July 25, 2014

Modinomics and not Reaganomics

India needs contextual and not ideological policy-making.

This piece is not a review of Professor Ha-Joon Chang’s book, 23 things they don’t tell you about capitalism. It merely draws heavily from it. In this book published in 2010, Ha-Joon argues that capitalism was a bad way to organise an economic system but for all others. He is for capitalism but he is sceptical of the ability of free-market capitalism to deliver economic prosperity as its proponents claim or at least, the evidence is somewhat thin. In fact, most economists who would be aghast at that claim do not practise what they preach.


As of November 2013 when he had his “Lunch with FT”, his book had sold about 650,000 copies and had been translated into thirty-two languages. When the Dean of the Lee Kwan Yew School of Public Policy asked him recently as to how neo-classical economists in a room would respond when he walked in, he answered that the situation would not arise since he would not be invited to a gathering of neo-classical economists!

As I searched for ‘Ha-Joon Chang’ in the pages of, I came across an article by Niranjan Rajadhyaksha published in November 2008 on the dangers of protectionism following the global economic crisis. He had cited an article by Ha-Joon published in FT the week before wherein Ha-Joon had said that, in the wake of the global crisis and the consequent prospect of weak economic growth globally, countries could choose some specific industries to be protected and nurtured from competition and allow others to die smoothly. Niranjan concluded his piece with the observation that it was far easier to engage in open trade than for governments to pick winners and losers.

Yet, developed countries are recent converts to free trade. At his inauguration, George Washington insisted on wearing only “Made in America” clothes. America was one of the most protectionist countries in the world during its phase of ascendancy (from the 1830s to the 1940s) as was Britain during its rise (1720s to 1850s). Between the 1930s and 1980s, Finland used to classify all enterprises with more than 20 percent foreign ownership officially as ‘dangerous enterprises’. Arguing that patents are artificial monopolies that go against the principle of free trade (a point which is strangely lost on most of today’s free-trade economists), the Netherlands and Switzerland refused to protect patents until the early 20th century.

His book contains many other and similarly interesting nuggets of information it contains. Andrew Jackson, the conservative President of the USA cancelled the license of the Second Bank of the USA. One of the excuses was that foreigners owned too much of it (30 percent). One of the earliest to recognise the potential of limited liability to advance capitalism was Karl Marx. He called the joint-stock company “capitalist production in its highest development”. However, while limited liability offers shareholders an easy exit, it makes them unreliable guardians of a company’s long-term future. Today’s stock investors do not provide the patient capital necessary to nurture long-term growth.

His characterisation of the welfare state for workers as one that provides a second chance for them just as the bankruptcy law offers a second chance to capitalists is an interesting one. He notes that the Scandinavian countries have higher social mobility than the UK, which in turn has higher mobility than the US. It is no coincidence that the stronger the welfare state, the higher the mobility. In his view, what distinguishes rich from poor countries is their ability to channel individual entrepreneurial energy into higher productivity. Towards that end, he calls for a range of institutions that encourage investment and risk-taking –a trade regime that protects and nurtures firms in “infant industries”, a financial system that provides “patient capital” necessary for long-term productivity-enhancing investments, institutions that provide a second chance for both capitalists (a good bankruptcy law) and for the workers (a good welfare state), public subsidies and regulation regarding R&D and training and so on.

He finds support from Professor Gerald Davis of the University of Michigan. In his book, Managed by the markets, Davis argued that anthropological evidence did not support Adam Smith’s assertion that humans possessed an intrinsic ability to trade and barter and that markets were, in some sense, fundamental to the human condition. Markets played little part in pre-modern societies and were regarded with great suspicion throughout the Middle Ages in Europe due to their disruptive effects.

What these books show is that the philosophy of free markets was more a self-serving argument for capitalists to enrich themselves at the expense of workers and for rich nations to prise open markets in the developing world and less a coherent philosophy of economic growth and prosperity. Just as labour unions tested the limits of their powers in the 1970s and failed, the socially harmful effects of capitalism came to the fore with its extension to financial liberalisation since the 1980s, culminating in the global financial crisis of 2008. As the world had not learnt the lessons of the crisis, it may suffer something worse than the last crisis yet. Egregious executive compensation continues to be the norm in both financial and non-financial sectors.

Jack Welch, famous head of General Electric was one of the prime examples of executive compensation ran amok. Barry Ritholtz of ‘Big Picture’ blog, drawing from the book, Origins of the crash by Roger Lowenstein, published in 2004 observed:
 “Huge stock option grants create perverse incentives. GE’s Jack Welch pocketed over $400 million dollars in salary, bonuses, and options. Lowenstein argued in his book that Welch essentially managed the earnings with very creative accounting and the help of GE Capital’s impenetrable financial black box. The credit crisis caused the collapse of GE’s earnings management, confirming Lowenstein’s thesis of earnings management. It is hard to avoid his conclusion that the greatest industrial CEO in recent American history was little more than a clever accounting cheat.”

As countries maintain zero interest rates or something slightly above that, there is little inducement to invest but more to speculate. Extremely low cost of capital spurs excessive risk-taking and nothing is riskier than speculation. This has boosted stock prices in the US and home prices again in the UK Further, loans at low interest rates are available only to those who have the amount of net worth or real assets that provide some sort of protection to lenders. So, the rich can leverage and invest, adding to their wealth. As a result, low interest rates have boosted wealth and widened inequality rather than reducing them, Thomas Piketty’s spreadsheet errors, notwithstanding. Financialisation and ultra-loose monetary policies have played a great part in fanning income and wealth inequality in the last quarter century. Besides, as John Kay noted tersely in his column in the FT in July 2013, “Quantitative Easing” had surely benefited the financial services sector and those who work in it even as its efficacy in benefiting the non-financial economy is questionable.

However, India that has had its own share of problems with the State occupying the commanding heights of the economy over the first five decades of its independent existence should be wary of embracing these criticisms of capitalism too tightly. The problem with these arguments, if copied by developing country policymakers, is that they may not do everything else that the rich countries did on their way to richness – on education, on land reforms, on science and technology, etc., on incentives for infrastructure building, etc. As part of such a comprehensive policy package that had many other elements, infant industry protection, trade protectionism and anti-foreign investment might have worked. But, politicians might engage in cherry-picking, choosing the worst of the policy choices adopted by the rich countries leading to sub-optimal outcomes.

As Dr Subbarao put it in a speech in 2010, economics cannot stand the scrutiny of the falsifiable hypothesis test since empirical results in economics are a function of the context. So are economic policies. That is why attempts to characterise India’s prime minister as a Reagan or a Thatcher or a Lee Kwan Yew are misguided. They were products of the situations that their countries faced. They made use of them. Reagan and Thatcher’s free market policies failed spectacularly as the financial industry proved singularly incapable of self-regulation. Western countries have bailed out banks, automobile companies and extended subsidies favouring particular sectors.

Ultimately, economic policies –whether they are of the interventionist kind or not – must pass the tests of feasibility, viability and sustainability. They must also be demonstrably superior to other alternatives considered and rejected. Finally, they must be discarded if they did not deliver the outcomes sought within reasonable time-frame. Public policy ought to be a context-specific, open-minded empirical exercises and not driven by ideology of any kind. For example, most economists in India, regardless of their ideological preference, will agree on the need to tweak the Food Security Act, substantially modify the legislation on land acquisition and reverse retrospective tax laws. Just as subsidies are held up to scrutiny, so should tax exemptions and concessions granted to industrialists be. If the Indian government’s decisions and actions were based on this recognition, then the Prime Minister would become the benchmark against which future heads of governments will be judged.

Photo: Jon McGovern

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