Development issues

A festschrift collection to honour Prof. Mihir Rakshit, the book under review takes the theme of economic growth and the various dimensions and processes associated with it. It would be invaluable to students of macro economic theory, says KALYANJIT ROY CHOUDHURY.

IF any Indian under-graduate institution can be singled out for producing a large output of extraordinary students specialising in economics, particularly in the U.K. and U.S. Universities, it must be the Presidency College of Kolkata. It is also quite gratifying to note that the old students of this college have been bringing out, at regular intervals, commemorative volumes on their former teachers. The book under review is one such festschrift volume of Prof. Mihir Rakshit of the Economics Department of the College (currently director of ICRA). All the contributors (except a co-author, Udo Broll) have been Prof. Rakshit's former students (14 of them) in Economics Honours at the Presidency College, in the post-1965 period. There are 10 papers in this edited volume, divided into five sections, dealing with contemporary issues in macro-economic theory, "a subject close to Prof. Rakshit's heart".

The theme of the book is economic growth, in its various dimensions, facets, and processes. As a consequence, the first section deals with national income, consisting of two papers. The first by Pradip Maiti of the Indian Statistical Institute, Kolkata, deals with the theory of national income accounting and the estimates of various aggregates by the CSO. The second paper by Swapan Dasgupta and Tapan Mitra of Dalhousie University, Canada, and Cornell University, U.S., respectively, deals with national income, economic welfare and sustainable development.

In his 50-page article, Pradip Maiti brings out with utmost conceptual clarity the various concepts and aggregates (of national income) with their interrelationships, measurements and estimate procedures, backed up by the Indian data for the period 1994-95. I must admit that in recent years, I have not seen a better exposition of national income accounting (including flow of funds analysis) than that provided by Pradip Maiti (I have been reminded of Prof. Sivasubramannian's treatment of the subject in the early 1960s, when I was a student in DSE). I would strongly recommend this paper to the teachers and students of national income accounting and should be included in the syllabus of economics. The treatment is very accurate, comprehensive and compact.

The second paper by Dasgupta and Mitra deals with a much more difficult question - in a dynamic context how does one derive a welfare index (reflecting well being of current and future generations) from current investment activities, when one takes into account considerations like the effect of exhaustible, non- exhaustible resources, as well as the effect on the environmental factors (on sustainable development). The theme of their joint paper is that "sustainable development requires policies that ensure for future generations at least the same level of welfare as that of the current generation. The question is particularly important in the context of consumption of non-renewable resources. A competitive programme, for which the Net National Product (NNP) is an exact measure of current and future welfare, does lead to sustainable development if and only if the value of investment, net of the depreciation of non-renewable resources, is never negative".

To develop the sustainability conditions the authors use M. L. Weitzman's 1976 famous paper "on the welfare significance of national product in a dynamic economy", as well as 1997 paper "sustainability and technical progress", as the benchmark. Since the economic well being of a nation is measured by the present discounted value of current and future utilities, it is the NNP, as the sum of the value of net current investment and current consumption, which "provides a precise measure of the present discounted value of current and future utilities". This would imply that current investment, by adding to future consumption via enlarged future output, also at the same time adds to future utilities, and as a consequence "the current value of net investment should turn out to be such an accurate proxy for the present discounted value of future utilities". If current net investment is to have any welfare significance in a situation involving consumption of exhaustible (non-renewable) resources (like mineral resources), the concept of investment needs to be more broadened, to include not only changes in the value of stocks of producible capital goods, but should also include changes in any stock (like exhaustible resources) which affects production. Hence for sustainable development, producible capital goods must be augmented at a rate that is sufficient to offset the depletion of non-producible capital goods so that the aggregate value of net investment never becomes negative at any point of time. This condition is mathematically derived by using a dynamic programming (optimisation) model.

The next section deals with developmental issues with two papers; the first is the time old problem of the operation of wage goods constraint and the demand constraint, in the interaction between agriculture and industry in LDCs. The contributor is Amitabh Krishna Dutta of the University of Notre Dame; the second paper, contributed jointly by Sugata Marjit (JNU), Udo Broll (Munich), and Sarbajit Sengupta (ViswaBharati), deals with the wage gap in LDCs resulting from the operation of free international trade.

The study of the interaction between agriculture and industry has a long history in economics, starting with the physiocrats in the 18th Century (around the 1750s). What makes Dutta's model different from the other models (Ricardo, Lewis, Kaldor, Kalecki, Taylor, Rakshit etc.) is that he develops mathematically, a framework using a dynamic setting (the synthesis models), which could handle simultaneously both the demand constraint and the supply constraint (the wage goods constraint if agriculture is stagnant) originating from the agricultural sector and putting a brake on the industrial sector, during the process of capital accumulation in both the sectors. Such a framework can also be used to handle inflationary situation and money wage dynamics during the process of development. The authors also have two distinct models dealing with the two constraints separately. Though the synthesis models are more difficult to handle, they nevertheless have contemporary relevance in developing countries like India. The models could have been extended to cover free movements of agricultural goods and labour across national boundaries. I am sure the synthesis models would have given a few more interesting results.

The second paper on development by Marjit, Broll, Sengupta (MBS) deals with international trade and the wage gap between skilled and unskilled labour in LDCs. The question they have analysed is - does free trade increase or decrease the skilled and unskilled wage gap in developing countries? If developed countries' exports are skill intensive while developing countries' are unskilled intensive (not always so), should not the wag gap be reduced with the expansion of trade? This is what the prediction would be if the logic of the Heckscher-Ohlin and Stolper-Samuelson trade models hold in every trading country. The actual outcome is just the opposite. The MBS paper attempts to explain the why of it in terms of general equilibrium framework. They find the explanation in the existence of a very large informal sector not only in the rural sector but also in the urban sector, irrespective of whether they deal with traded goods or non-traded goods. The methodology used is comparative static, a framework very popular with trade theorists. The authors point out two areas where further research can be done - (a) developing a vertical relationship between informal and formal sectors; (b) allowing foreign capital inflows in the MBS models and examining the effect on the wage gap.

The next section is on economic dynamics, with two papers; one by Dipankar Dasgupta (ISI and Osaka) on new growth theories; and the other by Tapan Mitra (Cornell) dealing with the theory of optimal growth. Both the papers traverse the most difficult terrain of economics. Dipankar Dasgupta analyses the various results of endogenous growth models (New Growth Theories) by using the familiar Marshallian demand-supply framework. The general reader may be keen to know what constitutes a theory of growth! Well, in the words of Dasgupta, "A Theory of Growth is concerned with an explanation of the manner in which real macro economic variables, such as output, consumption, capital stock, labour force, technology, the general price level, the real rate of interest (real rental on capital), etc., behave over time."

Of particular interest to Dasgupta is the steady state growth rate or balanced growth rate, where the relevant variables grow at a constant rate over time. Using the demand-supply model, the author tries to focus on the equilibrium balanced growth path. He defines such a path as the rate at which the economy wishes to grow. The economy's capability to grow defines the supply rate of growth, while the economy's wishes to grow defines the demand rate of growth. The equilibrium rate of growth equates the demand rate with the supply rate.

This 50-page article by Dasgupta covers most of the essential grounds of the existing growth models (old as well as new). The readers will find growth models of R. Solow (where increase in labour productivity comes from unknown exogenous sources like technical progress); K. Arrow (emphasising learning by "linking technical progress to the process of capital accumulation itself"); S. Rebelo (where linearity in the technology used in one sector - human capital formation - offsets any tendency for diminishing returns - physical capital formation - in another sector); R. E. Lucas, S. Rebelo, H. Uzawa (where output depends not only on physical capital but also on human capital - households make conscious attempt to improve skill); P. M. Romer (where the source of economic growth lies in the accumulation of human capital - by means of human capital only, hence "a minimum size of human capital is a necessary pre-condition for growth"); P. Aghion and P. Howitt (where obsolescence caused by the threat of new research has detrimental effects on private investment on existing research); R. Barro (where public sector services are considered to be inputs into the growth process). Readers will find the various sections of Dasgupta's paper reflecting on the relative expected performance of command economy vs. private market economy as quite rewarding, including some of the policy implications for developing countries. Two limitations of NGT are the assumption of full employment, and the neglect of environmental considerations. I must say that the diagrams need lot of improvement in Dasgupta's article. There are some printing mistakes not only in this paper but in other papers also.

Tapan Mitra's paper deals with dynamic optimisation models and the associated relationship with optimal policy functions. As an introductory course in macro economics for under-graduate students, this is going to be the toughest paper, unless one knows dynamic programming (optimisation techniques). The question is, does optimisation techniques adequately describe human behaviour? In other words, is observable behaviour pertaining to human actions rationalisable? Even with so much progress in mathematical economics this is not always possible. This is in spite of continuity and differentiability conditions being fulfilled for the policy functions. A chaotic policy function can also be accommodated under dynamic optimisation programmes. For this, some additional restrictions must be placed on the inter- temporal discount factor. Mitra gets more definitive results in his later articles.

The next section has two papers on finance with contributions by Sudipto Dasgupta (Hong Kong) and Bhaswar Moitra (ISI, Delhi). The first article explores the relationship between the mode of financing used by a firm and its behaviour in the product market. Dasgupta shows that the Brander-Lewis result that debt financing by oligopolistic firms leads to larger output being supplied in the product market, is questionable. It all depends on the nature of uncertainty faced by the oligopoly firms when leverage increases. According to the editors of this volume, "Dasgupta questions the robustness of the Brander-Lewis result, which studies firms engaged in Cournot competition. In particular, he shows that if firms choose prices rather than quantities, the effect of an increase in leverage depends on the nature of uncertainty. If there is demand uncertainty, the effect of increased leverage is to raise product prices, contrary to the Brander-Lewis result. If on the other hand, the uncertainty is with respect to cost, the effect on prices is reversed; they fall". There are many other interesting issues discussed in Dasgupta's paper which draws from the results of current research into the subject of mode of financing and the behaviour of firms with respect to the investment choice, quality of the product, market predation, future financing needs, leveraging buy-outs and leveraging re-capitalisation, bankruptcy and financial distress, leveraging and bi-lateral outcomes in factor and product markets. Students of economics will find this paper highly stimulating in terms of throwing up ideas for further research in firms' behaviour in a dynamic context.

The second paper of finance by Bhaswar Moitra (Jadavpur, Calcutta) deals with contract enforcement problems associated with sovereign debt. As the author says "if the borrower is outside the jurisdiction of the courts of the lender's country, then it becomes difficult (if not impossible) to enforce contracts through the legal mechanism. This is the distinctive feature of sovereign debt: the lender has no legal means of ensuring that contracts are not violated". Moitra tries to answer through his inter-temporal model the question, why then private lenders willingly lend to govts. of foreign countries, when the threat of default is very real (LDCs have a long history in it)? To avoid default by a particular nation, often "lenders move in packs, concentrating on certain regions of the globe. When one or more countries in a region default, there is a crisis of confidence and lenders begin to withdraw from the region. This leads to a domino effect, as country after country faces payment difficulties and re-negotiation of payments becomes the order of the day. Ultimately, lenders withdraw totally and do not return till the crisis is a distant event recorded in history books that the new generation of fund managers choose to ignore". To the question why a borrowing country tries to avoid default when default seems to be staring in the face, the author says "- the perceived cost of default is ultimately quite high. For countries that are fairly open to international trade, the loss of trade credits can be fairly expensive. There is also the fear that suspension of payments can lead to a drop in the level of support that the country receives from the international agencies and foreign aid agencies, together with a loss of support on foreign policy that smaller nations often need from major countries like the U.S. and its allies". Since default could arise due to misuse of the money borrowed, or due to some unforeseen events (like the sudden rise in oil price) Moitra develops a simple model to explore such possibilities where a debt crisis can occur. The remedial measures offered are debt forgiveness by creditors (in line with the Brady Plan) and collective lending to push back the day of reckoning.

The last section is on Institutional Economics, with two papers, one by Gautam Bose (New South Wales), and the second one by Bhaskar Dutta (ISI, Delhi). Institutional Economics deals with the "contextual device within which social and economic relationships are framed". It has both a positive as well as a normative aspect. The positive aspect deals with the effect of a given institutional framework (like the system of contracts and mode of implementation - the legal system, the constitution, social norms defined by customs and habits) on economic and social activities. The normative aspect deals with the appropriate design of an institutional arrangement to foster efficiency in economic and social relationships. Gautam Bose deals with the first aspect. The title of his paper is: "Dealers, Markets, and Exchanges: A Study of Intermediation". In an exchange economy, the trading institutions through which potential buyers and sellers are brought into contract affect production decisions, and economic welfare, by providing immediacy in exchange (reducing transaction costs) and by reducing search costs through screening and sorting (to weed out undesirable pairing of economic transactors - say pairing between impatient traders or between traders with inferior bargaining ability and stronger bargaining ability). Using a simplified model based on existing works of P. Diamond, H. Demsetz, S. Bhattacharya, K. Hagerty, A. Rubinstein M. Pingle, T. Gehrig, A. Yaavas, S. Moresy, M. Pagano and his own, Bose finds that in equilibrium all impatient traders trade on the floor (stock exchange) while all patient traders trade outside or over the counter; and the weaker agents would go to the formal trading center while the stronger ones would use "the decentralised bazaar" - a pair wise matching. Externalities generated by intermediation though recognised, are however ignored.

The next article by Bhaskar Dutta deals with modern theory of implementation - how various "social goals can be achieved or implemented through decentralised decision making procedures. Using a game theoretic structure, Dutta derives the conditions under which "a game form implements a particular set of social goals if its equilibrium correspondence coincides with the social choice correspondence". In a decentralised system, appropriate incentives will become necessary, so that individuals' private preferences coincide with social preferences. But that need not always happen. Dutta gives illustrations from public goods provisions, fair division problems in Walrasian allocations (dividing an inherited estate), and the voting problem. In order to get an efficient outcome in any planning exercise, the social choice correspondence to be implementable or not, depends on individuals' preference ordering satisfying the "preference reversal conditions" (which varies with the concept of equilibrium used to describe individual's behaviour) so that "socially inoptimal outcomes cannot be supported as equilibria". Dutta illustrates with three well constructed examples whether Nash equilibrium is implementable or not. Students of choice theory will find the paper highly rewarding.

The coverage of the volume is so wide ranging, that students intending to specialise on macro economics (particularly micro foundations of it), will find a plethora of ideas thrown up by the contributors to this commemorative collection, to honour one of the finest teachers of the subject in the Indian sub- continent. I must salute Oxford University Press for bringing out such volumes from time to time.

Contemporary Macro-Economics, edited by Amitabh Bose, Debraj Ray and Abhirup Sarkar, Oxford University Press, 2001, Rs. 595.