Milton Friedman: A Joke and Some Serious Stuff

One day an economist looked up and saw a little girl being attacked by a vicious dog, just down the street. He rushed over and saved the girl by strangling the dog.

A reporter interviews him and says, “Sir, this is a wonderful thing you have done. Did you say you are an economist?”

“Yes, I am,” says the economist.

“Very good, sir,” says the reporter, “this will be our lead story tomorrow, and the headline will be ‘Radical libertarian economist saves little girl from vicious dog.

“Well, I’m not that radical,” says the economist. “I’m really more of a classical liberal.”

The reporter scratches his head and says, “Well, we’ll come up with something. Whose views would you say you are closest to?”

“Oh, I suppose it would be Milton Friedman,” says the economist.

Next day, the economist buys the paper. Across the front page is splashed: “CHICAGOITE KILLS FAMILY PET!”

[Source: Mises.org]

Milton Friedman, economist, died at the age of 94 on Nov 16th. To note the passing of that intellectual giant of the 20th century, here are a couple of extracts from an address by him titled “ECONOMIC FREEDOM, HUMAN FREEDOM, POLITICAL FREEDOM” delivered on Nov 8th, 2002.

In addition to economic freedom, Hong Kong has a great deal of human freedom. I have visited many times and I have never seen any evidence of suppression of freedom of speech, freedom of the press, or any other human freedom that we regard as important.

However, in one respect Hong Kong has no freedom whatsoever. It has no political freedom. The Chinese who fled to Hong Kong were not free people. They were refugees from the communist regime and they themselves had been citizens of a regime that was very far from a free society. They did not choose freedom; it was imposed on them. It was imposed on them by outside forces. Hong Kong was governed by officials of the British Colonial Office, not by selfchosen representatives. In the past couple of years, in trying to persuade the world that Britain has not done a dastardly deed in turning Hong Kong over to the communists, the British administration has tried to institute a legislative council and to give some evidence of political representation. However, in general, over the whole of that period, there has been essentially no direct political representa tion.

That brings out an enormous paradox, the one that as I said caused me to rethink the relationship among different kinds of freedom. The British colonies that were given their political freedom after World War II have for the most part destroyed the other freedoms. Similarly, at the very time officials of the British Colonial Office were imposing economic freedom on Hong Kong, at home in Britain a socialist government was imposing socialism on Britain. Perhaps they sent the backward people out to Hong Kong to get rid of them. It shows how complex the relationship is between economic freedom and political freedom, and human freedom and political freedom. Indeed, it suggests that while economic freedom facilitates political freedom, political freedom, once established, has a tendency to destroy economic freedom.

Consider the example that I believe is most fascinating, India. It was given its political freedom by Britain over forty years ago. It has continued, with rare exceptions, to be a political democracy. It has continued to be a country where people are governed by representatives chosen at the ballot box, but it has had very little economic freedom and very limited human freedom. On the economic side, it has had extensive controls over exports and imports, over foreign exchange, over prices, over wages. There have been some reforms in the past year or so, but until recently you could not establish any kind of enterprise without getting a license from the government. The effect of such centralized control of the economy has been that the standard of life for the great bulk of the Indians is no higher today than it was forty years ago when India was given its political freedom.

The situation is even more extreme if you consider that Hong Kong, which I started with, got zero foreign aid during its growth. India has been a major recipient; it got some $55 billion of foreign aid over the past forty years. It is tempting to say that India failed to grow despite foreign aid. I believe that it was the other way: in part, India failed to grow because of foreign aid. Foreign aid provided the resources that enabled the government to impose the kind of economic policies it did.

What is true for India is true much more broadly. Foreign aid has done far more harm to the countries we have given it to than it has done good. Why? Because in every case, foreign aid has strengthened governments that were already too powerful. Mozambique, Tanzania, and many another African country testify to the same effect as India.

To come back to Hong Kong, the only reason it did not get its political freedom is because the local people did not want political freedom. They knew very well that that meant the Chinese communists would take them over. In a curious way, the existence of the Chinese communist government was the major protection of the economic and human freedoms that Hong Kong enjoyed. Quite a paradoxical situation.

Hong Kong is by no means unique. Wherever the market plays a significant role, whether you have political freedom or not, human freedoms are more widespread and more extensive than where the market does not play any role. The totalitarian countries completely suppressed the market and also had the least human freedom.

[Emphasis added.]

It just makes one wonder: it is easier to achieve political freedom than to achieve economic freedom, as is clear in India’s case. Here’s more from Friedman. Note especially that markets can be free, not just private.

In order to understand the paradox that economic freedom produces political freedom but political freedom may destroy economic freedom, it is important to recognize that free private markets have a far broader meaning than the usual restriction to narrowly economic transactions. Literally, a market is simply a place where people meet, where people get together to make deals with one another. Every country has a market. At its most extreme totalitarian stage Russia had a market. But there are different kinds of markets. A private market is one in which the people making deals are making them either on their own behalf or as agents for identifiable individuals rather than as agents of governments. In the Russian market, the market existed and deals were being made all over the lot, but people were dealing with one another not on their own behalf, not as representatives for other identifiable individuals, but supposedly as agents for the government, for the public at large. A private market is very different from a government market. In a strictly private market, all the deals are between individuals acting in their own interest or as agents for other identifiable individuals.

Finally, you can have a private market, but it may or may not be a free market. The question is whether all the deals are strictly voluntary. In a free private market, all the deals are strictly voluntary. Many of the cases of private markets that I cited before were not cases of free private markets. You have a private market in many of the Latin American countries, but they are not free private markets. You have a private market in India, but it is not a free private market because many voluntary deals are not permitted. An individual can deal with anotherto exchange a good or service only if he has the permission of the government. I may say a completely free private market exists nowhere in the world. Hong Kong is perhaps the closest approximation to it. However, almost everywhere what you have, at best, is a partly free, largely hampered, private market.

A free private market is a mechanism for achieving voluntary cooperation among people. It applies to any human activity, not simply to economic transactions. We are speaking a language. Where did that language come from? Did some government entity construct the language and instruct people to use it? Was there some government commission that developed the rules of grammar? No, the language we speak developed through a free private market. People communicated with one another, they wanted to talk with one another, the words they used gradually came to be one thing rather than another, and the grammar came to be one thing rather than another entirely as a result of free voluntary exchange.

Take another example, science. How did we develop the complicated structure of physics, economics, what will you? Again, it was developed and continues to develop as a result of a free private market in which scientists communicate with one another, exchange information with one another, because both parties to any exchange want to benefit.

A characteristic feature of a free private market is that all parties to a transaction believe that they are going to be better off by that transaction. It is not a zero sum game in which some can benefit only at the expense of others. It is a situation in which everybody thinks he is going to be better off.

A free private market is a mechanism for enabling a complex structure of cooperation to arise as an unintended consequence of Adam Smith’s invisible hand, without any deliberate design. A free private market involves the absence of coercion. People deal with one another voluntarily, not because somebody tells them to or forces them to. It does not follow that the people who engage in these deals like one another, or know one another, or have any interest in one another. They may hate one another. Everyone of us, everyday without recognizing it, engages in deals with people all over the world whom we do not know and who do not know us. No super planning agency is telling them to produce something for us. They may be of a different religion, a different color, a different race. The farmer who grows wheat is not interested in whether it is going to be bought by somebody who is black or white, somebody who is Catholic or Protestant; and the person who buys the wheat is not concerned about whether the person who grew it was white or black, Catholic or Protestant. So the essence of a free private market is that it is a situation in which everybody deals with one another because he or she believes he or she will be better off.

The essence of human freedom as of a free private market, is freedom of people to make their own decisions so long as they do not prevent anybody else from doing the same thing. That makes clear, l think, why free private markets are so closely related to human freedom. It is the only mechanism that permits a complex interrelated society to be organized from the bottom up rather than the top down. However, it also makes clear why free societies are so rare. Free societies restrain power. They make it very hard for bad people to do harm, but they also make it very hard for good people to do good. Implicitly or explicitly, most opponents of freedom believe that they know what is good for other people better than other people know for themselves, and they want the power to make people do what is really good for them.

The recent absolutely remarkable phenomenon of the collapse of communism in Eastern Europe raises in acute form the issues that we have been discussing. There is much talk in those countries about moving to a free market, but so far very limited success. In the past, free markets have developed in all sorts of ways out of feudalism, out of military juntas, out of autocracy and mostly they have developed by accident rather than by design. It was a pure accident that Hong Kong achieved a free market. Insofar as anyone designed it, it was the colonial officials who were sent there; but it was a pure accident that they were favorable to, or at least not hostile to, a free market. It was an accident that a free market developed in the United States, nothing natural about it. We might very well have gone down a very different road. We started to go down a very different road in the 1830s when there was widespread governmental activity in the building of canals, in the building of toll ways, and the taking over of banks there were state banks in Ohio, Illinois, and so on. What happened is that in the Panic of 1837 they all went broke, and that destroyed people’s belief that the way to run a country was by government. That had a great deal to do with the subsequent widespread belief that small government was the best government.

While free societies have developed by accident in many different ways, there is so far no example of a totalitarian country that has successfully converted to a free society. That is why what is going on in Eastern Europe is so exciting. We are witnessing something that we have not seen before. We know and they know what needs to be done. It is very simple. I tell the people in Eastern Europe when I see them that I can tell them what to do in three words: privatize, privatize, privatize. The problem is to have the political will to do so, and to do so promptly. It is going to be exciting to see whether they can do so.

However, the point that impresses me now and that I want to emphasize is that the problem is not only for them but for us. They have as much to teach us as we have to teach them. What was their problem under communism? Too big, too intrusive, too powerful a government. I ask you, what is our problem in the United States today? We have a relatively free system. This is a great country and has a great deal of freedom, but we are losing our freedom. We are living on our capital in considerable measure. This country was built up during 150 years and more in which government played a very small role. As late as 1929, total government spending in the United States never exceeded about 12% of the national incomeabout the same fraction as in Hong Kong in recent years. Federal government spending was about 3 to 4% of the national income except at the time of the Civil War and World War I. Half of that went for the military and half for everything else. State and local governments spent about twice as much. Again, local governments spent more than state governments. In the period between then and now, the situation has changed drastically. Total government spending, as I said, is 43% of national income, and two-thirds of that is federal.

Moreover, in addition to what government spends directly, it exercises extensive control over the deals that people can make in the private market. It prevents you from buying sugar in the cheapest market; it forces you to pay twice the world price for sugar. It forces enterprises to meet all sorts of requirements about wages, hours, anti-pollution standards, and so on and on. Many of these may be good, but they are government dictation of how the resources shall be used. To put it in one word that should be familiar to us by now, it is socialist.

The United States today is more than 50% socialist in terms of the fraction of our resources that are controlled by the government. Fortunately, socialism is so inefficient that it does not control 50% of our lives. Fortunately, most of that is wasted. People worry about government waste; I don’t. I just shudder at what would happen to freedom in this country if the government were efficient in spending our money. The really fascinating thing is that our private sector has been so effective, so efficient, that it has been able to produce a standard of life that is the envy of the rest of the world on the basis of less than half the resources available to all of us.

The major problems that face this country all derive from too much socialism. If you consider our educational system at the elementary and secondary level, government spending per pupil has more than tripled over the past thirty years in real terms after allowing for inflation, yet test scores keep declining, dropout rates are high, and functional illiteracy is widespread. Why should that be a surprise? Schooling at the elementary and secondary level is the largest socialist enterprise in the United States next to the military. Now why should we be better at socialism than the Russians? In fact, they ought to be better; they have had more practice at it. If you consider medical care, which is another major problem now, total spending on medical care has gone from 4% of the national income to 13%, and more than half of that increase has been in the form of government spending. Costs have multiplied and it is reasonably clear that output has not gone up in anything like the same ratio. Our automobile industry can produce all the cars anybody wants to drive and is prepared to pay for. They do not seem to have any difficulty, but our government cannot produce the roads for us to drive on. The aviation industry can produce the planes, the airlines can get the pilots, but the government somehow cannot provide the landing strips and the air traffic controllers. I challenge anybody to name a major problem in the United States that does not derive from excessive government.

Can we extend the challenge to cover India as well?

Crime has been going up, our prisons are overcrowded, our inner cities are becoming unlivable all as a consequence of good intentions gone awry, the good intentions in this case being to prevent the misuse of drugs. The results: very little if any reduction in the use of drugs but a great many innocent victims. The harm which is being done by that program is far greater than any conceivable good. And the harm is not being done only at home. What business do we have destroying other countries such as Colombia because we cannot enforce our laws?

It is hard to be optimistic about how successful we can be in preserving our relatively free system. The collapse of the communist states in Eastern Europe was the occasion for a great deal of self congratulation on our part. It introduced an element of complacency and smugness. We all said, ” Oh my, how good we are! See, we must be doing everything right.” But we did not learn the lesson that they had to teach us, and that lesson is that government has very real functions, but if it wanders beyond those functions and goes too far, it tends to destroy human and economic freedom.

And here is the most important part that we all need to understand very very clearly.

I am nonetheless a long term optimist. I believe that the United States is a great country and that our problems do not arise from the people as such. They arise from the structure of our government. We are being misgoverned in all these areas but not because of bad motives or bad people. The people who run our government are the same kind of people as the people outside it. We mislead ourselves if we think we are going to correct the situation by electing the right people to government. We will elect the right people and when they get to Washington they will do the wrong things. You and I would; I am not saying that there is anything special about them.

The important point is that we in our private lives and they in their governmental lives are all moved by the same incentive: to promote our own self interest. Armen Alchian once made a very important comment. He said, “You know, there is one thing you can trust everybody to do. You can trust everybody to put his interest above yours.” That goes for those of us in the private sector; that goes for people in the government sector. The difference between the two is not in the people; it is not in the incentives. It is in what it is in the self interest for different people to do. In the private economy, so long as we keep a free private market, one party to a deal can only benefit if the other party also benefits. There is no way in which you can satisfy your needs at the expense of somebody else. In the government market, there is another recourse. If you start a program that is a failure and you are in the private market, the only way you can keep it going is by digging into your own pocket. That is your bottom line. However, if you are in the government, you have another recourse. With perfectly good intentions and good will nobody likes to say “I was wrong”. You can say, “Oh, the only reason it is a failure is because we haven’t done enough. The only reason the drug program is a failure is because we haven’t spent enough money on it.” And it does not have to be your own money. You have a very different bottom line. If you are persuasive enough, or if you have enough control over power, you can increase spending on your program at the expense of the taxpayer. That is why a private project that is a failure is closed down while a government project that is a failure is expanded.

The only way we are really going to change things is by changing the political structure. The most hopeful thing I see on that side is the great public pressure at the moment for term limits. That would be a truly fundamental change.

I want to close on a slightly optimistic note. About 200 years ago, an English newspaper wrote: “There are 775,300,000 people in the World. Of these, arbitrary governments command 741,800,000 and the free ones … Only 33 1/2 million… On the whole, slaves are three and twenty times more numerous than men enjoying, in any tolerable degree, the rights of human nature” [cited in Forrest McDonald, Novus Ordo Seclorum (Lawrence: University Press of Kansas, 1985), p.9]. I know of no such precise estimate for the present, but I made a rough estimate on the basis of the freedom surveys of Freedom House. I estimate that, while slaves still greatly outnumber free people, the ratio has fallen in the past two centuries from 23 to 1 to about 3 to 1. We are still very far from our goal of a completely free world, but, on the scale of historical time, that is amazing progressmore in the past two centuries than in the prior two millennia. Let’s hope and work to make sure that that keeps up. Thank you.

Thank you and goodbye, Prof Milton Friedman.

4 thoughts on “Milton Friedman: A Joke and Some Serious Stuff

  1. Guru Gulab Khatri Saturday November 18, 2006 / 11:34 pm

    I am posting the text of a memorandum that milton friedman gave to government of india in 1950’s

    +++++++++++++++

    A Memorandum to the

    Government of India 1955

    MILTON FRIEDMAN

    [EDITORIAL NOTE: This memorandum is dated 5 November 1955, and was written at the invitation of the Government of India, where the author was working for some months as a consultant to the Ministry of Finance. It has not been published before. The editors believe it remains relevant to Indian discussions today. The history of the advice given by other Western economists in the early years of the Indian Republic has been recently surveyed by George Rosen in Western Economists and Eastern Societies: Agents of Social Change in South Asia 1950-1970 Delhi: Oxford University Press, 1985).]
    Note from Milton Friedman

    The Goal

    A 5 percent per annum rate of increase in real national income ,seems entirely feasible, on the basis of both the experience of other countries and of India’s own recent past. The great untapped resource of technical and scientific knowledge available to India for the taking is the economic equivalent of the untapped continent available to the United States 150 years ago. The basic question is one of method, of the social and economic arrangements that will best promote the conversi on of these potentialities into realities while at the same time maintaining freedom and democracy and giving ever-widening opportunities to the mass of the Indian people. The belief that underlies these notes is that the basic requisites are a steady and moderately expansionary monetary. framework, greatly widened opportunities for education and training, improved facilities for transportation and communication to promote the mobility not only of goods but even more important of people, and an environmen t that gives maximum scope to the initiative and energy of farmers, businessmen, and traders. The conquest of the technical frontier like the conquest of the geographical frontier requires a varied initiative by millions of individuals, flexibility of out look and organization, and willingness to venture. The Government of India is doing much, and much that is highly effective, to bring these requisites into being. There is much more to do that at least in Indian conditions can be done only by the Governme nt. But the Government also is following some: policies and proposing others that are likely to hinder rather than promote economic development. The following comments, which are mainly restricted to such policies, deal with investment policy; policy towa rd the private sector; monetary policy; resources available to the public sector; and foreign exchange policy.

    INVESTMENT POLICY

    Over-Emphasis on the Capital-Output Ratio

    There is a tendency not only in India but in most of the literature on economic development to regard the ratio of investment national income as almost the only key to the rate of development to take it for granted that there is a rigid and mechani cal ratio between the amount of investment and additions to output. In the opinion of this writer, this seems a serious mistake. At the one extreme, output can increase even without investment; at the other, too high a ratio of investment may actually pro duce a lower rate of increase in income.

    There are two reasons why the amount of investment and the increase in output can be, and empirically are, only loosely connected. First, the form and distribution of investment are at least as important as its sheer magnitude. Second, what is called c apital investment is only part of the total expenditure on increasing the productivity of an economy. The first reason needs little additional comment. The second is perhaps less clear. In any economy, the major source of productive power is not machinery , equipment, buildings and other physical capital; it is the productive capacity of the human beings who compose the society. Yet what we call investment refers only to expenditures on physical capital; expenditures that improve the productive capacity of human beings are generally left entirely out of account. In the United States, for example, only about one-fifth of the total income is return to physical capital, four-fifths to human capital. By this. writer’s estimate similarly, only about one fifth o f the annual rate of growth in the United States can be attributed to the direct effects of investment in the usual sense; four-fifths must be attributed to the growth in the productivity of human beings. Annual expenditures on improving the quality and q uantity of human resources are at least as large as and perhaps much larger than investment as usually defined. Destroy the physical plant of the United States and leave the skills of the people and it would take but a few years to restore the initial pos ition. Destroy the skills and leave the plant and the level of output would sink irretrievably. The cathedrals of medieval Europe, the pyramids of Egypt, the monuments of the Moghul empire in India are all testimony to the possibility of a high rate of in vestment in physical capital without a growth in the standard of living of the masses of the people. These considerations are especially important for India, precisely because its frontier is the frontier of technical knowledge and skill.

    This is not to deny in any way the desirability of investment in physical capital. It is certainly highly important and is to some measure an indispensable concomitant of the development of human capital. But it is not the whole or even the most import ant part of the story. The danger is that concentration on it may lead to policies that increase physical investment at the expense investment in human capital; and even within the area of physical investment, may lead to increases in the kind of physical investment that we can measure at the expense of kinds that we can measure. We must be aware lest we become the victims of our statistical creations.

    Emphasis on Two Extremes Against the Middle

    The form of investment is no less important than its kind. The chief problem in the Indian program that impresses one her, the tendency to concentrate investment in heavy industry at one extreme and handicrafts at the other, at the expense of small and moderate size industry. This policy threatens an inefficient use of capital at the one extreme by combining it with too little labor and an inefficient use of labor at the other extreme by combining it with too little capital. The presumption for an economy India’s is that the best use of capital is in general somewhere in between, that heavy industry can best develop and be built upon a widely diversified and much expanded light industry. We may hasten to add that this is only a general presu mption which may well admit of special exceptions. Perhaps, for example, the steel industry is one exception in India.

    Attempt to Do Too Much in the Public Sector

    Indian thought may not have taken full account of the post-war experience of European countries in expanding the public sector. Country after country moved in this direction immediately after. the war; to the best of the present writer’s knowledge, the results were, in every case, disappointing. This experience has produced drastic change in the attitudes of the labor and left-wine toward nationalization and detailed state control over economic activity. The elements in the parties that have not ch anged the approach are now being dubbed ‘reactionary’ by some of their fellows!

    This point may be especially important for India. The areas for which only Government can take responsibility are here so large, so vital, and require such large investments that they alone would be a heavy burden on the limited administrative personne l of high calibre. It seems the better part of wisdom therefore to avoid any activities that can be left to others. The problem involves both the kind of activities taken into the public sector and the magnitude of investment. Some further comments are ma de on the latter below in discussing the resources available to the public sector.

    Attempt to Control Private Investment in Too Rigid and Detailed a Fashion

    (i) Cutting off particular investment projects may not make resources available for other uses but may simply eliminate savings that would otherwise have been available. Much saving is made to finance specific investment projects. I f it cannot be used for that purpose, it may well be directed to consumption or to the accumulation of bullion or its equivalent. (ii) It is impossible to predict in advance the lines of investment that will turn out to be the most productive-as the failu re of so many private enterprises amply demonstrates. There is therefore great need for a system that is flexible and can change easily. (iii) Detailed direction wastes scarce energies and abilities of public servants in producing and enforcing regulation s and of private individuals in trying to evade or avoid or change them. (iv) Given that the public sector gets the resources it demands, is not the market criterion appropriate for the allocation of the rest of investment? To frustrate it means to deny c onsumers freedom of choice and so to reduce the value to them of the goods produced. (v) Government does have a responsibility for seeing to it that the total of public and private investment is kept within the total resources of the community without inf lation. But this can best be accomplished by monetary find fiscal policy, rather than by detailed regulation, leaving the allocation of investment among private industries to be accomplished by the interest rate. Insofar as this mechanism works imperfectl y, measures to improve its operation seem preferable to supplanting it.

    POLICY TOWARD THE PRIVATE SECTOR

    Protection of Inefficient Methods of Production

    In addition to the Government controls already considered which are designed to direct investment, there are others whose purpose is mainly protective: the excise tax on factory-made shoes and factory-made textiles; reservation of markets, and the like. In the opinion of this writer, such policies seem misdirected. India’s basic problem is the inefficient use of manpower; it is no solution to protect inefficiency, and the attempt to do so leads to a waste not only of human resources but also of phy sical capital. The extra money consumers have to pay for the products, let alone direct subsidies to producers, could be channelled at least in part into investment. And there may even be actual disinvestment-we were told that some shoe machinery was lyin g idle and depreciating because of the tax.

    There is a tendency to underrate the importance of nominally low taxes in promoting inefficiency. For example, there is a 10 percent tax on factory-made shoes. But half to two-thirds of the cost of shoes is the raw material. The tax therefore amounts t o 20 percent or 30 percent of the value added by the factory, and it will not pay to produce shoes unless factory production is at least this much more efficient than hand production. The justification for these devices is to increase employment. The obje ctive is fundamental, and would be worth achieving even at some cost in total output, but it seems to the present writer dubious that these means accomplish their objective even in the very short run, and certain that they work against it in the moderate or long run. What they do is to increase the number of people employed inefficiently; but they also decrease the number of workers in factories producing the same product, and in other industries stimulated by the higher income of the factory worke rs; the decrease is likely to exceed the increase but because it is more diffuse and less obvious, it tends to be neglected.

    Coddling of Private Industry In Certain

    Directions Combined with Severely

    Restrictive Controls In Others

    Just as it is inappropriate to discriminate in favor of the cottage industries, so it is equally inappropriate to discriminate in favor of factory industry or large concerns. Granting them special favor the form of especially ad vantageous loans, guaranteed markets, refusal of licenses to competitors, enforcing or even permitting private price-fixing and market-sharing agreements-simply encourages inefficiency and wastes scarce resources. If private industry is granted special fa vors by the Government, it is certainly inevitable that its use of these favors will be controlled; but this does not offset the harm done by the favors; it merely introduces new sources of rigidity and inefficiency. Business ingenuity is devoted to carvi ng out protected sectors instead of to opening up new markets and lowering costs. There is no justification for private industry unless it is competitive, unless the right to receive profits is Accompanied by acceptance of the risk of loss. Private indust ry should be made to stand on its own feet without either favor or harassment.

    MONETARY POLICY

    Erratic Policy

    A stable monetary climate is a basic prerequisite for healthy economic growth. Yet over the past five years, monetary policy has been highly erratic. It first permitted and facilitated substantial price rises, then reacted too far in the opposite d irection. More recently, monetary policy has again reversed direction and again threatens to go too far, this time in an inflationary direction. This erratic policy is recorded directly in the behavior of the stock of money and of wholesale and retail pri ces, and indirectly, in a less rapid rate of economic advance than would have been feasible.

    The present writer believes that monetary policy in India would be more stable and consistent if the monetary authorities paid more attention to the size of the money stock and less to other indicators, and if they took as their proximate goal, a stead y expansion in. the money stock (allowing for seasonal influences) at a rate of something like 4 to 6 percent per year. It may be noted that detailed examination of the record of American monetary authorities persuades one that this general proposition is equally true for the United States, with a desirable rate of expansion of the money stock of 4 percent per year.

    The importance of a stable monetary policy hardly can be overemphasized. There is probably no other single area in which mistakes can be more disastrous or appropriate policy more beneficial. The fact that it operates on a general level and makes its e ffects felt impersonally and indirectly is at one and the same time the reason for its crucial importance and for the widespread failure to recognize its importance.

    Deficit Financing

    Deficit financing is currently proceeding at the rate of something like Rs. 150 to 200 crores a year. Given the generally deflationary trend of the recent past, such a rate doubtless can be absorbed for a time without a serious price rise. It is ex ceedingly doubtful, however, that it can be for more than a year or- so. According to some rough yet fairly detailed estimates made by this writer, something less than Rs. 500 crores is the maximum amount that can be absorbed over the next five years with out a substantial rise in prices. By this estimate, continued deficit financing at a rate of Rs. 200 crores per year over that period would produce a price rise of at least 30 percent, and perhaps much more.

    REESOURCES AVAIALABLE TO THE PUBLIC SECTOR

    There seems to be a general agreement that planned expenditures in the public sector substantially exceed expected receipts, even after allowing for a shortfall of actual expenditures, for deficit financing to the extent of Rs. 1,000 to 1,200 crore s, and for a substantial amount of foreign aid. If we are right about the safe amount of deficit financing, the actual gap is substantially larger than the amounts generally cited. This financial gap corresponds to a real resource gap. It can be filled wi thout curtailing the Plan only by either getting additional resources from abroad; or making domestic resources more productive over and above the 5 percent per year increase already allowed for in the estimates; or transferring resources from other uses. The transfer of resources can be brought about by additional taxation, forced savings, additional voluntary savings, or a reduction in private investment. Additional voluntary savings and a reduction in private investment can in turn be brought about to some extent by a monetary policy that allows interest rates to rise. Inflation is of course a possible danger, but it is not really a separate method of filling the gap; it is a form of taxation and, in the view of this writer, a particularly inefficient and inequitable form.

    This only states the problem. We have not been able to study in detail either the tax structure of India or the financial structure for mobilizing and encouraging savings, so no independent judgement can be given on the possibility of filling the resou rce gap by the various means. Casual impression suggests that there is some possibility of increasing tax revenues without doing much harm, but that any substantial expansion in tax revenues or heavy reliance on any of the other methods except for foreign aid is currently subject to extremely serious limitations. If this is so, filling the gap by their use, if successful, might make public investment larger only at the expense of reducing the rate of growth of aggregate real income by killing incentives o utside the public sector, eliminating potentially productive private investment, and producing either inflation or a deadening network of direct controls. This is a special case of the point made earlier about the loose connection between the rate of inve stment and the rate of growth of income. It may well be that under the circumstances, cutting the size of the program may be preferable to trying to fill the gap on the revenue side.

    On the tax side, three comments may be made: (i) The small scope of direct income taxes seems an obvious defect in the tax structure. A more broadly based tax with lower exemptions and more effective administration might both raise considerable revenue s and produce a more equitable distribution of the tax burden. (One recognizes that for a country like India there are special problems of administration and enforcement that this writer is incompetent to assess.) (ii) The use of excise taxes for the prod uction of one method of production or one product as opposed to another not only promotes inefficiency but is also wasteful of revenue. A 10 percent tax on shoes would yield more revenue, do less harm to productive efficiency and cost the consumer little if any more than a 10 percent tax on factory-made shoes. As a side observation, is it clear that if the extra proceeds were used to facilitate the retraining and placement of hand workers it would be of less value even from the point of view of the employ ment problem? (iii) A minor possible source of additional revenue that would have favorable effects on efficiency is the auctioning off of licenses to use foreign exchange suggested as a possibility below.

    THE FOREIGN EXCHANGE PROBLEM

    The Foreign Exchange Gap

    It is generally accepted that present programs are likely to involve a substantial excess in the demand for foreign exchange over the available supply, even if allowance is made for foreign aid at roughly the present level. These estimates

    take for granted not only the investment program but also retention of the existing exchange rate and the existing structure of import and export controls. Even under these assumptions, the foreign exchange gap in part and perhaps in whole is a particula

    r aspect of the total resource gap: any reduction in the total resource gap will automatically reduce the foreign exchange gap. Given the special foreign exchange resources that are likely to be available, we may guess that solution of the total resource

    gap would largely solve the foreign exchange gap as well.

    Exchange Controls

    The existing structure of exchange-controls and their associated system of import and export licenses and of discrimination between sources of purchases, seem to this writer a major obstacle to the growth and progress of the Indian economy. They in volve waste and inefficiency in the use of foreign exchange. They introduce delay, uncertainty, and arbitrariness into domestic business activities. They impose on officials in charge of exchange control a task that is bound to be discharged most imperfec tly, however able and devoted the officials may be. The criteria the officials use-and must use-tend to perpetuate the status quo ante, and therefore constitute an obstacle to dynamic change and adaptation in an area that traditionally has been one of the most dynamic sectors in the economy and the source of much of the impetus to change. Exchange controls necessarily involve the indiscriminate distribution of implicit subsidies to those granted import licenses, and they lend themselves to abuse as a means of granting administrative protection from foreign competition to inefficient or monopolistic domestic producers.

    The elimination of the exchange-controls and import and export restrictions is thus a most desirable objective of policy. It must be recognized, however, that it would probably increase the demand for foreign exchange, but the likelihood of an increase means that elimination of controls would have to be accompanied by the introduction of some other means of rationing exchange. It should be emphasized that this increase in the demand for foreign exchange is not a fresh problem that would be created by t he elimination of exchange-controls. The problem is there now. That is why controls are deemed necessary. The question is whether there are not less harmful ways of solving it.

    Alternatives to Exchange Controls

    One alternative, which retains central control over the amount of foreign exchange to be released, is to auction off whatever amount of foreign exchange it is decided to release, permitting the purchasers to use it for anything they wish and in any currency area they wish. This would be a far more efficient system of rationing and would hinder internal economic development far less than the present system and at the same time yield some revenue. We have not been able to construct even a rough estim ate of the amount of revenue, but it is unlikely to be of major magnitude.

    It would be preferable to avoid this auctioning system as well. While it eliminates any distortion in the pattern of imports, it does not produce the appropriate adjustment of exports to imports. Only two other basic alternative modes of adjustment to changes in the conditions of external trades are available: first., to inflate or deflate internally in response to a putative surplus or deficit in the balance of payments; second, to permit the exchange rate fluctuate. At least in the present worldwide monetary conditions the first is not desirable economically, since it puts internal conditions of trade at the mercy of changes in external conditions these are about as likely to result from vagaries in the internal policies of other countries as from ch anges in the ‘real’ conditions of trade. The preferable method is to let the exchange rate be determined in a free market-the method of a floating exchange rate that has been adopted by Canada with such conspicuous success.

    It may be worth saying a few words about how a floating exchange rate eliminates any foreign exchange gap and means that,’ there are not two problems, at total resource gap and a foreign exchange gap, but only one, a total resource gap. Suppose the tot al program is in balance but, at the existing exchange rate, there is an excess of demand for foreign exchange over the supply. The result is to lower the rate. This makes India’s products more attractive to the outside world, foreign products more expens ive to Indians. The result is to lead to an increase in exports, thus making more foreign exchange available, to shift the pattern of investment within India away from kinds with a larger import component and toward kinds with a larger domestic resource c omponent, away from production for the domestic market to production for the foreign market, and to shift consumption from foreign goods toward domestic goods. A putative foreign exchange surplus clearly has the opposite effects. In addition to these effe cts on trade, there are also, of course, effects on capital movements, which depend on whether the change in rate is regarded as temporary or permanent.

    India’s membership in the Sterling Area raises obvious difficulties in the way of India’s acting alone, and may make it impossible for India to free her exchange rate except in concert with a similar move by Britain. However, if these difficulties coul d be surmounted, an independent movement by India might have very great advantages precisely because India is entering into a period of rapid economic change and is not a major financial center. This writer believes there is more of an analogy between Ind ia’s and Canada’s positions than might at first appear. In a world of inconvertible currencies, a country that offers convertibility, albeit at a fluctuating rate, has a special attraction for investors and traders.

    The problem of trade is frequently considered separately from that of the import of foreign capital. This is a mistake. Imports of goods may bring with them no capital directly but they bring businessmen and contact, and discovery of investment opportu nities by people who are anxious to exploit them and who have contacts at home interested in such opportunities. Such continuous and intimate contact is likely to produce both a larger and, equally important, more productive flow of foreign investment tha n any number of missions coming out for brief periods with the objective of exploring investment opportunities.

    Foreign Assistance

    Any foreign assistance will of course help to fill both the total resources gap and the foreign exchange gap. Its direct impact, However, is much greater on the foreign exchange gap. In consequence, foreign assistance is especially lik ely to permit an elimination of import and export controls without threatening the existing exchange rate. But it would be a mistake to suppose that foreign assistance, however extensive, would permit elimination of controls, a fixed exchange rate, and an independent domestic Monetary policy for any length of time. Even though the exchange rate is in some sense in long-run equilibrium, accidental fluctuations will from time to time produce large drains on reserves and if there is no mechanism for adjustin g to them, these drains may well make the short-run position untenable.

    CONCLUSION

    If these comments have concentrated largely on the financial machinery of economic organization, it is not because that is the only or even the most important problem facing India but rather because, on the one hand, it is more within this writer’s special competence, and on the other, it seems to be the area in which current policy can be improved most. The present writer is convinced that the fundamental problem for India is the improvement of the physical and technical quality of her people, the awakening off sense of hope, the weakening of rigid social and economic arrangements, the introduction of flexibility of institutions and mobility people, the opening tip of the social and economic ladder people of all kinds and classes. And what gives a n outsider like t writer a feeling of optimism and hope about the future of India makes one feel that India is on the move and will continue move, is that so much is being done and such a good beginning has been made on this fundamental problem of creatin g the human and social basis for a dynamic and progressive economy

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  3. Ike Wednesday November 29, 2006 / 11:26 pm

    Too many people are woefully uneducated about economics, particularly the applications and the effects of unintended consequences.

    Friedman is already missed.

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  4. Ashwin Nambisan Tuesday July 10, 2007 / 2:00 pm

    In my opinion, the Indian government at the time(1955) should have put aside its socialistic tendencies and striven for economic improvement of its citizens. What I admire about Milton Friedman is his astute observations of human nature and the politics of money.If only the Indian government had taken his recommendations seriously! I suppose Nehruji was too much in love with the Communists and Socialism to care about what Milton Friedman had to say !! At least now India is waking up and shaking off some of those chains……

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