The Hindu Business Line : Now for a four-in-one economic theory

ECONOMIC debates have tended to focus on the relevance and obsolescence of economic theories and their protagonists. Theories have been debunked when conditions do not support their tenets (just as the phenomenon of stagflation in the early 1970s following the first oil shock relegated Keynesian economics to the sidelines). How relevant really are economic theories? Are they practical solutions or mere fancy theoretical constructs?

Alfred Marshall's principles of micro-economics surrounding demand-supply dynamics, marginal utility, costing, diminishing returns etc are accepted by all. The issue is more with macro-economic theory, which seeks to find macro solutions to economic travails based on certain principles.

All theories are applied under varying economic conditions, and since globalisation talks of one world, logically, all of them have a role to play. More important, just as one size cannot fit all, there is perhaps no single theory which can serve as a panacea to all economic problems.

Keynesian work has been trivialised as being Economics of the depression. But governments do spend a lot on `non-development purposes' to generate income and spending power, with two outstanding cases being those of India and the US. India's deficits run close to 10 per cent of GDP, while for the US the figure is in the region of 4 per cent of GDP. The US came out of the recession a year back thanks to tax refunds, which was again what Keynes had suggested as an alternative to government spending.

Our own subsidy and interest payments are actually helping to keep the economy moving by providing spending power. Therefore, Keynesian economics is still relevant for countries trying to get out of a recession.

In fact, Keynesian economics is even more sharply manifested in the US twin-deficit syndrome. The US spends more than it produces. This has given rise to high fiscal and current account deficits with rising imports. Higher imports have brought East Asia, Japan and China on a high growth trajectory, as their exports and GDP have risen.

The current account surplus of these exporting nations are curiously mostly re-invested in Fed bonds, which support the higher fiscal deficits of the US. Hence, by taking on the role of the anchor country/currency, excess spending a la Keynes has provided the `big push' to the rest of the world.

At the same time, the Federal Reserve chief, Mr Alan Greenspan, has started raising the interest rates to ensure that future inflation does not arise from excess deficits and spending led-growth. This is monetarism, where the central bank controls the growth in money supply to check demand-pull inflation.

The rise in the CRR announced by Reserve Bank of India governor, Dr Y.V. Reddy, in October was a monetarist move to check inflation on the demand side as the supply-side factor was outside the RBI's purview. So, monetarism is also alive today in a very big way and coexists with Keynesian thoughts.

Governments world over drive for lower tax rates on the assumption that lower tax rates lead to higher tax collections with better compliance. This is the famous Laffer Curve hypothesis within the realm of supply side Economics. The rationalisation of tax rates and duties to 5-10 per cent levels is a manifestation of this thought process even in India. The Rational Expectations theory of Robert Lucas and Thomas Sarjent did give a new twist to economic theory in the 1980s by coming up with radical tenets.

It said that governments should not systematically fool the public by continuously changing policy variables (Keynesian fine-tuning). They should set targets, sit back and watch the market mechanism do the rest. The Euro zone is a vindication of this theory where targets have been set for all the nations in terms of inflation and deficits. Policies change only when the boundaries are transgressed; so all economic agents know that governments will not or will raise taxes in case certain economic conditions materialise. In fact, the rules `rather than discretion' approach brought Finn E. Kydland and Edward C. Prescott closer to winning the Nobel Prize last year.

Therefore, it can be seen that all economic theories have their place in policy formulation as they are based on certain assumptions about the prevailing economic environment. If there is less than full employment, then Keynesian prescriptions work while monetarism makes sense when inflation is a worry on the demand side, even though it would be impotent if it is a supply side phenomenon.

When governments are rigorously bound by economic limits, the rational expectations tenets hold. Supply side fundamentals work when markets are efficient.

And above all, almost all countries have gravitated to free market economics, and while Adam Smith's invisible hand was the first word in economics, it has now also been accepted as the last one.

(The author is Chief Economist, NCDEX Ltd)

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