Crisis in economic theory : Itsimplications for India

Functioning of the economy mirrors the strengths and the gaps in the theory and practice in economics. The global financial and economic crisis that broke out four years ago was the worst that the world had faced since the Great Depression of 1930s. This is the most recent instance of the crisis in economics as a discipline when economists not only failed to predict the economic crisis, but many of them worked with a theory and policy that, in fact, precipitated the crisis.

Market fundamentalism (the belief that markets are self-correcting, allocate resources efficiently and ensure full employment) has now been called into question as never before after the Great Depression of 1930s. This is because an important factor behind the current global financial crisis is a serious underestimation of the potential for market failures.

Further, State or government failure has been no less glaring. Dr Y V Reddy, former Governor of the Reserve Bank of India, calls it 'Regulatory Capture': Financial markets developed far more rapidly than the real economy and the process fostered considerable linkages with the political economy that drove the actions and inactions of both the central banks and governments, leading to the failure of both the market and the State.

The mainstream opinion now among economists and other policymakers is in favour of continuing with market orientation with a greater role for the governments. But the idea of 'Regulatory Capture' goes deeper and points to the need for structural changes, as pump-priming or public investments may not be a sufficient remedy and, indeed, by itself, may have the effect of postponing the required structural changes.

What are these structural factors? Dr.Robert A. Johnson, another scholar who made an in-depth study of the crisis, says "the incentives faced by public officials, regulators, and elected officials and the role of money in politics are important antidotes to romantic notions of the efficiency of regulation to correct for the market failures. In addition, the role of expertise, and the incentives of experts who themselves are incentivised by considerations of power, prestigious awards and compensation should be thoroughly examined".

There is yet another policy lesson for both the developed and developing economies: The rising inequalities in income have led to insufficiency of global aggregate demand exacerbating the present crisis. Hence the emphasis on inclusive growth and measures for social protection. For large developing economies like India and China, an inclusive growth strategy for raising domestic demand could provide a safety net against the vagaries of global markets.

The question whether capitalism can survive the present global financial crisis is being debated fiercely in certain quarters. Nearly 70 years ago, in the wake of the Great Depression, Joseph A. Schumpeter in his classic work, Capitalism, Socialism and Democracy, had predicted the demise of capitalism and the rise of socialism. But, thanks to Keynesianism and other developments, capitalism has survived so far, and socialism is nowhere round the corner. When Schumpeter wrote the above treatise, socialism appeared like a rising sun, the former Soviet Union showing a promise of a viable alternative to capitalism.

Since then socialism and centralized economic planning had a sway for well over half a century and economic planning as a discipline in economics has had a great appeal in large parts of the globe. A However, in a period when technological change and rise in productivity became the predominant source of accelerated economic growth in Western capitalist economies, the socialist economies lagged way behind on account of closed nature of their economies, lack of competition and absence of incentives for innovation and enterprise.

Economics as a discipline or, more precisely, economics of socialism failed to see the consequences from such a tardy progress on the productivity front under socialism. In retrospect, the demise of centralized bureaucratic planning the world over since the 1980s and the 1990s can be attributed basically to the inefficiency and low productivity that the system had perpetuated over a long period. The system collapsed under its own weight without any outside intervention.

So, what is the way out? It seems we are back to some variant of Keynesianism as a via media between purely market-oriented development and a model of State-led development. A The experience of the last two decades following the implementation of economic reforms in India when poverty reduction was slower than expected and economic inequalities increased significantly with various deprivations e.g. under-nutrition, lack of adequate health care and education, coming to the fore, the idea of inclusive growth has become popular among policymakers.

The 12th Five Year Plan has come out with a blueprint of inclusive growth. But welfare schemes like employment guarantee and public distribution of food grains do not, by themselves, make for inclusive growth. After all, several such schemes have been there in India throughout the planning era. Economists are yet to formulate a theory of inclusive growth and economic policymakers need to present alternative models of such a growth, where equity and social justice are built into the growth process itself.

Further, State or government failure has been no less glaring. Dr Y V Reddy, former governor of the Reserve Bank of India, calls it 'Regulatory Capture': Financial markets developed far more rapidly than the real economy and the process fostered considerable linkages with the political economy that drove the actions and inactions of both the central banks and governments, leading to the failure of both the market and the State

(The writer is Chancellor, University of Hyderabad.This article is based on the lecture delivered by him at the inaugural session of the National Economics Conference on 'Crisis in Economics as a discipline and its implications for the Indian Economy', organized by the Young A Economist School, University of Hyderabad, on May 10)