Journal Issue


International Monetary Fund. External Relations Dept.
Published Date:
January 1992
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Bimal Jalan

India’s Economic Crisis— The Way Ahead

Oxford University Press, New York, NY, USA, 1991, vii + 245 pp., $19.95.

It is always nice to welcome back a prodigal son, even one who has not completely eschewed his past rebellion! Bimal Jalan, who has been at the center of India’s financial bureaucracy for two decades, has written a book that is, in part, a personal expiation of past ways of thinking. As he notes, he “along with most Indian economists and civil servants at that time, shared the vision and assumptions of India’s Plans and the early development literature regarding the nature of the State, of its supposedly unlimited capacity to intervene in society’s interest” (p. 10). In retrospect, he admits he “did not pay adequate attention to the real determinants of state action, nor to the economic consequences of excessive bureaucratic intervention” (p. 11).

Alas, as his conversion to economic liberalism is only partial, many of the defects of the book are due to his inability to completely slough off his past skin. Perhaps one of the major reasons why Indian intellectuals promoted policies that repressed the economy’s growth rate below its potential after Independence was a misreading of India’s economic history under the British Raj. The nationalist cum Marxist distortion of the lessons to be learned, particularly regarding fiscal, trade, and industrial policy in the near century since 1857, haunt Jalan’s pages. Many of his recommendations—for instance on containing fiscal deficits through a constitutional limit on the government’s power of deficit finance, are wholly commendable. But many others—such as a partial trade liberalization, the conversion of public sector enterprises into publicly owned conglomerates, and the continuation of food subsidies—are mere tinkering at the edges of the traditional Revenue Economy (in the sense of Hicks) that India has recreated since 1947.

One cannot, in the short space allowed, detail the sources of the intellectual errors underlying what Jalan would call a “pragmatic” approach to reform. For reasons most clearly set out in Hayek’s The Constitution of Liberty, half-hearted measures to restore economic liberty are unlikely to succeed. More important, however, is Jalan’s neglect of the political economy of reform. Here, the parallels drawn from the crisis faced by India, by many other statist regimes in the Third World, as well as those by the mercantilist “ancien regimes” of 18th-century Europe, as detailed in Eli Hecksher’s monumental Mercantilism, are instructive.

The motive behind the system of controls called mercantilism, established by Europe’s Renaissance monarchs, was the nationalist desire to weld their disparate populations into a nation. But paradoxically, after a certain stage, the increasing state control of the economy bred dissatisfaction and disorder. The result of the ensuing loss of state control was a fiscal crisis. This, in turn, triggered the period of economic liberalism in the 19th century, as the State sought to restore its fiscal base by inducting more of the populace into the legal economy by reducing its onerous controls. Economic nationalism, combined in many cases with the socialist idea, first leads to a neomercantilist system of controls, and then to their reform as the State seeks to recover the loss of control over its fiscal base.

Free trade, a hard currency (preferably underwritten by an independent central bank), and Gladstonian finance, are the three economic policy pillars of a liberal economic constitution. They are in the interests not only of the citizens but also of the State (at least in the long run). Whether they are in the interests of intellectuals is another matter. In a revealing footnote, Jalan notes that whereas many of India’s former economic bureaucrats have now recognized the virtues of the market, most Indian intellectuals have not. Jalan seems to be torn between these two camps. But perhaps, as good Marxists, Indian intellectuals will accept the verdict of their god—History. The worldwide collapse of socialism, for political economy reasons similar to those outlined above, might persuade my old friend Bimal Jalan, too, to finally endorse the economic liberalism that some of us have so unsuccessfully espoused in India for so long.

Deepak Lal

James S. Coleman Professor

of International Development Studies

University of California, Los Angeles

Rudiger Dornbusch and Sebastian Edwards (editors)

The Macroeconomics of Populism in Latin America

The University of Chicago Press, Chicago, IL, USA, 1991, ix + 402 pp., $65 ($21.95 paper).

This book is a collection of country-specific essays written by various well-informed authors that explore the question, “What is populism?” In an insightful overview chapter, the two editors offer various definitions. Populism is characterized by “political mobilization, recurrent rhetoric and symbols designed to inspire the people.” Elsewhere, substantial differences are noted “between ‘classical’ populism,” based on the existence of populist movements, e.g., under Peron and Vargas, “socialist” experiments (Allende or the Sandinistas in Nicaragua), and nonorthodox stabilization programs, such as the Austral plan of Argentina and the Cruzado plan of Brazil, which certainly included populist elements but do not qualify, strictly speaking, as populism. Politically, populism ranges from the military right (Peron) to the socialist left (Allende). Like the giraffe, populism is extremely hard to describe but when you see it, you know what it is.

Most of the essays in the book focus on the macroeconomic dimensions of populism, because of the attempted use of (or rather disregard for) fiscal, monetary, exchange rate, and wage policies in pursuit of economic reactivation and (at least according to rhetoric) poverty alleviation and income redistribution. Populism also favors considerable and detailed government intervention in the economy, as well as increased protection from foreign competition. The risk of inflation is discounted at the outset because of the mistaken belief that additional output will bring idle capacity to life.

What is the record of populist episodes? Growth may be boosted for a year or two but collapses once foreign currency reserves are exhausted, as the overvalued exchange rate wrecks the trade balance and capital flees the country. Pervasive shortages, extreme acceleration of inflation, and demonetization of the economy then herald the inevitable hang-over: Another government will try to pick up the pieces and, by this time, wages and the level of economic activity are lower than they were to begin with. The poor, on whose behalf populist policies were launched, end up being worse off because populism invariably favors urban wage earners at the expense of farmers and of those in the “informal sector.”

Why then are there so many populist episodes? Why does not economic rationality prevail? This is a bit like asking why there are so many teenage pregnancies. Economists are (luckily) only an infinitesimal fraction of the world population; their universe of discourse is quite alien to the public and indeed to many politicians. Populist politicians, on the other hand, often have immense popular appeal. It is hardly surprising, therefore, that orthodox economists often enter the scene only after the debacle.

The book rejects the populist lure convincingly and should be required reading in most of the countries of Eastern Europe and the former Soviet Union. Its main message is that “concerns for poverty and inequality are not only legitimate, but clearly of great urgency. The issue is not whether… distributional problems should be addressed … but how to better tackle them.” William R. Cline spells out the only proven recipe for a successful strategy for growth with equity:”… [it] must include: overall fiscal balance; the avoidance of unrealistic wage increases; concentration of antipoverty action on government spending on low-end social services, especially in rural areas; an open-trade model for efficiency and greater labor intensity; and firm anti-inflation programs, because inflation is the biggest enemy of the poor.”

Guy Pfeffermann

Ronald I. McKinnon

The Order of Economic Liberalization

Financial Control in the Transition to a Market Economy

The Johns Hopkins University Press, Baltimore, MD, USA, 1991, xii + 200 pp., $28.

For 20 years, Professor McKinnon has been writing about how to open up repressed financial and foreign trade systems in less developed countries.

He has made many original contributions to thinking about the optimal order of liberalization. This book consists mainly of the essays he has written on this subject over the last ten years, with some adaptations and extension. It is, however, more than this. By adding new material, especially an introductory chapter on the order of economic liberalization and an expanded chapter on stabilizing the ruble, the book paints a broad picture of problems of financial control in the transition from a centrally planned to a market economy.

McKinnon argues that the first priority in liberalizing depressed economies is fiscal control. In the case of centrally planned economies, this requires that a tax system for raising revenue from enterprises be put in place before the enterprises are privatized, otherwise their surpluses will move beyond the government’s reach. Fiscal control must cover quasi-fiscal deficits, such as losses incurred by central banks in subsidizing credit or guaranteeing foreign currency deposits, as well as the government’s own deficit.

After fiscal control, the domestic financial sector can be liberalized. Here one should start with the liberalization of interest rates, so that they become positive in real terms. More generally, the system of money and credit should be “hardened” at a relatively early stage to bring about the stabilization of the price level. This should include forcing repayment by chronically indebted enterprises and strictly limiting credit expansion. The decentralization of the banking system through private ownership or control of commercial banks might well come near the end of the reform process.

Turning to the external sector, McKinnon argues that the exchange rate should be unified before eliminating centralized controls over who can import or export—something that was not done in Russia or any of the states of the former Soviet Union. While quantitative restrictions on trade should be removed at an early stage, preferably when prices are liberalized, they could be temporarily replaced by tariffs set at an equivalent level. These tariffs would be phased out over a preannounced period of years. Full capital account convertibility should wait until domestic financial liberalization has been completed and price stability established. This is usually the last stage in the optimal order of economic liberalization.

If these prescriptions appear familiar, it is perhaps because they are incorporated in much of the policy advice of the IMF and the World Bank. McKinnon himself deserves part of the credit for this because of his pioneering work, which is clearly described in this book. However, while the book sets out the key points of the order of economic liberalization, it also provides a wealth of detailed illustrations and analyses of specific aspects, such as reserve requirement policy, adverse risk selection, capital flight, monetary over-hang, and seignorage in a number of countries, most of them in South America, East Asia, and Eastern Europe. It will, therefore, be invaluable for those wishing to pursue in more detail specific aspects of financial liberalization.

John Odling-Smee

Michael Roemer and Christine Jones

Markets in Developing Countries

Parallel, Fragmented, and Black

The International Center for Economic Growth and the Harvard Institute for International Development, ICS Press, San Francisco, CA, USA, 1991, xvii + 267 pp., $12.95.

Politicians often want to control markets. This does not mean that they should be encouraged to do so. Indeed, their attempts to exercise control should be under constant scrutiny. Economists should make every effort to analyze and explain the cost and inefficiency of controls and remind, or even shame, politicians about the cost to society of some of these policies. This book does an excellent job in reminding us of such problems, using nine papers to analyze specific examples of parallel, fragmented, and black markets.

Parallel markets arise in response to government interventions that create excess supply or demand in product or factor markets. For example, managed foreign exchange rates create—usually illegal—foreign exchange markets; import quotas and licensing give rise to parallel markets in smuggled goods and bribes for licenses; interest rate controls inculcate curb markets; legislated minimum wages and special employees’ benefits generate parallel labor markets; and taxes can bring about parallel, illegal, nontaxed supplies of goods, services, and labor. Fragmented markets can develop even in the absence of controls. Markets can be segmented by, for example, transportation costs, access, or information costs. Rural credit, for instance, is often separated from the large urban capital market. Black markets are most often illegal, sometimes dealing in prohibited goods for which there can be no legal parallel market. Black money can generate an underground economy where the risk of arrest can involve substantial payments to avoid discovery.

The principle policy conclusion that is formed is that parallel markets help soften the bad effects of government controls but, of course, at a cost. The cost will be higher the more the government tries to enforce its controls. Fines and bribes (and indeed the higher margins) of parallel markets tend to exacerbate inequality of incomes. Parallel markets also “offer an escape from bad policies that cannot be reformed.” Politicians and bureaucrats are more likely to reinforce the controls rather than relax them and let parallel markets allocate resources more efficiently.

Because of the very nature of parallel markets, data is hard to come by. Therefore, most of the chapters have had to spread a little data a long way. One of the most interesting, on “Time and Money in Western Sahel,” is entirely descriptive. Another, on “Taxes, Corruption, and Bribes: A Model’ of Indian Public Finances,” is analytical, but uses no data; it suggests that a decision to lower tax rates may also lower the incentive to audit. When many tax officials are corrupt, this leads to a decline in tax revenue. Whether this “important result” is valid in the absence of any empirical data is questionable. After all, it could be reasoned that higher tax rates, although increasing the incentive to audit, also increase the incentive to evade taxes and thus increase the value of the bribe. Whether or not the increased bribe reduces revenue more than the reduced likelihood of audit with an equivalent reduction in tax rates would be an interesting empirical problem. However, given the data needed for “areas of future theoretical and empirical research” (e.g., among others, the proportion of corrupt auditors and the agreed bribe rate), the likelihood of rigorous testing seems remote.

Three chapters on informal credit markets suggest that where markets are fragmented (e.g., rural money lenders), the best policy may be not to deregulate the markets, but to first work on integrating the informal markets into the formal. Then, when deregulation actually takes place, everyone, including those in the fragmented market, can benefit.

The aim should not be, as this book argues, to alert officials and major aid agencies of the impact of parallel markets on policy reform. Officials in developing countries are all too well aware of the impact of control policies. After all, that is where some get their bribes from. In many such economies, the officials have their own agenda with respect to maintaining the structure of controls. Certainly, “major aid agencies” are aware of this problem. The need is to convince those in power of the costs to society of such controls, and, by reason, help to eliminate such inefficient policies. This book helps to that end.

Alan Tait

Miroslav N. Jovanovic

International Economic Integration

with foreword by Richard G. Lipsey

Routledge, New York, NY, USA, 1992, xxiv + 302 pp., $49.95.

The recent debate over the implementation of economic and monetary union in Europe and the prospects of widening membership in the European Community have once again focused attention on the costs and benefits of economic integration. It is fortunate, therefore, that this book has arrived at this time. In this ambitious work, Dr. Jovanovic presents an exhaustive survey of the existing literature on economic integration and attempts to update it to incorporate the new industrial organization and strategic trade theory. It is essentially the second of these tasks that makes this book unique in the field.

The traditional theory of integration, based on neoclassical trade models, concludes that the gains from free trade imply a welfare case for integration. However, this argument, taken to its logical conclusion, implies a case not for integration among a subset of economies with external tariff barriers between such units but for free trade between all countries. Moreover, the assumptions underlying the theory are no longer tenable. In a world with market imperfections and scale economies, free trade is not necessarily the optimal policy.

What the new theory adds is an appreciation of the dynamics of the adjustment to integration and of the benefits that accrue from the exploitation of scale economies in a secured market. The book, however, does not really solve the problem of identifying geographical limits to integration. In addition, while integration is presented as part of a possible package of policies designed to correct market imperfections or exploit scale economies, in fact, strategic trade theory provides justification for government intervention on an industry-by-industry basis rather than on a national basis.

Presented in an easily readable mixture of theory and practice, the book, at each step, provides examples and lessons from experience with integration. In this way, the reader does not have to wait until the end to find out how integration works in the real world. The book deals first with customs unions, then common markets, and finally with complete economic union. This latter chapter is the longest, and rightly so. In it, the author discusses the conduct of monetary, fiscal, industrial, regional, and social policy. The final substantive chapter provides a summary of empirical work on integration.

The exhaustive review of the literature and the extensive bibliography make this book an indispensable reference work. Its easy presentation makes it accessible to almost any interested reader. More important, the incorporation of noncompetitive theory and frequent illustrations from practice will give the reader greater insight into current developments.

Michael Spencer

Georg Sorenson

Democracy, Dictatorship and Development

St. Martin’s Press, New York, NY, USA, 1991, vi + 308 pp., $45 ($28 paper).

Development scholars and practitioners are currently revisiting one of the oldest—and most controversial—questions: What is the relationship between types of political regimes and economic development? Sorenson, an Associate Professor at Aarhus University, Denmark, reviews some of the literature addressing this theme, examining four cases in light of two competing hypotheses: (1) democratic regimes may not perform well for economic development since they are less able to withstand popular pressures for increases in consumption and welfare. Further, policy processes are sometimes seen as vulnerable to influence from powerful interest groups; and (2) autocratic regimes committed to growth may achieve economic development, but are likely to deprive citizens of welfare, focusing mainly on acquiring capital for investment.

Much of the book is an examination—largely descriptive—of four cases: India, China, Taiwan Province of China, and Costa Rica. In each case, Sorenson concentrates on the economic aspects of land reform, agriculture, industrialization strategies, and the role of external factors. He then returns to the central arguments and compares similar types of regimes—India with Costa Rica, and China with Taiwan Province of China. Sorenson concludes, not surprisingly, that democratic regimes may be more susceptible to elite interests and hence slower to reform, while autocratic rule in small open countries can generate higher savings as a basis for higher levels of growth. We know that there are authoritarian regimes that have brought growth but little welfare; others that have brought growth and welfare; and yet another group that has brought neither growth nor welfare—but only elite enrichment. The author’s findings, therefore, are hardly original.

Indeed, Sorenson might have provided greater insight had he drawn upon A.K. Sen’s theory of “entitlements.” Sen points to the way in which India’s and China’s past development strategies created political entitlements that had an impact on future growth and welfare. Sen observes that India, with its entitlement to a free press, has not had famines, but does have widespread malnutrition. China, on the other hand, with no entitlement to a free press, has much less malnutrition, but has had famines. His point is that more analysis should focus on the role of entitlements in affecting regime behavior. Only then will development scholars and practitioners know some of the answers to the problem of the relationship of democracy to economic development.

Coralie Bryant

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