Understanding Development: Alternatives to Conventional Economic Approaches

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Jayati Ghosh November 2, 2016

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Understanding Development: Alternatives to Conventional Economic Approaches

Jayati Ghosh

Executive Summary

Since the sixteenth century, economists have been essentially concerned with understanding the processes of economic growth and structural change: how and why they occurred, what forms they took, what prevented or constrained them, and to what extent they actually led to greater material prosperity and more general human progress. Since the 1950s, we have seen an upsurge in economic literature relating to both development and underdevelopment. There were many diverse approaches, but they all shared the common perspective that development is not about simply reducing deprivation, but essentially about transformation – structural, institutional, and normative – in ways that add to a country’s wealth-creating potential, ensuring the gains are widely shared and extending the possibilities for future generations. For most developing countries, that still meant building industrial capacity, providing secure livelihoods for rapidly growing urban populations, guaranteeing food security, and providing other basic needs. Then in the 1980s, we witnessed a shift away from development economics to a focus on poverty alleviation. This paper explores the underlying principles and assumptions behind this shift and argues that we should refocus on transforming the economies in which poor people live, rather than simply ameliorating the conditions of their poverty. The author argues that macroeconomic process need to be taken into consideration and criticises several recent attempts to accomplish this, including the use of purchasing power parity exchange rates and financial deregulation. She makes a strong case for the urgency of accepting and implementing alternative economic models.

Policy Recommendations:

The effective implementation of alternative economic models would require the following principles to be recognised and tailored to the specific circumstances in individual countries:

• a single-minded focus on GDP as a measure of economic success is counterproductive; • the focus should be on improving the material life and social conditions of at least the bottom half of society; • this revised focus will generate aggregate income growth through a bubble-up (rather than trickle-down) process; • employment generation must be a critical goal; 2 Dialogue of Civilizations Research Institute

• fiscal austerity policies should be avoided; • trade and industrial policies are essential to ensure the diversification of production towards greater shares of higher value added activities.

Keywords: financial liberalisation; purchasing power parity; PPP; gross domestic product; GDP: macroeconomics; microeconomics; development economics; poverty alleviation; economic growth; alternative economic models Dialogue of Civilizations Research Institute 3

There was a time when economists were inevitably concerned with development. From the early economists of the sixteenth and seventeenth centuries to those of the mid-twentieth century, all were essentially concerned with understanding the processes of economic growth and structural change: how and why they occurred, what forms they took, what prevented or constrained them, and to what extent they actually led to greater material prosperity and more general human progress. And it was this broader set of ‘macro’ questions which in turn defined both their focus and their approach to more specific issues relating to the functioning of capitalist economies.

It is true that the marginalist revolution of the late nineteenth century led economists away from these larger evolutionary questions towards particularist investigations into the current, sans history. Nevertheless, it might be fair to say that trying to understand the processes of growth and development has remained the basic motivating force for the study of economics. To that extent, it would be misleading to treat it as a branch of the subject, since the questions raised touch the core of the discipline itself.

But what is now generally thought of as development economics has a much more recent lineage and is typically traced to the second half of the twentieth century – indeed, to the immediate postwar period of the 1950s and 1960s, when there was a flowering of economic literature relating to both development and underdevelopment. Some of this literature found its inspiration in the planning literature of the Soviet Union in the interwar period, while other work focused on the systemic tendencies in global capitalism that generated inequality and ensured lack of development in some countries, as reflected in

‘structuralist’ analysis. Others retained the fundamentals of the mainstream approach, even while altering some of the assumptions. Thus the economic dualism depicted by

Arthur Lewis (1954), the co-ordination failures inherent in less developed economies described by Rosenstein-Rodan (1943), and the efficacy of unbalanced, ‘big push’ 4 Dialogue of Civilizations Research Institute strategies for industrialisation advocated by Albert Hirschman (1969) all in a sense dealt with development policy as a response to the market failures that were specific to latecomers.

All of these diverse approaches shared the common perspective that development is not about simply reducing deprivation, but essentially about transformation – structural, institutional, and normative – in ways that add to a country’s wealth-creating potential, ensuring the gains are widely shared and extending the possibilities for future generations.

For most developing countries, that still meant building industrial capacity, providing secure livelihoods for rapidly growing urban populations, guaranteeing food security, and providing other basic needs, among other features. This in turn meant the critical issues related to the nature of growth: the extent to which it generates structural changes in the economy that are associated with increases in the aggregate productivity of labour; the extent to which it generates productive employment for the labour force; the extent to which it ensures that asset and income distribution changes (possibly through redistributive policies) allow the benefits of growth to reach the poor; the extent to which the process increases the population’s access to basic goods and services that affect the quality of life and human poverty.

1. From Development to Poverty Alleviation

But sometime in the 1980s, all of this discussion receded into the background, and development economics, even of the mainstream variety, suffered a fate similar to

Keynesian economics in developed countries – of being first reviled, then ignored, and finally forgotten.

The associated focus on poverty alleviation, in what could be called the global

‘development industry’, involves a much sharper focus on the micro, on the miniature as a useful and relevant representation of the larger reality. It is very much a product of the Dialogue of Civilizations Research Institute 5 intellectual ethos prevailing in the academic centres of the North – almost all of the practitioners, whatever their country of origin, actually live and work in these places.

Therefore it is a reflection of a deep internalisation of the basic axioms of mainstream

North Atlantic economic thinking, especially in terms of the dominance of the neoliberal marketist paradigm.

Some underlying principles of this approach are worth noting, since they are rarely explicitly stated. This approach remains firmly entrenched in the methodological individualism that characterises all mainstream economics today. The models tend to be based on the notion that prices and quantities are simultaneously determined through the market mechanism, with relative prices being the crucial factors determining resource allocation as well as the level and composition of output. This holds whether the focus of attention is the pattern of shareholding tenancy, or semiformal rural credit markets, or a developing economy engaging in international trade.

This literature also posits a basic symmetry not only between supply and demand, but also between factors of production. Thus, the returns on factors – land, labour, capital

– are seen as determined along the same lines as the prices of commodities, through simple interaction of demand and supply. Where institutional determinants are acknowledged, they are seen as unwelcome ‘messing about’ with market functioning, and

‘government failures’ tend to be given wide publicity. An implicit underlying assumption in much of the literature remains that of full employment, or at the very most underemployment, rather than open unemployment. Further, while externalities are recognised, they are sought to be incorporated into more tractable models, thereby reducing the complexity of their effects. Similarly, while market failures are admitted, the policy interventions proposed or discussed are typically partial-equilibrium attempts to insert incentives/disincentives into the market mechanism, with the objective of promoting

‘efficiency’. And even the basic fact of uneven development tends to be translated into 6 Dialogue of Civilizations Research Institute models of ‘dualism’, which in turn also implies less attention to the differentiation internal to sectors and the patterns of interaction of different groups or classes within and across sectors.

Finally, even when there is a growing acceptance that ‘history matters’, this is typically reduced to certain simple and modelable statements. Thus in the literature, a standard way of dealing with the effects of history is in the form of complementarities, along the lines made famous by the example of the QWERTY typing keyboard.1 Other common ways of incorporating history are through inserting ‘social norms’ as a variable or analysing the effects of the ‘status quo; in creating inertia with respect to policy changes.

As a result, particular micro features of developing economies tend to be seen as

‘exotica’ in terms of prevalent economic institutions in developing countries and explanations are then attempted along the lines of methodological individualism, albeit with some cultural nuances. This can be described as a ‘National Geographic’ view of the broader process of development, whereby snapshots of particular institutions or economic activities are taken, the difference from the ‘norm’ of developed capitalism is highlighted, and then these are sought to be explained using the same basic analytical tools developed for the ‘norm’. The means whereby these economies or institutions can then become less different, or more like the developed market ideal (which, of course, does not exist in reality either), then becomes the focus of the policy proposals emanating from such analyses.

As a result, those who in earlier periods would have been studying development as structural transformation now focus instead on the more limited issue of poverty alleviation.

This idea reached its apotheosis in the Millennium Development Goals and their newly

1 In a fascinating article, Paul David showed how QWERTY, which was effectively the ‘wrong’ (that is, less efficient) technological choice in terms of the design of the typewriter keyboard, was eventually adopted and became the industry standard because of the combination of ‘strong technical interrelatedness, scale economies, and irreversibilities due to learning and habituation’(David, 1985: 336).

Dialogue of Civilizations Research Institute 7 anointed successor, the Sustainable Development Goals, which effectively are directed towards ameliorating the conditions of those defined as poor, rather than transforming the economies in which they live. Even here, the focus is on specific interventions – micro solutions that are seen to work in particular cases – and considering how they can be modified and scaled up. So the global development industry has kept searching for magic silver bullets for poverty alleviation. Over the past decades, the fads around supposed panaceas have included (successively): freeing markets and getting rid of government controls; recognising the ‘property rights’ of informal settlements of slum dwellers; microfinance; and, most recently, cash transfers.

It is interesting that even the focus on poverty alleviation takes a very limited view of what poverty is or how it is generated. Essentially, this is an approach that somehow abstracts from all the basic economic processes and systemic features that determine poverty. So ‘class’ tends to be absent from the discussion, or included only in the form of

‘social discrimination’, with the economic content being effectively wiped out. The poor are not defined by their lack of assets – which would then necessarily draw attention to the concentration of assets somewhere else in the same society – but by lack of monetary income or various other dimensions (such as poor nutrition, bad housing, and inferior access to utilities and basic social services, etc.) that are actually symptomatic of their lack of assets. Similarly they are not defined by their economic position or occupation, such as being workers engaged in low-paying occupations, or unable to find paid jobs, or having to find some livelihood in fragile ecologies where survival is fraught with difficulty.

Macroeconomic processes are entirely ignored: patterns of trade and economic activity that determine levels of employment and its distribution and the viability of particular activities; or fiscal policies that determine the extent to which essential public services like sanitation, health, and education will be provided; or investment policies that determine the kind of physical infrastructure available and therefore the backwardness of a 8 Dialogue of Civilizations Research Institute particular region; or financial policies that create boom and bust volatility in various markets. No link is even hinted at between the enrichment of some and the impoverishment of others, as if the rich and the poor somehow inhabit different social worlds with no economic interdependence at all, and the rich do not rely upon the labour of the poor. This shuttered vision is particularly evident in the neglect of the international dimension in such analyses and of the ways in which global economic processes and rules impinge on the ability of states in less developed countries to even attempt economic diversification and fulfilment of the social and economic rights of their citizens.

These silences enable a rather two-dimensional view of the poor, who are given the dignity of being treated as subjects with independent decision-making power, but who apparently inhabit a world in which their poverty is unrelated to a wider social, political, and economic context, but is more a result of their own particular circumstances and their own often flawed judgement. Since these larger issues are not addressed at all, the only dilemma posed for policy practitioners is which particular poverty alleviation scheme to choose and how to implement it. In making such decisions, the newest research instrument of choice is that of the ‘randomised control trial’ (RCT), especially as developed by the MIT Jameel Poverty Action Lab and similar institutions. Yet the problems with the widespread use of RCTs in this manner extend beyond the fact that they completely ignore the broader macro processes: quite apart from the statistical problems associated with

RCTs as predictors of behaviour or outcomes, there is the simplistic and mechanical belief that what has ‘worked’ in one context can be easily defined and can work in another quite different context.

Rescuing development economics from the miasma created by the discourse on poverty alleviation would require recognising that economic outcomes reflect social and historical factors – the level and nature of institutional development, relative class and power configurations – and that the processes of production and distribution inevitably Dialogue of Civilizations Research Institute 9 involve the clash of class interests along with the interaction of social, historical, and institutional factors. Since the process of development is an evolutionary one in which there is a continuous interplay of various forces which determine actual outcomes, attempts at poverty alleviation or elimination that do not recognise this are bound to fail.

2. The Use of Purchasing Power Parity Exchange Rates

Consider just some of the ways in which the broader, more evolutionary and historical approach would cause us to interrogate concepts that are now accepted without much question in standard economic development literature. Take the measure that is typically used to compare per capita incomes across countries – the use of Purchasing Power

Parity exchange rates rather than prevailing market exchange rates to calculate national incomes.

One of the problems that constantly vex economists is how exactly to measure incomes across countries. This is important not only in itself, but because it then translates into many other issues that have direct policy significance: What is real variation in global inequality in terms of differences across countries? What is the extent of poverty in different countries? How is this changing over time? The obvious method would simply be to compare per capita incomes across countries, deflated by nominal exchange rates.

However, this method has been criticised – and effectively abandoned by most international organisations – because of the well-known fact that the purchasing power of different currencies varies dramatically in the actual countries where they are used. For example, one US dollar can buy far fewer goods and services in the United States than 60 rupees can in India.

Therefore, the increasingly popular way of dealing with this issue is to use

‘Purchasing Power Parity’ (PPP) estimates instead of nominal exchange rates to deflate incomes and thereby compare across countries. This method was pioneered in the 1980s, 10 Dialogue of Civilizations Research Institute and it has now become standard practice, typically based on the ‘Penn World Tables’ produced by the International Comparison Programme of the University of Pennsylvania in collaboration with the United Nations or other similar international estimates.

The economic theory behind this is that exchange rate comparisons of less developed economies consistently undervalue the non-traded goods sector, especially labour-intensive and relatively cheap services, and therefore underestimate real incomes in these developing economies. In some cases, this can be quite significant. For example, according to the Penn World Tables, total incomes in countries with large poor populations, such as India or China, increased by multiples of around 3 with the PPP estimate, compared to the nominal exchange rate estimate in 2000. This is what led to the grandiose statements of China becoming the second-largest economy in the world, or

India reaching sixth position on the global economic ladder, based on the assessment that our currencies command several times more goods and services than are reflected in the nominal exchange rates.

But there are some major problems with the estimates of income using exchange rates based on PPP. One is that of deriving the actual price comparisons. Obviously, PPP calculations should be based on comparing the prices of identical (or at best very similar goods) in different countries, and these should in turn be the goods that are most commonly represented in total expenditure. But this is easier said than done. It is almost impossible to find identical goods that dominate consumption and investment across different countries. Unfortunately, the standard taken is one developed for the United

States, based on a ‘standard’ or ‘average’ basket of consumption, which then forms the basis for the price calculation in all other countries. But there is no reason for this basket to be the same or even similar in other countries, and in fact there is every reason why the baskets should be different in countries at very different levels of income. It is quite obvious, for example, that the share of food in the average consumption basket will be Dialogue of Civilizations Research Institute 11 much higher (at nearly half) in a country like India, compared to the US (where it is around ten percent). If food prices rise faster than other prices (as they certainly have over the past decade), then a low weight to this will give a very misleading picture of the real income of the average person in India, and an even worse idea of the real income of a poor person.

The second – and quite daunting – problem is how to find the actual prices of such goods and services and what to take as the representative price of each. One obviously has to use either existing price data or data from surveys that are constantly updated. But this is also very difficult, especially in most developing countries, including very large ones.

There are real concerns about the poor and often outdated quality of the data on actual prices prevailing in different countries (including large developing countries such as China and India) that are used in such studies and which affect the reliability of such calculations.

In fact, until recently there had been no major survey or even careful estimate of prevailing prices in India and China, so that PPP estimates before 2005 have been based on very outdated evidence on prices of goods and services in these two countries.

The most recent revision of the Penn World Tables, based on new information on prices in some important countries, shows how dramatically PPP estimates can change with more accurate data, as the 2005 PPP-adjusted per capita income for China in US dollar terms, for example, shows a 40 percent decline compared to the 2000 estimate!

This is because the new PPP for China is estimated to be around half the nominal rate, whereas the previous estimate (dating from 1993) had suggested it was only around one- fourth of the nominal rate. This downward revision of per capita income in China also adds significantly to the estimate of poverty, using the standard US dollar per day definition, more than doubling the estimated number of poor people in China. In the Indian case, the

PPP-adjusted income declined by nearly 30 percent. 12 Dialogue of Civilizations Research Institute

There is a less talked about but probably even more significant conceptual problem with using PPP estimates. In general, countries that have high PPP – that is, where the actual purchasing power of the currency is deemed to be much higher than the nominal value – are typically low-income countries with low average wages. It is precisely because there is a significant section of the workforce that receives very low remuneration that goods and services are available more cheaply than in countries where the majority of workers receive higher wages. When even these activities are further subsidised by the widespread incidence of unpaid labour (as is typically the case in poor households in low- income countries), then it is clear that the greater purchasing power of that currency reflects conditions of indigence and low or no remuneration for probably the majority of workers. Therefore, using PPP-modified GDP data may miss the point, by seeing as an

‘advantage’ the very feature that reflects the greater poverty of the majority of workers in an economy.

In other words, a country’s exchange rate tends to be ‘low’ – or the disparity between the nominal value of the currency and its ‘purchasing power’ tends to be greater – because the wages of most workers are low or even non-existent. A low-currency economy is a low-wage economy, which is hardly something that should be celebrated.

And this makes inter-country comparisons of per capita income based on PPP quite misleading, at least so far as they do not properly reflect the actual material conditions of most of the people living in them.

3. Financial Deregulation and Its Effects

A realm of policy that has achieved similar widespread acceptance relates to the nature and significance of financial markets. It is now almost commonplace to believe that financial liberalisation and openness to all forms of capital flows is not only a desirable instrument for development, but even a goal in itself that developing countries should Dialogue of Civilizations Research Institute 13 strive for. Yet this is quite a surprising perception, since there are reasons to believe that the process of financial liberalisation and integration with global capital markets actually impedes the ability of an economy to undergo structural transformation and diversify towards more high-value-added activities in a sustained and stable way. In other words, the process of ‘emerging’ (which really involves greater integration with global capital markets) actually reduces the capacity to develop.

There are several reasons for this adverse impact of financial liberalisation. To begin with, it has resulted in an increase in financial fragility in developing countries, making them prone to periodic financial and currency crises. These relate both to internal banking and related crises and to currency crises stemming from more open capital accounts. The origin of several crises – whether in Argentina and Mexico or in Southeast

Asia or Russia – can be traced to the shift to a more liberal and open financial regime, since this unleashes a dynamic that pushes the financial system towards a poorly regulated, oligopolistic structure, with a corresponding increase in fragility (Ghosh and

Chandrasekhar, 2009). Greater freedom to invest, including in sensitive sectors such as real estate and stock markets, ability to increase exposure to particular sectors and individual clients, and increased regulatory forbearance all lead to increased instances of financial failure. In addition, the emergence of universal banks or financial supermarkets increases the degree of entanglement of different agents within the financial system and increases the domino effects of individual financial failures.

Left to themselves, financial markets are known to be prone to failure because of the public good characteristics of information, which agents must acquire and process.

They are characterised by insufficient monitoring by market participants. Individual shareholders tend to refrain from investing money and time in acquiring information about management, hoping that others will do so instead and knowing that all shareholders, including themselves, benefit from the information garnered. As a result, there may be 14 Dialogue of Civilizations Research Institute inadequate monitoring, leading to risky decisions and malpractice. Financial firms wanting to reduce or avoid monitoring costs may just follow other, possibly larger, financial firms in making their investments, leading to what has been called the ‘herd instinct’ characteristic of financial players. This not only limits access to finance for some agents, but could lead to over-lending to some entities, the failure of which could then have systemic effects. The prevalence of informational externalities can create other problems. Malpractice in a particular bank leading to failure may trigger fears among depositors in other banks, resulting in a run on deposits there.

Disruptions may also occur because expected private returns differ from social returns in many activities. This could result in a situation where the market undertakes unnecessary risks in search of high returns. Typical examples include lending for investments in stocks or real estate. Loans to these sectors can be at very high interest rates because the returns in these sectors can reach extremely high levels, even as they tend to be volatile. Since banks accept real estate or securities as collateral, lending to finance-speculative investments in stock or real estate can spiral. This type of activity thrives because of the belief that losses, if any occur, can be transferred to the lender through default, and lenders are confident of government support in case of a crisis. This moral hazard can feed a speculative spiral that can, in time, lead to a collapse of the bubble and to bank failures.

Meanwhile, all too often the expected microeconomic efficiency gains are not realised. In developing countries, the market for new stock issues is small or non-existent, except in periods of a speculative boom. Deregulated bank lending tends to privilege risky, high-return investment rather than investment in commodity-producing sectors, such as manufacturing and agriculture. This tends to generate housing and personal finance booms, which also, in many circumstances, tend to increase the fragility of the system. Dialogue of Civilizations Research Institute 15

Another result of financial liberalisation in imperfect markets is the strengthening of oligopolistic power through the association of financial intermediaries and non-financial corporations. Financial intermediaries that are part of these conglomerates allocate credit in favour of companies belonging to the group, which is by no means a more efficient means of allocation than could have occurred under government directed-credit policies.

Moreover, while financial liberalisation does encourage new kinds of financial savings, total domestic savings typically do not increase in many cases, and the expansion of available financial savings is often the result of an inflow of foreign capital. Nor does liberalisation necessarily result in intermediation of financial assets with long-term maturities, because the majority of deposits and loans are of less than six months’ duration. And despite short booms in stock markets, there tends to be relatively little mobilisation of new capital or capital for new ventures. In fact, small investors tend to withdraw from markets because of allegations of manipulation and fraud, and erstwhile areas of long-term investments supported by state intervention tend to disappear. Not surprisingly, investment performance also does not usually reflect signs of either improved volume or more efficient allocation.

External financial liberalisation, with associated capital inflows, only aggravates these consequences. Indeed, all the evidence on capital inflows and subsequent crises suggests that once an emerging market is ‘chosen’ by financial markets as an attractive destination, this sets in motion processes that are eventually likely to culminate in crisis

(Ghosh, 2006). This works through the effects of a surge of capital inflows on exchange rates (unless the capital does not add to an increase in domestic investment, but simply ends up adding to reserves).

An appreciating real exchange rate encourages investment in non-tradable sectors, the most obvious being real estate, and in domestic asset markets generally. At the same time, the upward movement of the currency discourages investment in tradeables and 16 Dialogue of Civilizations Research Institute therefore contributes to a process of relative decline in real economic sectors, and possibly even deindustrialisation in developing countries. Given the differential in interest rates between domestic and international markets and the lack of any prudence on the part of international lenders and investors, local agents borrow heavily abroad to directly or indirectly invest in the property and stock markets. Thus it was no accident that all the emerging market economies experiencing substantial financial capital inflows also at a similar time experienced property and real estate booms, as well as stock market booms, even while the real economy may have been stagnating or even declining. These booms in turn generated the incomes to keep domestic demand and growth in certain sectors growing at relatively high rates. This soon results in macroeconomic imbalances, not in the form of rising government fiscal deficits, but as a current account deficit reflecting the consequences of debt-financed private profligacy.

However, once there is growing exposure in the form of a substantial presence of internationally mobile finance capital, any factor that spells an economic setback, however small or transient, can trigger an outflow of capital as well. And the current account deficits that are necessarily associated with capital account surpluses (unless there is large reserve accumulation) eventually create a pattern whereby the trend becomes perceived as an unsustainable one, in which any factor, even the most minor or apparently irrelevant one, can trigger a crisis of sudden outflows.

One very common argument relates to the importance of ‘sound’ macroeconomic policies once financial flows have been liberalised. It has been suggested that many emerging markets have faced problems because they allowed their current account deficits to become too large, reflecting too great an excess of private domestic investment over private savings. This belated realisation is a change from the earlier obsession with government fiscal deficits as the only macroeconomic imbalance worth caring about, but it still misses the basic point: with completely unbridled capital flows, it is no longer possible Dialogue of Civilizations Research Institute 17 for a country to control the amount of capital inflow or outflow, and both movements can create consequences that are undesirable. If, for example, a country is suddenly chosen as a preferred site for foreign portfolio investment, it can lead to huge inflows, which in turn cause the currency to appreciate, thus encouraging investment in non-tradables rather than tradables and altering domestic relative prices and therefore incentives.

Simultaneously, unless the inflows of capital are simply (and wastefully) stored up in the form of accumulated foreign exchange reserves, they must necessarily be associated with current account deficits.

Large current deficits are therefore necessary by-products of the surge in capital inflow, and that is the basic macroeconomic problem. This means that any country which does not exercise some sort of control or moderation over private capital inflows can be subject to very similar pressures. These then create the conditions for their own eventual reversal, when the current account deficits are suddenly perceived to be too large or unsustainable. In other words, what all this means is that once there are completely free capital flows and completely open access to external borrowing by private domestic agents, there can be no ‘prudent’ macroeconomic policy; the overall domestic balances or imbalances will change according to the behaviour of capital flows, which will themselves respond to the economic dynamics that they have set in motion.

This points to the futility of believing that capital account convertibility accompanied by domestic prudential regulation will ensure against boom-bust volatility in capital markets. With completely unbridled capital flows, it is no longer possible for a country to control the amount of capital inflow or outflow, and both movements can create consequences that are undesirable. Financial liberalisation and the behaviour of fluid finance have therefore created a new problem analogous to the old ‘Dutch disease’, with capital inflows causing an appreciation of the real exchange rate, which causes changes in 18 Dialogue of Civilizations Research Institute the real economy, which therefore generates a process that is inherently unsustainable over time.

There are also adverse implications for investment and therefore for the overall growth and diversification prospects of economies. Financial liberalisation generates a bias towards deflationary macroeconomic policies and forces the state to adopt a deflationary stance to appease financial interests. The need to attract internationally mobile capital means that there are limits to the possibilities of enhancing taxation, especially on capital. Typically, prior or simultaneous trade liberalisation has already reduced the indirect tax revenues of states undertaking financial liberalisation, and so tax–

GDP ratios often deteriorate in the wake of such liberalisation. This then imposes limits on government spending, since finance capital is generally opposed to large fiscal deficits.

This not only affects the possibilities for countercyclical macroeconomic stances of the state, but also reduces the developmental or growth-oriented activities of the government.

These tendencies affect real investment in two ways. First, if speculative bubbles lead to financial crises, they squeeze liquidity and increase costs for current transactions, resulting in distress sales of assets and deflation that adversely impact employment and living standards. Second, inasmuch as the maximum returns to productive investment in agriculture and manufacturing are limited, there is a limit to what borrowers would be willing to pay to finance such investment. Thus, despite the fact that social returns to agricultural and manufacturing investment are higher than those for stocks and real estate, and despite the contribution that such investment can make to growth and poverty alleviation, credit at the required rate may not be available.

This is why it is increasingly recognised that liberalisation can dismantle the very financial structures that are crucial for economic growth. When the financial sector is increasingly left unregulated or covered by a minimum of regulation, market signals determine the allocation of investible resources and therefore the demand for and the Dialogue of Civilizations Research Institute 19 allocation of savings intermediated by financial enterprises. This can result in the problems conventionally associated with a situation where private rather than overall social returns determine the allocation of savings and investment. It aggravates the inherent tendency in markets to direct credit to non-priority and import-intensive but more profitable sectors, to concentrate investible funds in the hands of a few large players, and to direct savings to already well-developed centres of economic activity. The socially desirable role of financial intermediation therefore becomes muted. This certainly affects employment-intensive sectors such as agriculture and small-scale enterprises, where the transaction costs of lending tend to be high, risks are many, and collateral is not easy to ensure. It also has a negative impact on any medium-term strategy of ensuring growth in particular sectors through directed credit, which was the basis for the industrialisation process through much of the twentieth century.

This is all the more significant because the process of financial liberalisation across the globe has not generated greater net flows of capital into the developing world, as was expected by its proponents. Rather, for the past several years, the net outflows have been in the reverse direction. Even the emerging markets that have been substantial recipients of capital inflows have not experienced increases in aggregate investment rates as a consequence, but have built up their external reserves. This is only partly due to precautionary measures to guard against possible financial crises; it also indicates a macroeconomic situation of ex ante excess of savings over investment resulting from the deflationary macroeconomic stance. The curious workings of international financial markets have actually contributed to international concentration, whereby developing countries hold their reserves in US Treasury bills and other safe securities and thereby contribute to the fact that the US economy continues to absorb the bulk of the world’s savings. At the same time, developing countries are losing in terms of the seigniorage costs of holding these reserves, as typically the reserves are invested in very low-yielding, 20 Dialogue of Civilizations Research Institute

‘safe’ assets, while capital inflows include debt-creating flows at much higher rates of interest. This inverse and undesirable form of financial intermediation is in fact a direct result of financial liberalisation measures, which have simultaneously created deflationary impulses and increased financial fragility across the developing world.

4. Conclusion

These examples serve to underline the strong case for alternative models and theoretical frameworks to understand economic reality, and for a greater acceptance of heterodoxy within the economics profession. They also point to the need for more creative thinking about strategies for economic development. These alternative strategies are necessary for both developed and developing economies (Flassbeck et al., 2013). In essence, they would require the following principles to be recognised and then tailored to specific circumstances in individual countries: GDP growth is not an end in itself, but a means for a better life for the people in a society; therefore the latter should be the goal, and a single- minded obsession may even be counterproductive. Rather, the focus should be on improving the material life and social conditions of at least the bottom half of society, which should in turn generate aggregate income growth through a bubble-up (rather than trickle- down) process. This in turn means that employment generation must be a critical goal, and wages in the economy should not be viewed as a cost, but as a source of demand. Fiscal austerity policies that are pro-cyclical in nature should be avoided, and trade and industrial policies remain essential to ensure the diversification of production towards greater shares of higher value added activities, which remains a crucial essential feature of development.

Jayati Ghosh Professor, Centre for Economic Studies and Planning, School of Social Sciences, Jawaharlal Nehru University, New Delhi, India Dialogue of Civilizations Research Institute 21

References

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