India’s recycling sector has also been adversely affected due to GST implementation.

Economic policies or reforms cannot afford to be short-sighted either intentionally or out of ignorance. The second volume of the Economic Survey proudly states that the GST regime has formalised the informal textile and clothing sector. But at what cost’

It is true that the big firms will benefit from lowered transaction costs and will be able to enjoy an increased volume of inter-state business. Small firms mostly buy their inputs and sell their output within their own state. In short, the lower transaction costs benefit big firms.

While around 160 countries have implemented GST, its effects have been varied. In Malaysia, household consumption reduced after the implementation of GST; in Australia, the burden of GST was more on the poor than the rich; whereas the weaker sections of the populace benefited from GST in Ethiopia, Pakistan, and Vietnam.

To conclude, while ‘one nation, one market, one tax’ sounds alluring, it presupposes an economically homogenous nation and a uniform market for commodities and labour. Is one tax justified in India, which has several many different labour markets, each with its own ‘equilibrium’ price’ Or do our policy makers think that imposing ‘one tax’ can transform India into a single market’ Just like demonetisation, the GST is yet another bad economic ‘reform’ with detrimental impacts on India’s poor and vulnerable.

Acknowledgement

This is a condensed version of a talk I gave at National Public School, Indira Nagar, Bengaluru on August 11th. I thank the students for posing interesting questions.’

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.

A Review of Mian & Sufi’s House of Debt

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)