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The Politics of 'Sound Finance'

With the retreat of Keynesianism in the advanced industrial economies and the Fund-Bank backing a whole array of financial market friendly policies, including those based on the principle of sound finance, the United Progressive Alliance government is falling in line by being overly concerned about the perception of private foreign investors. In this context one needs to consider what strategic interests are being served by the implementation of the Fiscal Responsibility and Budget Management Act.

The Politics of ‘Sound Finance’

With the retreat of Keynesianism in the advanced industrial economies and the Fund-Bank backing a whole array of financial market friendly policies, including those based on the principle of sound finance, the United Progressive Alliance government is falling in line by being overly concerned about the perception of private foreign investors. In this context one needs to consider what strategic interests are being served by the implementation of the Fiscal Responsibility and Budget Management Act.


I The Retreat of Keynesianism

he climate of opinion in almost all the advanced industrial countries of Europe has turned decisively by now against the Keynesian style of demand management in pursuit of contra-cyclical stabilisation and the high employment objective. In the US its acceptance had always been less enthusiastic, and the doctrine lost intellectual respectability even more easily. The process began in the late 1960s, and a decisive turning point came with the “stagflation” of the 1970s following the two oil shocks. Nevertheless, such dramatic changes in the intellectual climate seldom have a single cause. In this case, three reasons come immediately to mind. First, the Keynesian argument was almost selfconsciously set in the context of an economy closed to international trade and capital flows. The intention might have been to emphasise the importance of domestically oriented economic policies for fighting unemployment. After all, the disastrous consequences of “beggar-my-neighbour” policies of trying to export unemployment through competitive devaluation of the national currencies during the inter-war period was still fresh in memory, while the prestige of the City of London for propounding the virtues of “sound finance” was in ruins [Bhaduri and Steindl 1985]. It was rather natural in that context to look inward for a domestic solution to the problem of unemployment. However, the global setting changed vastly by 1970s. Not only had the volume of international trade grown, but also even more significantly the “dollar standard” agreed at the Bretton Woods had collapsed to usher in a new regime of flexible exchange rates and deregulation of capital accounts. It was easy to claim in these circumstances that the Keynesian theory is outdated.

Secondly, although the arms race was the most visible aspect of the contest between the competing systems of capitalism and socialism in the cold war years, its ideological dimension was rooted in economics. The socialist system appeared capable of providing full employment through deliberate state policies, although much of it was neither satisfactory to the employees nor socially gainful. (A common joke of the time in these countries was, “they pretend to pay, we pretend to work”.) In the capitalist market economies the level of employment depended largely on the decision of private business with an opposite problem. The employment it provided had to be necessarily gainful to the private employer irrespective of whether private and social gain differed. However, the level of economic activity was prone to cyclical fluctuations, at times resulting in severe and persistent unemployment. Given this visible difference in the performance of the two systems in terms of employment, initiatives like the Marshall Plan were influenced by the economic competition between the two systems [Hobsbawm 1994]. It was also around this time of post-war reconstruction that the welfare state found wider political acceptance with its theoretical rationale provided by Keynesian demand management doctrine. And, over time under this new style of economic governance with a rising real wage at near-full employment, leading to a rapidly improving standard of living for the working population, most western democracies could be posed as a counter-challenge to the socialist ideology.

Thirdly, there was also an ironical side to it. The very success of Keynesian demand management with high employment and rising mass consumption, which had ushered in a “golden age” of welfare capitalism, came to be troubled by its own success [Marglin and Schor 1990]. Years of high employment had reduced the fear of job-loss for the workers, and increased workers’ wage claims. Against this background, the experiences of the two major oil price shocks of the 1970s made it clear that the burden of such shocks could not be passed on easily to the workers. The model of cooperative capitalism of the welfare state was giving away to the model of conflictive capitalism, in which conflict over the distribution of income tended to manifest itself through inflationary or stagflationary price rise. Even more problematically, the tax policy of the state itself got entangled in this distributive conflict, as both the workers and their employers tended to pass on the additional tax burden to one another. Understandably, targeting inflation rather than unemployment became the new battle cry of economic policies. New economic doctrines, at times reviving old ideas that had been pushed aside by the success of Keynesian economic policies, returned in academic circles and policy discussions under the broad heading of monetarism. A central idea was the “natural rate” of unemployment [Friedman 1968], or its modified version of the non-accelerating inflation rate of unemployment (NAIRU). The underlying common message of these theoretical constructions was that, keeping inflation and inflationary expectations under control requires accepting a certain, at times fairly high rate of unemployment. In particular, it requires giving up demand management policies intended at keeping the rate of unemployment lower than that “natural” or NAIRU rate.

The new terminology of monetarism revived in a way the Marxian idea that a “reserve army of labour” is needed to keep a check on the real wage. Kalecki (1943, reprinted in 1971) had already made use of a similar idea towards the end of the second world war to predict that in order to keep control over the workers, “political trade cycles” would be imposed deliberately in the name of sound finance (read, no deficit financing) to inflict unemployment from time to time. Since deficit financing by the government is the most potent instrument for demand management, unsurprisingly it came under special attack. The doctrine of the virtues of a balanced budget, and the evils of a fiscal deficit by a self-seeking government were propounded in the name of “public choice theory” as general truths, applicable to almost all countries under all circumstances. The International Monetary Fund (IMF) and the World Bank, known for their adherence to economic doctrines that restrain the economic role of the government, predictably found “sound finance” a particularly welcome idea to impose on developing countries.

Economic and Political Weekly November 4, 2006

The emerging policy perspective directed against Keynesian welfare statism was embedded in a wider process of globalisation that had been going on mostly through gradual expansion in post-war international trade. However, it gathered irresistible momentum with successive waves of deregulation of the national capital markets since mid-1970s in OECD countries. These two aspects of greater economic openness due to globalisation, in trade and in finance, undermined Keynesianism in different ways.

The greater economic opening up in goods and services trade means an increase in the relative importance of the foreign or external market compared to the domestic or internal market. Stimulation of demand through an export surplus rather than fiscal policies requires each country to be more price competitive compared to its rivals, by cutting unit cost through measures like wage restraint, flexibility in labour contracts, and higher labour productivity through downsizing the labour force. And yet, there are obvious “fallacies of composition” in this strategy. First, all countries cannot achieve an export surplus at the same time. Even if a particular country manages to achieve an export surplus in this international zero sum game, such policies may still turn out to be counterproductive, if the contraction in the size of its internal market more than outweighs the expansion of its external market. Wage restraint would depress consumption by the working people, while labour productivity growth brought about by the corporations through the downsizing of the labour force reinforces this depressive effect. The overall consequence might turn out to be a decrease in the size of the domestic market despite an increase in the external market through an export surplus in the wage-led regime, in which, the depressive effect on consumption of the wage restraint and downsizing outweigh its possible stimulating effect on investment and export [Bhaduri and Marglin 1990].

The second aspect of openness resulting from financial deregulation of capital markets since the mid-1970s increased phenomenally the volume of private trade in foreign exchange. In comparison to its daily volume of some 1.2 trillion dollars, the total foreign exchange reserve of all the central banks together barely amount to a couple of days’ volume of private trade. Foreign trade and investment together do not account for even 4 per cent. In formulating their economic policies, national governments can no longer ignore the sentiments of the private traders in the financial markets. Since expansionary fiscal policies for fighting unemployment through a budget deficit, or higher taxes on the rich to expand government programmes are generally not favoured by financial markets; instead regressive tax cuts, stimulation of the stock and real estate market through monetary or tax policies are seen as preferred options for managing demand. Politically it makes a mockery of the original Keynesian and social democratic vision of cooperative capitalism, in which a neutral state is supposed to follow more even-handed policies towards capital and labour. The typical consequences of abiding by the sentiments of the financial market have been over-sensitivity to inflation and a tight money policy to discourage capital outflows through insistence on greater independence of the central bank, and most importantly, a near-paralysis of expansionary fiscal

The First Ten K R Narayanan Orations

Essays by Eminent Persons on the Rapidly Transforming Indian Economy

Raghbendra Jha (editor)

The rapidly transforming Indian economy has thrown up a number of possibilities as well as several challenges with profound implications for India’s vast population as well as globally. The K R Narayanan Oration Series at the Australia South Asia Research Centre in The Australian National University has been devoted to in-depth examination of this important issue by leading experts. The present volume collects the first ten essays in this series. Contributors include Dr Raja Chelliah, Dr U R Rao, Prof. Jagdish Bhagwati, Mr P. Chidambaram, Dr C. Rangarajan, Lord Meghnad Desai, Prof. Pranab Bardhan, Dr Vijay Kelkar, Dr M S Swaminathan, and Dr K. Kasturirangan. The essays cover a broad array of topics from various aspects of economic reforms, the political economy of India’s development, the role of agriculture in India’s food security and the role of space research in India’s economic development. His Excellency Dr Narayanan and his successor as President of India, His Excellency Dr A.P.J. Abdul Kalam, have provided introductory messages to the orations.

First published in September 2006 by ANU E Press, Canberra. $A19.95 + post&handling ($A10 for 1 or $A15 for 2), ISBN 1 920942 71 8 (Print version); ISBN 1 920942 72 6 (Online document)

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Economic and Political Weekly November 4, 2006

policies through higher government expenditure under the false pretence that wage restraint, labour market flexibility and labour training can substitute for demand management policies.

The Indian Case

What goes under the names of IMF“conditionalities” and the Washington“consensus” bears unmistakable resemblance to the array of financial marketfriendly policies mentioned above. Notsurprisingly, the IMF and the WorldBank as leaders of multinational banks and financial institutions encouragedeveloping countries to pursue thesepolicies under normal circumstances.And, when developing countries inbalance of payments difficulties turn tothem for assistance, these policies areimposed. Viewed from this angle, theFiscal Responsibility and Budget Management (FRBM) Act of 2003 has implications that might have been less obvious at first sight. Note that the act wasnot crisis-driven, but strategy-driven. Itwas enacted at a time when the Indian economy was not facing in any particular international payments crisis; insteadour foreign exchange position was comfortable and the stock market was booming. So we need to consider what strategic interests of the Indian economywould be served by this act.

The act, by crippling governmentaction certainly does not serve the interests of the poorer section of the Indianpopulation. It is a cruel joke in the presentIndian context to talk of intertemporaloptimal choice involving successivefuture generations when about half ofour children remain undernourished, with India heading in the 21st centuryas the country with the highest numberof illiterates and homeless. By virtue ofthis act, directly the central and indirectly the state governments are restrained from spending in social sectorslike basic education and health. In particular, it starves the recent Rural Employment Guarantee Act, constrainseven minimal social security in theunorganised sector, all justified underthe banner that the government has nomoney! It is simply anti-poor in the nameof financial prudence. This is particularlyunfortunate at a time when the excess demand from higher government spending can be met to a significant extentthrough utilisation of existing excesscapacity in many of the critical construction materials and wage goodssectors, and a comfortable reserve of foreign exchange has accumulated tosmooth over particular supply-sidebottlenecks. The standard Keynesianargument has a very good chance of succeeding in rural India in these circumstances in expanding productiveemployment. However, this cannot happen unless government spending isgenuinely decentralised by giving financial autonomy to the gram sabhas todecide on the local investments, and panchayats to execute the spending.For this purpose the nationalised banking system can provide support undergreater transparency of the Right toInformation Act [Bhaduri 2005]. Yet,almost no serious initiative is in sightexcept tall political talk; instead, we hearof road maps for liberalising the capitalaccount, special economic zones,privatisation of basic services in thename of public-private partnerships, andrestricting the scope of the Right toInformation Act.

Even in a hypothetical scenario notfavourable to employment expansion,greater spending would lead to someincrease in prices. Mostly wage goodsprices would increase. In effect, however, it means a redistribution of income in favour of the poorest sections amongthe unemployed who starve today without an employment guarantee schemefrom the rest of the society. Should notthe government try to strengthen anddecentralise the public distribution system in rural areas, giving more teeth tothe Right to Information Act? What weare seeing instead is that, both the centraland the state governments are undulycautious in expanding the employmentguarantee scheme for the poorest. Sowe must return to the question: what isthe economic strategy behind this act,enthusiasm about which is shared bythis and the previous coalition government?

The imprint of rising financial interests on India’s development strategyhas been unmistakable in recent years.While economic policies are increasingly being formulated as never beforewith a view to the sentiments of the financial markets, the dominant Englishlanguage media shape Indian middleclass opinion, behave as if the dailyfluctuations of the stock market are the barometer to judge the health of the realeconomy. Since the Indian stock marketis pathetically small in relation to thevast global trade in foreign exchange,the rupee and Indian stocks can easilybe set into an uncontrollable downward spiral by a few large international players speculating against some Indianstocks or the rupee, while the increasingquantitative importance (about 52 per centof inflows) of anonymous “participationnotes” (PN) might leave the origin ofsuch a crisis unnamed.

Things have been gradually developing in this direction over several yearsunder the guise of economic reforms. Itis no longer about dismantling the police inspector raj, or improving the efficiency of the public sector. Indeed,one of the factors behind the drive to privatise public enterprises and publicprovision of basic services has been togenerate the resources to narrow thefiscal deficit. Clearly, the game haschanged. Recall how the Dalal Streetnose-dived immediately after the 2004general elections results, because a fewlarge, mostly foreign institutional investors began to withdraw from the Indiancapital market under the fear that a coalition government supported by the Leftwill be unfriendly towards private businesses. However, as soon as the United Progressive Alliance government namedits top economic team, a trio of the primeminister, the finance minister and the deputy chairman of the Planning Commission, all known for their extreme promarket, pro-finance and pro-corporationoutlook, the stock markets began tostabilise in no time. Nothing hadchanged about the ground realities ofthe Indian economy in those few weeks,except international finance capitalneeded assuring political signals. In theprocess, the future course of economicpolicies for the country got set.

The confidence that the team of economic policy-makers enjoy with the IMFand the World Bank is a critical part ofthe story, because those two institutions are in a pivotal position to influence the perception of private foreigninvestors like multinational corporations,banks and other financial institutions. This is the name of the game that isbeing played under the name of sound




Bhaduri, A (2005): Development with Dignity, National Book Trust, New Delhi.

Bhaduri, A and J Steindl (1985): ‘The Rise of Monetarism as a Social Doctrine’ in P Arestis and T Skouras (eds), Post-Keynesian Economic Theory, Wheatsheaf, Sussex, pp 24-56.

Bhaduri, A and S Marglin (1990): ‘Unemployment and the Real Wage: The Economic Basis of Contesting Political Ideologies’, Cambridge Journal of Economics, 14, pp 375-93.

Friedman, M (1968): ‘The Role of Monetary Policy’, American Economic Review, 58, pp 1-17

Hobsbawm, E (1994): The Age of Extremes: A History of the World, 1914-1991, Pantheon Books, New York.

Kalecki, M (1971): ‘Political Aspects of Full Employment’ in his Selected Essays in the Dynamics of the Capitalist Economy, Cambridge University Press, Cambridge.

Marglin, S and J Schor (1990): The Golden Age of Capitalism, Clarendon Press, Oxford.

Economic and Political Weekly November 4, 2006

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