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Updated: April 23, 2013 02:05 IST

Beware the nostrums of economists

T. T. Ram Mohan
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Politicians should not fall for the economic fad of the day. Policies should be subjected to democratic processes and be responsive to people’s aspirations

“The ideas of economists,” John Maynard Keynes famously wrote, “… are more powerful than is commonly understood. Indeed the world is ruled by little else.” He might have added that the ideas of economists can often be dangerous. Policies framed on the basis of the prevailing or dominant economic wisdom have often gone awry and the wisdom was later found to rest on shaky foundations.

A striking case in point is the debate on austerity in the Eurozone as an answer to rising public debt and faltering economic growth. One school has long argued that the way to reduce debt and raise the growth rate is through austerity, that is, steep cuts in public spending (and, in some cases, higher taxes). This school received a mighty boost from a paper published in 2010 by two economists, Carmen Reinhart and Kenneth Rogoff (RR). The paper is now at the centre of a roaring controversy amongst economists.

The RR paper showed that there is a correlation between an economy’s debt to GDP ratio. As the ratio rises from one range to another, growth falls. Once the debt to GDP ratio rises beyond 90 per cent, growth falls sharply to -0.1 per cent. For some economists and also for policymakers in the Eurozone, this last finding provided an ‘aha’ moment.

Cuts in spending

Since public debt was clearly identified as the culprit, it needed to be brought down through cuts in spending. The IMF pushed this line in the bail-out packages it worked out for Greece and Portugal among others. The U.K. chose to become an exemplar of austerity of its own accord.

It now turns out that there was a computational error in the RR paper. Three economists at the University of Massachusetts at Amherst have produced a paper that shows that the effect of rising public debt is nowhere as drastic as RR made it out to be. At a debt to GDP ratio of 90 per cent, growth declines from an average of 3.2 per cent to 2.2 per cent, not from 2.8 per cent to -0.1 per cent, as RR had contended.

You could say that even the revised estimates show that growth does fall with rising GDP. However, as many commentators have pointed out, correlation is not causation. We cannot conclude from the data that high debt to GDP ratios are the cause of low growth. It could well be the other way round, namely, that low growth results in a high debt to GDP ratio.

There is a broad range of experience that suggests that high debt to GDP ratios are often self-correcting. Both the U.S. and the U.K. emerged from the Second World War with high debt to GDP ratios. These ratios fell as growth accelerated in the post-war years. India’s own debt to GDP ratio kept rising through the second half of the 1990s and the early noughties. As growth accelerated on the back of a global boom, the ratio fell sharply. The decline in the ratio did not happen because of expenditure compression, which the international agencies and some of our own economists had long urged.

Needed, rethink

The controversy over the RR paper should prompt serious rethinking on austerity in the Eurozone. Many economists have long argued that the sort of austerity that has been imposed on some of the Eurozone economies or that the U.K. has chosen to practise cannot deliver higher growth in the near future. It only condemns the people of those economies to a long period of pain.

The IMF itself has undergone a major conversion on this issue and is now pressing the U.K. to change course on austerity. Its chief economist, Olivier Blanchard, went so far as to warn that the U.K. Chancellor, George Osborne, was “playing with fire.” The IMF’s conversion came about late last year when it acknowledged that its own estimates of a crucial variable, the fiscal multiplier, had been incorrect. In its World Economic Outlook report published last October, the IMF included a box on the fiscal multiplier, which is the impact on output of a cut or increase in public spending (or an increase or reduction in taxes). The smaller the multiplier, the less costly, in terms of lost output, is fiscal consolidation. The IMF had earlier assumed a multiplier for 28 advanced economies of around 0.5. This would mean that for any cut in public spending of X, the impact on output would be less than X, so the debt to GDP ratio would fall.

Revised estimate

The IMF now disclosed that, since the sub-prime crisis, the fiscal multipliers had been higher — in the range of 0.9 to 1.7. The revised estimate for the multiplier meant that fiscal consolidation would cause the debt to GDP ratio to rise — exactly the opposite of what policymakers in the Eurozone had blithely assumed. The people of Eurozone economies that have seen GDP shrink and unemployment soar are unlikely to be amused by the belated dawning of wisdom at the IMF.

This is not the first time the IMF has made a volte face on an important matter of economic policy. Before the East Asian crisis and for several years thereafter, the IMF was a strong votary of free flows of capital. During the East Asian crisis, many economists had pointed out that the case for free flows of capital position lacked a strong economic foundation, unlike the case for free trade. This did not prevent the IMF from peddling its prescription to the developing world. India and China refused to go along.

In 2010, the IMF discarded its hostility to capital controls. It said that countries would be justified in responding to temporary surges in capital flows. A year later, it took the position that countries would be justified in responding to capital surges of a permanent nature as well. Last December, it came out with a paper that declared that there was “no presumption that full liberalisation is an appropriate goal for all countries at all times.” The IMF’s realisation was a little late in the day for the East Asian economies and others whose banking systems have been disrupted by volatile capital flows.

Capital account convertibility is one instance of a fad in policy catching on even when it lacked a strong economic foundation. Another is privatisation, for which Margaret Thatcher has been eulogised in recent weeks. Thatcher’s leap into privatisation in the U.K. was driven by her conviction that the state needed to be pushed back. After privatisation became something of a wave, economists sought to find theoretical and empirical grounds for it and initially came out overwhelmingly in favour.

Graduated approach

It took major mishaps in privatisation in places such as Russia and Eastern Europe for the conclusions to become rather more nuanced. Privatisation works in some countries, in some industries, and under conditions in which law and order, financial markets and corporate governance are sound. Moreover, partial privatisation — or what is called disinvestment — can be as effective as full privatisation. As in the case of capital account convertibility, India’s graduated approach to liberalisation has been vindicated. It is, perhaps, no coincidence that the fastest growing economies in the world until recently, China and India, did not embrace the conventional wisdom on privatisation.

Other fads have fallen by the wayside or are seen as less than infallible since the sub-prime crisis, and these relate to the financial sector. ‘Principles-based’ regulation is superior to ‘rule-based’ regulation. The central bank must confine itself to monetary policy and regulatory powers must be vested in a separate authority. Monetary policy must focus on inflation alone and must not worry about asset bubbles and financial stability. One can add to this list.

What lessons for policymaking can we derive from the changes in fashion amongst economists? Certainly, one is that politicians and policymakers must beware the nostrums of economists, and they must not fall for the economic fad of the day. Economic policies must always be subject to democratic processes and be responsive to the aspirations of people. Broad acceptability in the electorate must be the touchstone of economic policies. Another important lesson is that gradualism is preferable to ‘big bang’ reforms.

India’s attempts at liberalisation, one would venture to suggest, have conformed to these principles better than many attempted elsewhere. Such an approach can mean frustrating delays in decision-making and the results may be slow in coming. However, social turbulence is avoided, as are nasty surprises, in economic outcomes. At the end of the day, economic performance turns out to be more enduring.

(The author is a professor at IIM Ahmedabad; ttr@iimahd.ernet.in)

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Very informative article. Policymakers should heed to the advice.

from:  Vinci
Posted on: Apr 24, 2013 at 08:03 IST

"Economic policies must always be subject to democratic processes and
be responsive to the aspirations of people. Broad acceptability in the
electorate must be the touchstone of economic policies." - How can
this statement be justified? Is it right to invest tax money on the
right avenue or the one that most people prefer?
For example, Should we not invest in alternate non-polluting sources
of energy because a major portion of the population see it to be
uneconomical and big corporations prefer the economy to be tied to
fossil fuels?
If we democratize fields like economics which is more or less a field
of science in which you require an expertise, wouldn't that be an
other form of populist politics?

from:  Manoj BS
Posted on: Apr 24, 2013 at 07:51 IST

Economics is Philosophical ideas with Money. For any given issue,
economist, like philosophers, cannot come to a definite solution or
idea. Unlike philosophy, economist can make life miserable.

Paul Krugman would never cut across from his Keynesian economics and
say that US stimulus program will not work. Marc Faber would never cut
across from his neo-classical economics and say that US stimulus
program will work.
Like Philosophy, and unlike Science, any Economic idea has a place in
economics. We can only hope to pick an economic theory that minimize
the damages.

from:  Sandeep
Posted on: Apr 24, 2013 at 07:46 IST

I can't comprehend the last paragraph of your article.If you can
elaborate that it will be helpful.
I am unsure are you castigating India for vacuous & haphazard reform
or for its gradualism approach.
I belief that India has never have clear approach.It always take
lobbyist view and try to strengthen their issue.

India reaping demographic dividend and it depend upon this.


from:  Uttam
Posted on: Apr 23, 2013 at 23:34 IST

Even without reading further, one can smell something extremely fishy abut RR paper. It may be purported to be a "computational error" but seeing its impact on world economic policies, one has to suspect that the error was a "calculated" one. Time and again we have seen that many Economists belonging to the top Universities of the world never minded churning out papers advocating pro-corporate economic measures in their country, even as they remained in the payrolls of the same Corporates who would have benefited from such measures. It is time an investigation is launched to bring out the real reasons behind such "errors". Author has convincingly argued that such economists need to be shown their place with the democratic power that people hold. After all, it is people who decide how their economy must run, not a few corporate paid fabricators of "economic theories".

from:  Madhu
Posted on: Apr 23, 2013 at 22:38 IST

Economists in India are more dependent on borrowed ideas of economists in foreign countries. They follow what is called as "global practices". Service-tax is one such tax which is based on global tax practices according to which a maid servant pays service tax @ 12.36% because she is owner of a mobile phone while a company (service provider)as consumer's service-tax liability remains zero because of cenvat/input tax credits. In other words, a maid servant pays service tax @ 12.36% while a company pays service-tax @ 0% after claiming input/input tax credits. This is all justified because India's tax policies are based on global tax practices.

from:  SC Aggarwal
Posted on: Apr 23, 2013 at 18:44 IST

The author is correct in arguing that policymakers should not be carried away by the economic fads of the day. However, it would be a folly to try to invariably align economic policy closely with democratic process. Popular acceptance is not necessarily good economics. If people are so enlightened, there is no need for any economist.

from:  K.R.Srivarahan
Posted on: Apr 23, 2013 at 18:07 IST

The salient feature of this article is economic policies,which in turn affect not only a nation but also whole globe,in our closely coupled world,should be carefully formulated and meticulously implemented.The points which he made to vindicate his points are:
1)-policy of austerity which is recommended by european union and adopted by european countries,could not solve the problem
2)-Epic failure of free capital flow principle
3)-Various degree of suceess which could be yielded by privatisation in various countries.
Here i would like to add one point that economics is a dynamic and experiment oriented,most of the models,given by the greates ever economists,are nothing but a lesson learnt from the past,hence what is needed to check the success of any notion at the small scale,after that to make it part of a larger frame.
One thing which is completely out of my reach is,how a larger debt to GDP ration can lead to higher growth of economy,as mentioned in the article.

from:  Kushagra Singh
Posted on: Apr 23, 2013 at 15:43 IST

"Politicians should not fall for the economic fad of the day."

I wish the same applied 55 years before when the copy-and-paste of five
year plan fads were going on...sigh!

from:  mayukh
Posted on: Apr 23, 2013 at 15:12 IST

Fantastic article, well thought and well written.

from:  JOSHI MANISH ANIL
Posted on: Apr 23, 2013 at 14:39 IST
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