Thoughts on economics and liberty

Shenoy demanded a free economy in 1962. But the fools who governed India refused to listen

Here's is short and crisp article that Shenoy wrote in 1962, published in Challenge, January 1962. It is self-explanatory. Enjoy.

[An aside: My otherwise high opinion of Jagadish Bhagwati took a big hit when I read his foolish criticism of Shenoy in a review of one of Shenoy's books that he wrote in The Economic Journal (Sep., 1969).
In his book, Shenoy had hit out forthrightly against foreign aid, thus:
"Indirectly,  aid  has  fed  corruption, extravagant living  and  the construction of  less  essential  or  luxury  structures and  other  urban property;  and has provided foreign exchange finance for gold imports, smuggled import  goods  in  short  supply,  and  for  concealed  capital transfers and other illicit remittances abroad "  (p. x).
In response to this clear and forthright analysis, Bhagwati branded Shenoy an ideologue of "the Friedmannite variety". Bhagawati, you just lost a point.]
Anyway, back to Shenoy.


Most Indians feel that an acceptable rate of economic growth for their coun­try can be achieved only by a greater degree of government planning. This sentiment, however, is by no means unanimous. B. R. SHENOY, Director of the School of Social Sciences at India's Gujarat University, feels that India needs a free economy and that U.S. aid is a disservice in that it merely post­pones the consequences of wrong economic policies. His collaborator, PATRICK M. BOARMAN, is Associate Professor of Economics at Bucknell University.
THE PLANNERS in New Delhi would do well to take a good hard look in the direction of Bonn. During the past 13 years West Germany has shown that a free economy has tre­mendous powers of growth. India, on the other hand, though as eager as any country for growth, has chos­en a different path—that of govern­ment planning.
A considerable body of evidence is now available which shows that this was an unwise choice, has meant slower growth than might otherwise have been achieved. Not­withstanding, many Indians believe that the type of program used in Germany could not have worked in India with its allegedly vastly differ­ent conditions. They advance a con­siderable number of arguments to support their position. Many of these are weak in logic or even based on incorrect facts. [Sanjeev: with arrogant fools like Mahalanobis running India's planning commission, little more could have been expected]
But neither the planners' mistakes nor their faulty logic have succeeded in making the free, or market, econ­omy popular. The case for economic freedom suffers because its advocates in India, even in the universities, make up only an insignificant mi­nority of the population. As a result, it seems highly unlikely that the majority of Indians will abandon their faith in central planning as the best means of promoting their na­tion's growth unless the country ex­periences more drastic setbacks than in the past. [Sanjeev: this was prescient – after Nehru and his godchildren had bankrupted India in 1991, India did learn the basics of what Shenoy had been saying 30 years before]

To begin our criticism of current policies in India let us consider the poverty and desolation of Germany at the end of the war. Was Ger­many's situation then any less de­pressing than conditions today in many underdeveloped countries? This comparison is important in view of the frequently stated theory that the vicious circle of poverty, inadequate savings, the resulting lag of investment behind population growth and the persistence of eco­nomic bottlenecks can only be changed by the techniques of Com­munist planning or by governmental intervention.
The war destroyed 60 to 90 per cent of most German cities. Harbors, canals and rivers were blocked by sunken ships and cranes; the destruc­tion of bridges made most railroads and highways useless. In addition, West. Germany had to deal with an influx of refugees from the East-12 million of them, or 23 per cent of the truncated country's population—in the dozen years following the war. West Germany's population growth has, therefore, been greater than that of the underdeveloped coun­tries; yet it is the increases in popu­lation of the latter which are so often declared to be the primary obstacle to their efforts to arise from their economic misery.
THE phenomenal economic accom­plishments of a free economy are patent in the German case. But the German experience also shows that if the curve of production is to rise steeply, two basic conditions are needed: (1) the concentrated ap­plication of each individual to that activity to which he is by nature and training most suited; and (2) the greatest possible amount of savings. Such savings provide the means for an enlargement of the capital base of the economy; this, in turn, makes it possible for the output of each individual as well as of the total economy to increase still further.
The process of growth is more likely to continue uninterrupted where production and savings are the outcome of the free will and the free choice of each individual. This principle applies to all economies regardless of their special nature and structure since the economic process, like the technical process, is every­where the same.

In consequence, it is not at all cer­tain that governmental controls and interventions are the best policy for India simply because there are fun­damental differences between the In­dian and the German economies. Indeed, the tempo of economic de­velopment in the one as in the other case is dependent upon the creation of economic surpluses—defined as production minus consumption. Therefore, in both cases the government's policy must be aimed at in­creasing such surpluses.
For these reasons, a policy which favors the market economy is espe­cially necessary in underdeveloped economies where incomes are close to the subsistence level and where increased savings are only possible when production is increased. In such cases, it is clearly necessary to avoid all administrative and polit­ical measures that will lessen the in­centives of entrepreneurs.
The current economic policy of India, however, aims at a continual increase of governmental interfer­ence in economic life and at an ex­panded participation by the state in trade and industry. Here, as else­where, this policy affects individual effort and enterprise like a wet blanket.
LET US FIRST consider agriculture, which in recent years yielded 45 to 51 per cent of the national income of India and from which 70 per cent of the population draws its living. This pursuit is already subject to a variety of restrictive laws including:
  • Controls on credit and interest rates.
  • Price ceilings on a number of commodities.
  • Restrictions on the mortgaging and transfer of land (almost the only pledgeable asset of the farmer).
  • A socialist-inspired limitation on the ownership of land.
These interventions have lessened the availability of credit to agricul­ture, increased interest rates to fan­tastic levels (some loans to farmers cost 80 per cent and more per year) , reduced farmers' incentives to ex­pand output, and caused an "antic­ipatory" splitting up of the larger land holdings.
Similarly, Indian industry must contend with all manner of govern­mental controls and regulations. For example:
  • A license is required to estab­lish any new industrial enterprise and to add to the capacity of an existing one; restrictions even exist on tilt closing down of an inefficient factory.
  • In the cotton textile industry, which accounts for 36 per cent of industrial activity, the hurdles are extremely irksome—e.g., borders of white saris must conform to certain specifications, and there are limita­tions on the counts of the yarn in the warp and the woof.
  • There are comprehensive con­trols over joint-stock companies, in­cluding their capital structure, div­idend rates, loans, contracts and payments.
EXCHANGE CONTROLS and quota restrictions have been employed for the past 20 years-14 years of inde­pendence plus six years of wartime and postwar controls. And these gov­ernmental interferences with the free play of the market have pro­duced three developments whose consequences for the Indian econ­omy have been fateful.
First, extensive production of domestic substitutes for the lost im­ports has come at a high real cost to the economy, while simultaneously it has slowed the production of the traditional export goods. The result­ing slower growth of the country's gross national product has worsened rather than corrected the balance of payments deficit.
Second, a widening gap between foreign and domestic prices for im­port goods and gold has resulted in the emergence of a black market in import licenses and in the import of gold through smuggling.
Third, these unhealthy developments have caused a massive redis­tribution of income, but in the di­rection of greater rather than lesser inequality. A class of new rich has been created whose incomes have risen far more rapidly than those of the millions of poor. Many of the new rich are adept at evading taxes, and the loss of income to the govern­ment is estimated at around two to three billion rupees annually ($400 million to $600 million) . The latter development, in turn, has provided the state with a pretext for engaging in additional though ineffective in­tervention in the nation's economic life.
THERE is another hindrance to the effective functioning of the national economy—the effects of inflation. During the six years (1955-56 to 1960-61) in which real national in­come rose 21.9 per cent, the quantity of money increased by 51 per cent. The result was an inflationary rise in the general price level of 6.8 per cent annually in these six years. Moreover, on top of the "taxes" exacted by inflation (for inflation taxes savings) industry is subject to the usual legal taxes—which are quite high in India. This puts a heavy burden on industry and cuts savings drastically.
The originally announced target of the Second Five Year Plan was for an increase of 25 per cent in the national income between 1956-57 and 1960-61. However, the actual in­crease was 19.6 per cent. When this is set against an increase of 10.8 per cent in the population, against the construction of factories that pro­duce far below capacity, against the building up of inventories (which is inevitable under inflation, for businessmen hold goods in order to profit from a rise in price) , and against an unduly large output of capital goods, the net progress achieved is unimpressive.
This is reflected in the downward trend in the consumption of food grains and cloth—changes which pro­vide a dependable yardstick of the well-being of the masses of the peo­ple. The former is below the target of the Second Five Year Plan (18 ounces per head per day) , and the latter deplorably substandard. The consumption of food grains in 1960 was 15.4 ounces per head per day as against 15.7 ounces in 1954; and the consumption of cloth was 15.7 yards in 1959 as against 16 yards in 1955.
IF INDIA desires a more rapid rate of economic development, she must decide in favor of the right economic policy. It would seem advisable to abandon the policy of governmental interference with market forces and the free formation of prices—a policy for which justification has been sought in terms of the requirements of the Five Year Plans and the need to establish a model socialist society.
India must choose between two alternatives: the one is Communist planning according to which the planners exercise control over the country's entire means of produc­tion, determine its foreign trade and reduce private consumption to a minimum in order to attain a maxi­mum amount of capital formation. The Communist technique, how­ever, is not able to guarantee an accelerated rate of economic devel­opment, as the recent history of China shows., Experience indicates that communism tends to provoke conflicts and resistance, particularly in the agricultural sphere, thereby preventing the maximum develop­ment of the economy, though this type of central planning may pro­duce striking progress in a few sec­tors of the economy.
The free market economy is the other alternative. Whoever rescues India from its present economic policy and provides a transition to a free market economy would unques­tionably accomplish more for the fu­ture progress of the Indian economy than all the suppliers of foreign aid.
Today, in India, the prevailing opinion is that the principal eco­nomic difficulties confronting the country—namely, the rise in prices and the acute shortage of foreign ex­change—must be written off as the inevitable costs of economic prog­ress. Persons in positions of power and responsibility as well as the general, educated public appear to believe that economic progress is not possible without inflation and controls on foreign exchange. In contrast, it is proving extremely dif­ficult and time-consuming to gain adherents for the view that all of these difficulties can be traced to the attempts of India's planners to in­vest nonexistent capital—capital in excess of savings and foreign public and private investment.
THE CHOICE between a free market economy and communism cannot be put off in India very much longer. Sooner or later emerging fiscal prob­lems will require the country to choose between the two systems. These problems are largely due to inflation, and the government plan­ners have deliberately pursued an inflationary policy. The course of events since the beginning of the Second Five Year Plan shows how this result was produced.
During that Plan period total pub­lic and private investments amounted to 79 billion rupees (a rupee is worth 21 cents). Approximately eight per cent (5.98 billion rupees) of this amount was financed from the monetary reserves (gold and foreign exchange) of the Indian government and 18 per cent from foreign aid (14.6 billion rupees, including U.S. aid under Public Law 480 of 5.34 billion rupees). It is necessary to add that the share of investments in the public sector which was financed by foreign aid and by drawing down foreign exchange reserves exceeded by a considerable margin the above over-all percentages.
Much of the credit for avoiding a galloping inflation (even worse than the 29 per cent rise in prices which did occur during the period of the Second Five Year Plan) is due to the massive amount of foreign aid which was received. The inflow of goods under the foreign aid programs off­set the inflationary expansion of the domestic money supply.
Despite these difficulties, the Third Five Year Plan, which went into ef­fect in April, 1961, contemplates investments of 121 billion rupees in five years—a rate of annual invest­ment over one and a half times as high as in the Second Five Year Plan. Let us assume that national income increases to an annual rate of 3.5 per cent during the Third Plan period and the rate of saving to 8.5 per cent of the national income at the close of this period (as against 7.5 per cent currently). Even then, total savings during the period would amount to only 55 billion rupees. If we make the further as­sumption that foreign aid in the
Third Plan may amount to 32 bil­lion rupees—probably an overly opti­mistic figure—the funds available to the Third Plan amount to only 87 billion rupees, leaving 34 billion rupees still to be raised if the target is to be reached.
THE OFFICIAL SEARCH for a solution to the problem of inadequate savings is in the direction of more state in­tervention in economic activity. This tendency was particularly evident in the discussions at the Seminar on Planning, conducted by the All In­dia Congress Committee at Octacamund in June, 1959. The policies advocated there have been described as "institutional and organizational changes of a comprehensive charac­ter, affecting both governmental and nongovernmental agencies." Given these changes, the "conclusion" of the Seminar is that "it would be pos­sible to mobilize resources to the order of 100 billion rupees," of which two-thirds would be for in­vestment in the public sector. The changes in question include drastic increases in taxation, expansion of state trading activities and the col­lectivization of agriculture.
The need for foreign aid to help speed up the economic development of countries where average incomes are low is evident in the situation here described. It is essential, how­ever, that such aid be primarily used for the formation of capital in the most effective and economical man­ner. For this, important prerequisites are stable monetary conditions in­ternally and adequate reserves of foreign exchange.
During the First Five Year Plan, viewing economic operations in the aggregate, most of the 2.1 billion rupees in foreign aid was ineffective. This was so because about the same sum flowed out of the country for unproductive purposes. The govern­ment was unable to stop the smug­gling of gold into the country, and Indians spent about 1.6 billion rupees for gold, chiefly for hoarding. Also, financing the export of foreign-owned private capital cost 370 mil­lion rupees. As a result, very little more than the domestic savings of the period (31 billion rupees) was available to finance the investment program of the Plan.
Foreign aid, in other words, was converted mainly into the dead asset of gold and partly exchanged for existing capital assets purchased from foreigners. It did not con­tribute to a significant increase in the national product, though the service charges on foreign aid are paid for from this product.
During the Second Plan period, the wrong stimuli given to the econ­omy by foreign aid were increased. The aid, in effect, served to camou­flage the errors of the planners. In turn, the inroads on foreign aid re­sulting from its use for financing pri­vate capital outflows and gold smug­gling were augmented by the in­flationary pressures resulting from overinvestment. Moreover, since for­eign aid is indistinguishable from local currency in terms of its domes­tic buying power, foreign aid is in­evitably drawn upon, directly or in­directly, to finance increased con­sumption.
But to the extent that foreign aid is not used to enlarge the capital base in a manner appropriate to the needs and structure of the economy, the economic ability to repay the debt is not being built up. These considerations raise the important question of whether foreign aid, which provokes domestic inflation and basic economic disorder, is in the best interest of either the giver or the receiver. At the very least, there will be doubts in such a situa­tion of the debtor's ability to repay the debt. To the extent that foreign aid serves merely to counteract wrong economic policies—and hence encourages such policies by prevent­ing full recognition of their conse­quences—that aid becomes a dis­service in disguise to the nation that receives it. 
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