The Hindu Business Line : Hayekian approach: Lasting relevance for India

According to Hayek, if monetary tightening is undertaken after the upper turning point of the inflationary cycle is passed, the downturn is accelerated. This useful concept is, however, anathema to Indian policy-makers, whose main focus now is on spurring higher growth. But such measures will add to the suffering of the poor, says S. S. TARAPORE.

Friedrich August von Hayek (1899-1992)

When we in India consider the history of economic thought we often talk of Adam Smith, David Ricardo, John Stuart Mill and Alfred Marshall and invariably go no further. It would, therefore, be useful, in the context of the current macroeconomic policies, to briefly recapitulate some more recent developments in the history of economic thought.

Despite the fact that that Keynes’ General Theory was written over 70 years ago, we in India treat it as contemporary thought. What is more unfortunate is that most Indian economists are not appreciative of the roaring debate in the 1930s between the theories of Keynes and Hayek.

The absence of familiarity with the Hayekian approach is particularly unfortunate as it has great relevance to current macroeconomic policies in countries like India.

The basic Keynesian approach to the real sector cycle holds sway in the industrial countries but what is worrisome is that even in the emerging market economies (EMEs) the Keynesian approach is used to formulate macroeconomic policies. Keynes’ approach was that, starting from a downturn of the cycle, there is a glut of savings as compared with investment opportunities at the lower turning point of the cycle.

It is interesting that the US Fed Chairman, Ben Bernanke, the high priest of analysis of the Great Depression of 1929, holds the view that the present turmoil in the United States reflects a glut of savings and, therefore, it is advocated, rather aggressively, that like the US, other industrial countries should significantly ease monetary policy and also provide a fiscal stimulus. What is alarming is that the EMEs are, as part of international co-operation, expected to follow similar policies.

Multi-faceted scholar

Hayek was a multifaceted scholar, with monumental contributions in the fields of law, liberty and ethics. The young Hayek had made a lasting contribution to macroeconomic thought through his fundamental work on ‘Prices and Production (1929)’; this monumental work was difficult to follow, though it was published in English, as it was Germanic in thought and, therefore, not easily understood in Anglo-Saxon circles.

The Hayekian analysis deals with the upper turning point of the cycle. According to Hayek, during this phase of the cycle there is over-investment relative to savings. While the shortage of savings is made good via forced savings through injection of central bank created money, each successive round of production requires larger and larger injections of created money.

At some point, the central bank has to press the panic button — as inflation reaches intolerable levels — and with the deceleration or cessation of created money, there is a sharp downturn. In the Hayekian approach, any monetary tightening has to be undertaken well before the upper turning point. If such tightening is undertaken after the upper turning point of the cycle is passed, the downturn is accelerated.

Hayekian approach

John Hicks had postulated that it is desirable to creep along the ceiling of growth and to actively use monetary policy to ensure that the limit to growth is not exceeded. Neither the Hayekian approach nor Hicks’ recommendation is palatable to Indian policymakers and, hence, these theories have been totally banished from having any influence on Indian policymaking.

The concept of a limit to growth is anathema in India and we hum and haw when there is any reference to the economy growing beyond its potential. Incidentally, the top political leadership in China is unequivocal when it talks about overheating of the economy.

Hicks, in his Critical Essays in Monetary Theory (1967), has an insightful Chapter on “The Hayek Story”. While the Keynesian approach was appropriate for the 1930s, the Hayekian approach could be relevant at other times, particularly in developing countries. In the heat and dust of the Third and Fourth Indian Five Year Plans, no economist in India would have dared to espouse the Hayekian approach, and the few who did were banished into oblivion.

The distinguished Indian economist Dr V. K .R. V. Rao was of the opinion that to achieve full employment, the Keynesian prescription of deficit financing was not helpful to what were then called ‘under-developed” countries. Because of inelastic supply, deficit financing would increase prices.

Dr Rao argued that the particular form which unemployment takes in an under-developed country, viz. disguised unemployment, makes the economy, for Keynesian purposes, practically analogous with one of full employment and, to that extent, prevents the multiplier from working in the direction of an increase in either output or employment.

To achieve full employment the Keynesian prescription is not helpful in under-developed countries. Resort to deficit financing would merely result in inflation. He felt that the policy that would hold good in these countries was closer to the Classical theory — this was reflected in his slogan “Work harder and save more”.

Shift away from inflation control

It was this kind of thinking which put the fear of God into Indian policy-makers and Indian economists in the immediate post-World War II period, but the clear thinking of the 1940s and 1950s was soon forgotten, and the emphasis shifted from inflation control to growth. It is ironical that in the recent period there is a unanimous view that we in India should now go for higher growth and not worry too much about inflation.

It would, perhaps be useful if some percipient economists could spare the time to review the literature of bygone years. For starters economists would do well to peruse Dr V. K. R. V. Rao’s seminal article “ Investment, Income and the Money Multiplier in an Underdeveloped Economy”, Indian Economic Review, February 1952, Volume I.No.2 (Pages 55-67) and the papers of the Indian Economic Association Annual Conference,1954.

It is interesting that John Cunningham Wood’s book, Critical Assessment of Keynesian Economics (1983), discusses the pertinent work of Dr Rao. The work of Professor B. R. Shenoy also provides useful insights.

In the recent period we appear to have lost our heritage and now have an almost unanimous view that the answer to a slowdown in India is to actively put growth as a priority over control of inflation Despite our inflation rate of 8 per cent being significantly higher than in the major industrial countries we ape the industrial countries and have opened, widely, the monetary-fiscal spigots.

Such measures, inevitably, show up in an acceleration in inflation. Given that there are vast tracts of poverty in India, such measures would add to the suffering of the poor. As Prof P. R. Brahmananda said: “Not caring about inflation is like going into battle without caring for the wounded, the dying and the dead”. It is pathetic.

(The author is an economist. blfeedback@thehindu.co.in)