Cover Final Done.indd - The IIPM Think Tank

THE 

INDIA ECONOMY REVIEW 

2009 

Volume VI | Quarterly Issue: 30th September 2009 

THE HYPOCRISY OF FREE 

MARKETS & MYTH OF 

FREE TRADE 

INSIDE THIS ISSUE 

Murky Economics 

Wobble Markets 

Protection’s Price 

Open World 

Bound Together 

Rethink And Resurge 

www.iipmthinktank.com 

www.gidf.org 

RETHINK 

EDIFY 

DELINEATE 

A N I I P M T H I N K T A N K 

& 

G R E A T I N D I A N D R E A M F O U N D A T I O N P R E S E N T A T I O N

THE GREAT INDIAN DREAM 

“Let us together dream of a country where poor are not 

just merely reduced to statistics but where there are no poor. 

Let there be a day when small children are taken to a poverty 

museum like science museum where they shiver at the plight 

of the way people used to live in the last millennium. Let this 

dream take the form of a revolution and as long as our dreams 

keep outweighing our memories, India would remain a young 

and dynamic nation on this path to global equality. And for 

this let the wait not be for eternity. Let us together achieve this 

in the next 25 years.” 

Prof. Arindam Chaudhuri 

The Great Indian Dream, 2003, Macmillan 

India,New Delhi 

“A Society where man is at the centre of all activities, 

a society where exploitation of man by man has been 

abolished, where he is cared for as an in a family, where 

“to each according to his need’ is practised, a society where 

non bureaucratic National Economic Planning is given due 

importance for sustainable optimum growth, where adequate 

social safety net is a reality and yet market’s advantages are 

fully taken care of for creativity and entrepreneurship, such 

a society can be truly described as humane society and the 

vision as “Humanism”. 

Dr. M K Chaudhuri 

The Great Indian Dream, 2003, Macmillan 

India,New Delhi

IIPM: THE FUTURE IS HERE 

Since its incorporation (1973), IIPM has been an institution with privileged traditions, in the diversity of its fraternity, its global outlook, its world 

class research and its commitment to alternative national economic planning process. 

It can be said, without much oversimplification that there are no ‘underdeveloped economies’. There are only ‘under managed’ countries. Japan 

140 years was ago was an underdeveloped country by every material measurement. But it very quickly produced management of great competence, 

indeed of excellence. The policy inference is that ‘management’ is the prime mover and ‘development’ is the consequence. At IIPM, every one 

considers that development is a matter of human energies rather than economic wealth. And the generation and direction of these human energies 

is the task of ‘management’. Accordingly, we formed The Great Indian Dream. Unlike any other dream, this is one dream which each one of us 

are determined to realise and that too in our own lifetimes. Each bit of cynicism and condemnation from pessimists makes us evolve even stronger 

and determined. 

All our endeavours and initiative is towards realisation of this dream, where in we produce committed ‘bare foot’ managers and entrepreneurs 

who are needed by nation, on an insistent basis. As an educational institute, we aim at initializing a three dimensional personality in IIPMites, viz. 

� Pursuit of knowledge in economics and management 

� Commitment to economic, social, political and technological upliftment of masses and 

� Cultivation of taste for literature, fine arts and etc. 

Economists often have limited access to the practical problems facing senior managers, while senior managers often lack the time and motivation 

to look beyond their own industry to the larger issues of the global economy. It has set before it the twin tasks: to reorient education and research 

towards the needs of both the private and public sectors and to establish the link between the National Economic Planning and the development 

of private enterprises in Indian economy. IIPM dares to look beyond, and understands that what we teach today, other adopt tomorrow. IIPM’s 

service output (education, research and consulting,) is a unique combination of two distinct disciplines: economics and management. Through 

this integration, IIPM helps guide business and policy leaders in shaping the Indian and global economy, bringing together the practical insights of 

industry with broader national and global perspectives. 

A hall mark of IIPM is that it is armed with the comparative advantage of engaging the committed, passionate and brightest management post 

graduates and undergraduates, who pursued the education at IIPM and subsequently joined it, to realise the dream. IIPM alumni, spread across the 

globe, holding crucial decision-making positions in the corporate sector, are bonded by the one ideology of making a positive difference, turning 

that ideology into a movement itself. 

The India Economy Review is another humble initiative towards the realisation of the same and more distinctly, engaging the broader publics 

and pertinent stakeholders. 

SEARCH, SIEVE, SCHEME... 

In economics, like in everyday existence, it is imperative to hear, perceive and consider what others have to say. Each issue of The IER brings 

together a selection of important contributions on a particular theme, authored by some of the brightest minds in different areas of Indian economics. 

The provocation for publishing these issues arises from the fact that over the years economic journals have become copious, exclusive and expensive. 

Most of the journals and a good many of the books have gone beyond the cerebral and financial reach of general students and other scholars. It is 

for them that these issues are primarily being raised and debated here. 

Much about India is transparent enough. One does not require detailed criteria, cunning calibration or probing analysis to pinpoint India’s 

problems and recognise its antecedents. There is in fact much that is perceptible about India. But not everything about India is even if simplistic is 

so simple. The learned reader would appreciate the fact that India is like an elephant that looms too large to be grasped within a distinct structure 

and paradigm the constituent parts of which would fail to reveal the entirety. Obviously and observably, no suggested solution to any protracted 

and complex socio-economic problem will satisfy all sides and stake-holders evenly. Consequently, there exists an enormous diversity in economic 

thinking and perspectives, as is also reflected in the viewpoints of different expert contributors in this issue. The intended outcome of this exercise is to 

facilitate the invention, improvement, deliberation and dissemination of innovation in economic thinking and national economic planning, insisting 

merely on well-grounded, open and unbiased debates, without predetermined outcomes. It is impossible to do justice to the entire field of Indian 

economics in a single issue. The topics selected for this issue are those which are of critical and immediate importance to India. Majority of them were 

freshly and exclusively written. Encapsulated, it is a constructive attempt aimed at helping India actualise its promises and potential. The editors hope 

that this issue of IER proffer the reader a flavour of dynamism and excitement and persuade her/him to participate in the journey towards realising 

‘The Great Indian Dream’. At the same time, it illuminates the terrible, practical problems of India and Bharat. 

ACKNOWLEDGEMENTS 

The IIPM Think Tank likes to thank all the internal faculty who have been instrumental in coordinating with 

many authors all across India and according their unstinted support. The assistance of Prof. R.Krishnan (IIPM 

Lucknow) Prof. Amlan Ray (IIPM Lucknow), Prof. Tareque Laskar (IIPM Bangalore) and Mr. Robin Thomas 

(IIPM Ahmedabad) has been more valuable than, perhaps, they realise. Mr. R. Nagendra Prasad, Senior 

Manager at SMG, IIPM Hyderabad, particularly did all that it was possible to do for this issue of IER. Lastly, 

Prof. Shyam.S.Pujala (Dean, IIPM Hyderabad) deserves a special mention for his eager and energetic support, 

without which this issue would not have been possible.

CREDITS 

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Additional Thinking 


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Disclaimer : 

All efforts have been taken to ensure the veracity of the information 

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event shall the IIPM Think Tank be liable for any direct, indirect, 

incidental, punitive, or consequential damages of any kind 

whatsoever with respect to the and materials, although the reader 

may freely use the research and material provided, the IIPM Think 

Tank retains all trademark right and copyright on all the text 

The First Words And The Last Word 

Open Economy: A Boon or Bane for India? 

Dear Reader, 

Umpteen wasted years, countless useless 

treaties, innumerable No votes, unnumber- 

able broken promises and the growing sen- 

sation of helplessness by all economies (de- 

veloped and developing otherwise). Ever 

since the beginning of the fi nancial crisis, 

Prasoon.S Majumdar 

Managing Editor 

M.N.V.V.K.Chaitanya 

Deputy Editor 

the policymakers around the world exerted 

strong pressure to enforce the protectionist 

trade policy. China, India and other emerging 

market economies are on the crossroad 

between pursuing free trade policies or imposing 

protectionist trade policies. Against 

this macroeconomic backdrop, IER invited 

the participation of academia, industry and 

policy-makers to address theory and practice 

regarding the linkage between development, 

trade and policy making. An intent 

is to highlight the criticality of developing 

rightful policy decisions in boosting seamless 

fl ow of trade in all variants and across 

all markets. Research papers, case studies 

are invited on all aspects related to these 

strategic facets. Of special interest are those 

papers with specifi c focus on theoretical 

focus and development strategies with historical 

perspectives, specifi cally the opinion 

pieces authored by John Kozy, noted socioeconomic 

philosopher, Rok Spruk, doctoral 

candidate from Slovenia and Dr. Elisabeth 

Tuerk of UNCTAD. The research 

interested in. In non-thematic section, 

the joint paper authored by Dr. Suresh 

Chandra Babu and Dr. G. Bhalachandran 

stresses that let Indian society lead the 

rest of humanity towards pro-environmental-actions 

and thus paves the way for 

pollution -free planet. In ‘Sectoral Snap’ 

section dealing with Indian retailing sector, 

Dr. Mohammad Amin argues that 

competition policies that are currently 

focused exclusively on fi rm-behaviour 

should pay more attention to consumer 

behaviour and consumer attributes that 

shape consumer behaviour. 

You can click straight through to each 

one and read it online at our website, 

www.iipmthinktank.com. 

Happy Reading 

Best 

paper wrriten by Dr. M.S. Goel records the 

experience of developing economies in 

trade negotiations in twenty fi rst century. 

Aditionally, there are some other pieces 

Prasoon.S.Majumdar 

and graphics. from this periodic issue you might also be M.N.V.V.K. Chaitanya

Cover Design: Satyakam Banerjee 

OPEN WORLD: Wobble Markets 

Woebegone Government, Wobbly 

Markets and the Economic 

Management: Rethink, Recast, 

and Resurge 

K.K. Srivastava 08 

OPEN WORLD: India Arriving 

India’s Bits-Network 

Attracting Investment for 

Realizing Development Benefi ts 

Elisabeth Tuerk 16 

OPEN WORLD: Naked Economics 

Policy Transparency and Evaluation 

for Economic Growth in India 

Valentin Zahrnt 28 

OPEN WORLD: Power and Control 

Regulating Markets 

in the Post-Crisis World 

Shalendra D. Sharma 34 

OPEN WORLD: Missing Markets 

Market Failure and 

the Need for Regulation 

Anjan Panday 38 

OPEN WORLD: 

From Columbus To ConAgra 

Trade Liberalisation and Indian Farm 

Sector: Understanding the Situation 

from Available Evidence 

Subrata Dutta 46 

OPEN WORLD: Protection’s Price 

The Harmful Impact of Protectionism 

Rok Spruk 54 

OPEN WORLD: Goldilocks 

(F)ACT SHEET 

Globalization 

Open Economy: 

A Boon or Bane for India? 

Misu Kim & Susmita Mitra 60 

OPEN WORLD: Game Theory 

A Model of North-South Growth and 

Trade as a Differential Game Problem 

with an Empirical Illustration 

T. Krishna Kumar 68 

OPEN WORLD: Bound Together 

Evolution of World Trading System 

and Future of Free Trade: 

A 21 st Century Experience 

M.S. Goel 76 

OPEN WORLD: Murky Economics 

Murky Economics—Comparative 

Advantage & Free Trade Theory 

John Kozy 82 

GROWTH ECONOMICS: Stock Taking 

The India Story: Served Sunny Side Up 

Ketaki Sharma 88 

GROWTH ECONOMICS: 

What’s This India Business? 

Is Rising Share of Services 

Inevitable for GDP Growth? 

Madhusudan Dutta 92 

GROWTH ECONOMICS: 

An Elusive Quest 

Modern Theories of Growth: 

A Critique 

Ambar Ghosh & Chanadana Ghosh 100 

WELFARE ECONOMICS: 

Rethink and Resurge 

Employment Guarantee, Not 

Employment Subsidy Approach 

Suits Indian Conditions 

Saumitra Mohan 112 

WELFARE ECONOMICS: 

Recast and Restructure 

Governance and Employment 

Generation in Rural Areas: 

A Case Study of NREGs in Selected 

Districts of West Bengal 

Byasdeb Dasgupta & Bipul De 118 

WELFARE ECONOMICS: Water Wisdom 

NRDWP – A Paradigm Shift in Rural 

Drinking Water Supply 

Benny George 126 

LAW AND ECONOMICS: 

Law Growth Nexus 

Review of Economic Development 

and Legal System: An International 

Perspective 

Uma Sankaran 132 

LAW AND ECONOMICS: Flat World 

Free Trade and Free Markets: 

A General Law Perspectives 

Rabin Majumder 142 

ENVRIONMENTAL ECONOMICS: 

Silent Spring 

Mitigating Environmental Crisis: 

Can India Show the Way? 

G. Bhalachandran & 

Suresh Chandra Babu 146 

ENERGY ECONOMICS: Charging Ahead 

Wind Energy in India - 

Reforms to the Rescue 

Ritesh Agarwal & Shiva Agarwal 152 

MICRO MACRO: Entrepreneurial Ethos 

Mismatch between Entrepreneurial 

Intention and Environment - A Survey 

in Burdwan District of West Bengal 

Soumyendra K. Datta & 

Rimu Chaudhuri 158 

MICRO MACRO: Social Edge 

Microfi nance at Turning Point: 

Success Factors of Microcredit in 

Bangladesh and Its Future Prospects 

Tomohito Kanaizuka & 

Farhad Hossain 166 

SECTORAL SNAP: Retail Roulette 

Consumer Behavior and 

Competition in Indian Retailing 

Mohammad Amin 176 

COUNTER CURRENTS: Trust Busting 

Crisis in Academic Economics 

Amol Agarwal 184 

GLOBAL GOVERNANCE: IMF 

New Resources for 

an Unreformed IMF? 

Kunibert Raffer 196 

GLOBAL GOVERNANCE: Unbearable 

Lightness 

The Unbearable Lightness of 

Financial Markets 

Heiner Flassbeck & Sonia Boffa 202

O PEN WORLD 

Woebegone 

Government, Wobbly 

Markets and the 

Economic Management: 

Rethink, Recast, and 

Resurge 

8 

THE IIPM THINK TANK 

K.K. Srivastava 

Lead Economist, The IIPM Think Tank, 

New Delhi 

A 

stylized assumption is that if the government does 

what it must – provide a secure environment – and if 

markets have perfect competition then a free market 

economy will allocate resources with relative effi ciency. Alas, 

real world is characterized by existence of common property 

resources, public goods, negative externalities, and excessive 

market power concentrated in some hands. Government 

intervention, becomes necessary to correct market failures. 

Besides, in addition to potential for ineffi ciency a free market 

economy essentially deals with the dilemma of economic 

inequity. This further adds to government responsibilities. 

Markets are considered to be superior to central planning 

since they provide more, better and cheaper information for 

decision making. They provide a relatively more fl exible 

system with a great scope for personal adaptation. These 

adjustments can be made much faster. And they decentralize 

power. In a perfectly competitive market both production 

effi ciency and allocative effi ciency are attained. Thus each fi rm 

produces at least possible cost, all fi rms within an industry face 

the same price and marginal cost, and the marginal cost of

producing each good is equal to its market price. This is the 

idealized situation. In real world, almost all the fi rms face a 

negatively sloped demand curve, leading to equilibrium price 

being always higher than marginal cost. Market fails, i.e. 

allocative ineffi ciencies emerge. And government gets a 

legitimate right to intervene so as to improve – even if not 

eliminate altogether – the market effi ciency. Though any 

student of economics knows about circumstances under which 

markets fail, these bear a remention: 

One, producers with excess capacity set prices which lead to 

ineffi cient exclusion; two, each economy has common property 

resources that belong to none specifi cally but can be used by 

anyone; so these are prone to be overexploited; three, there 

exist public goods where nondiminishability and non exclusion 

apply; four, people not participating in a market transaction 

may still be affected due to the outcome, i.e. they may suffer 

negative externalities or enjoy positive ones; fi ve, there exists 

the problem of asymmetric information – one party having 

unfair advantage over the other because of access to better 

information needed for economic decision making; six, some 

markets – known as missing markets – may be needed but may 

not exist, may be due to uncertainties, adverse selection 

possibility, and so on; and, fi nally, seven, 

imperfect competition may lead to an equilibrium 

price higher than the marginal 

cost. 

Given all of the above the government 

has two options – replace the market with 

central planning (as was unsuccessfully 

tried in many centrally planned economies) 

or may seek to correct the ineffi ciencies 

through direct and indirect intervention. 

To be sure, however, such 

interventions are neither costless nor error free; the post 

intervention outcome may at times be less desirable than an 

ineffi cient market functioning! 

Thus we know that markets work best when goods and 

services are available in a fi nite amount, are diminishable 

upon consumption, and non payers are excludable. But 

actually some goods and services, say an art gallery, may be 

excludable though not diminishable. If these goods are 

provided privately then the price will exceed marginal cost and 

some people who are willing to pay more than this marginal 

cost but less than current price do not use it. This kind of 

Society’s resources 

are optimally 

allocated when 

the social 

marginal cost 

equals the social 

marginal benefits 

W OBBLE MARKETS 

failure is called ofcourse ineffi cient exclusion. And, to avoid 

ineffi cient exclusion the government itself often provides 

them, like a public park. The service is provided free and the 

costs are met out of other levies like taxes. 

On the other hand common property resources pose 

another problem: these are diminishable but non-excludable. 

Under the free market provision common property resources 

will be used upto a point where the marginal cost of the last 

entrant equals the average output of all existing producers. 

The socially optimal exploitation though would occur when 

the marginal cost of the last user equals the value of the 

marginal addition to total output. Result: overexploitation. 

While the solution may lie in fi xing quota (say, for fi shing in 

the sea) or licensing, the problem lies in enforcing the restriction 

which are both diffi cult and costly to implement. Another 

solution suggested is to make them excludable: privatize the 

forests, wildlife, etc. so that the private owners will have a 

tendency to exploit them effi ciently. But equity issues arise: 

those who were using them earlier for free perhaps will suffer 

a welfare loss. The classic dilemma of equity vs. effi ciency. 

Public goods are both nondiminishable and non excludable, 

i.e. these are produced for collective consumption, say 

information. But because public goods are 

non excludable, private producers are not 

interested in providing them. So products 

like weather forecast, fi re protection, etc. 

are provided by the government, and for 

free. So the free rider problem is also 

avoided. But the issues of over or under 

production is more diffi cult to settle since 

now there is no market for such products. 

Talking of externalities, society’s 

resources are optimally allocated when 

social marginal cost equals social marginal benefi ts. But in 

case of positive externalities the output produced is invariably 

less than the socially optimum level while in case of negative 

externalities this output exceeds the socially optimal levels. 

Naturally, therefore, to achieve optimally production of 

output with benefi cial externalities needs to be encouraged 

while the other kind, with harmful effects, needs to be cut 

down from the level that would be produced under free 

market conditions. 

Most – though not all – externalities arise because of 

absence of property rights – I don’t own the air that I pollute 

THE INDIA ECONOMY REVIEW 

9

O PEN WORLD 

nor does the one who suffers from polluted air. So to the 

extent that appropriate property rights can be created, these 

externalities can be internalized. Else, we will have to learn to 

live with externality. 

Asymmetric information of course leads to issues like moral 

hazard and adverse selection. Due to moral hazard social costs 

are unnecessarily high (a careless but insured driver) while in 

case of adverse selection market outcome is less effi cient than 

when all the participants were equally well informed. One 

possible solution could be again state intervention to impose 

standards and level to which information has to be compulsorily 

revealed. But in many situations government can’t do 

anything to ensure availability of ‘fair’ information to transacting 

parties (a doctor determines whether by pass surgery is 

essential on a heart patient or not, based on the fact may be 

that he will be richer by a few lakh rupees?) 

Coming to the missing markets, of course markets don’t 

exist for public goods or common property resources, but 

these don’t exist for products involving uncertainty (i.e. non 

insurable events) too. For example, while future markets for 

commodities do exist because these are well established and 

unchanging, no such markets exists for 

most manufactured products. Who knows 

after all whether LED will replace CFL in 

India in next three years or not, when 

CFLs themselves are struggling to replace 

the ordinary light bulbs. Future markets 

are missing and there is no way that the 

costs and benefi ts of planned future 

expenditure on these products can be 

equated by today’s transactions. 

Finally, market power is unequally 

distributed; perfectly competitive markets with atomic fi rms 

are mere theoretical constructs. Yet competition must be 

encouraged and monopoly practices must be curbed. This can 

be done by either infl uencing the market structure or the 

market behaviour. So most governments follow a competition 

policy wherein they may try to directly control natural monopolies, 

they may directly control harmful monopoly and 

oligopolies, and they may seek to create more competitive 

conditions. Thus in case of natural monopolies like say 

electricity distribution the government either assumes ownership 

of the single fi rm (Delhi Vidyut Board earlier) or privatizes 

it (BSES, etc) and then regulates it (through DERC). 

10 


Regulatory 

arbitrage infact 

causes as much 

economic losses to 

the country as do 

the poor decisions 

by the Executive 

Since 1980s (in India since 1991) there has been a movement 

in many developed and developing nations to deregulate and/ 

or privatize. This is mainly due to a growing belief among 

policy makers than private fi rms operating in free markets are 

more effi cient producers and innovators than governments. To 

be sure this is not to suggest zero intervention. Remember, we 

had quoted seven situations of market failure. In the presence 

of many of these it is not necessarily effi cient to allow the free 

markets to decide all issues of resource allocation. The least 

stringent form of government intervention of course seeks to 

create conditions of competitions by preventing fi rms from 

merging unnecessarily or colluding to set monopoly prices. In 

general competition by preventing fi rms from merging 

unnecessarily or colluding to set monopoly prices. In general 

competition policy aims at preventing the fi rm from ganging 

up against hapless consumers. 

Argument So Far..and Further 

Briefl y put, we can say that effective governments defi ne and 

protect the rights and obligations of private property. Market 

economies seek to coordinate decentralized decisions without 

conscious control. In the process they also 

determine the distribution of income. 

Thirdly, compared with the alternatives, 

perfectly functioning markets attempt to 

minimize concentration of economic 

power. To the extent desirable outcomes 

do not occur, the government needs to 

intervene – to enhance effi ciency and to 

come closer to (subjectively defi ned) 

equity goals. Thus even if the markets work 

well most times, they seldom work optimally 

because of the inevitable presence of one or more of 

market failures. So the government policy attempts to alleviate 

these failures. either by imposing more effi cient behaviour by 

rules, regulations, and even public production or by internalizing 

externalities. 

But while government interventions may have potential to 

improve the workings of the markets, this does not mean that 

they always get it right. In this regard we need to note fi ve 

important facts. First, governments have many objectives to 

pursue in addition to effi ciency, viz., growth, stability, and 

equity; second, growth and equity objectives may actually 

confl ict with effi ciency goal; third, government uses policy

tools like fi scal policy, legal provisions, regulations, as well as 

state entrepreneurship to attain the economic objectives; 

fourth, these government interventions involve both the direct 

cost of administration and indirect costs associated with 

interference with the price mechanism; and, fi fth, the government 

in practice may have incentives to consciously deviate 

from delivering economic effi ciency (an impending election 

and a soft budget). 

Thus the government policies are directed at modifying the 

income and wealth distribution that was ordained due to one’s 

parent’s abilities, luck, and market for him. But often the goals 

of a more equitable distribution confl ict with the goals of a 

more effi cient economy. The government has to at times 

protect one person from abusive potential exercised by other 

(thus law against child labor) or protect someone from his own 

Table 1: Functions of the State 

Minimal 

Functions 

Intermediate 

Functions 

Activist 

Functions 


ance costs, and even losses in productivity. Not only this even 

indirect external costs are involved such as effi ciency losses 

that spread throughout the whole economy; these in turn may 

be an outcome of the alteration in price signals caused by 

government tax and spending policies. 

Like we said earlier that the governments intervene to 

reduce the imperfections of the market, let’s also candidly 

admit that the potential for benefi ts would exceed costs also in 

a world where the government functioned perfectly. Which 

ofcourse is like a utopian dream. Government failure – not 

achieving some possible gains – can arise because of rigidities 

causing a lack of adequate response of rules and regulation to 

changing conditions, poorer foresight on the part of government 

regulators compared with private participants in the 

market, and government objectives – such as wining the next 

Addressing Market Failures Improving Equity 

Providing Pure Public Goods Protecting Poor 

- Defence 

- Law and Order 

- Property Rights 

- Macroeconomic Management 

- Public Health 

- Anti Poverty Program 

- Disaster Relief 

Externalities Monopoly Regulation Imperfect Information Social Insurance 

- Basic Education 

- Environment Protection 

Source: World Bank: World Development Report, 1997. 

- Utility Regulation 

- Anti Competitive Policy 

- Financial Regulation 

- Consumer Protection 

- Redistributive Pension 

- Unemployment 

Insurance 

Coordinating Private Activity Redistribution 

- Fostering Markets 

- Cluster Initiative 

self (a potential/actual drug addict). Besides, sometimes the 

government may have to invoke social obligations (like 

compulsory military enlistment, or vote in the election or at 

least have no right to buy one’s way out of jail for an offence 

committed!). For achieving all these goals and more the 

government has in its toolkit such instruments as taxes, 

spending, rules and regulations, as well as state ownership. 

But government activity entails incurring of direct external 

costs imposed on those directly affected by these policies. 

These could be in the form of extra production costs, compli- 

- Asset Redistribution 

election; they confl ict with such objectives as improving 

economic effi ciency. 

Having said so, contrary to the popular perception, the role 

of the State has increased in the economic management in 

recent decades rather than diminishing. Only that this increase 

in the State’s infl uence has shifted the emphasis from the 

quantitative to the qualitative, from the sheer size of the State 

and the scope of its intervention, to its effectiveness in meeting 

people’s needs. 

Today’s renewed focus on the State’s role has actually been 


11

O PEN WORLD 

inspired by dramatic events in the global economy, which have 

fundamentally changed the environment in which States 

operate. The global integration of economies and the spread 

of democracy have narrowed the scope for arbitrary and 

capricious behaviour. Taxes, investment rules, and economic 

policies must be ever more responsive to the parameters of a 

globalised world economy. Technological change has opened 

new opportunities for unbundling services and allowing a 

larger sole for market forces. These changes have meant new 

and different roles for government no longer as the role 

provider, but as facilitator and regulator. All under the triple 

infl uence of liberalization, privatization, 

and globalisation. In India too we are 

witnessing deregulation in many industries 

– banking, insurance, automobiles, civil 

aviation, telecom, and so on. 

When the economy moves from protected 

monopolies to market competition, 

in the interim we need strong and effective 

regulators. Else, there is likely to be a 

heavy cost in the form of rent seeking, 

reduced effi ciency, and compromise with 

consumer welfare. And even at the risk of stating the obvious 

different industries are at different stages of freedom and 

deregulation. So they need different kind of treatments. 

Whiffs of Competition in Successive Stages 

There exists a continuum from protected monopoly to market 

competition. Depending on historical evolution pattern 

different industries fi nd themselves in one of the fi ve distinct 

Table 2: Evolution of Competition and its Maturing 

12 


Global economic 

integration and 

the spread of 

democracy have 

narrowed the 

scope for arbitrary 

& capricious acts 

stages of this continuum, or even between the two stages. 

What one needs to appreciate is that each stage (from 

monopoly to dynamic competition) exhibits different characteristics 

and throws up different challenges. Depending on 

the pace at which the particular industry is orienting itself to 

fair competition, regulatory task will be customized; we can’t 

have standard regulatory process. Hence it is important for 

us to understand the unique characteristics associated with 

each stage. 

Stage-1: The Bliss of Solitude….and the Pains! 

This stage exists prior to deregulation. 

There are strict government controls, free 

entry is barred, and the customer is devoid 

of alternatives. At best there could be a 

regulated oligopoly structure. Naturally 

pricing is distorted with the cost being the 

major determinant of fi nal price. At times 

the government may intervene in matters of 

pricing in the interests of social justice; in 

such a case the monopoly maintains cross 

subsidization scheme to remain in surplus/ 

profi t. Many a time profi t may even be treated as a dirty word. 

So there is hardly room for, or inclination to, work effi ciently. 

On the other hand not much surplus is generated so that 

CAPEX is constrained. Alternatively, there may be an excessive 

bleeding of existing assets. Protected status and lack of incentives 

kills the scope for innovations. Sure, we witnessed all this, 

and more, in insurance industry, airlines business, oil and gas 

sector, etc. before 1991. 

Stage-1 Stage-2 Stage-3 Stage-4 Stage-5 

Solo Player Some Players Several Players Select Few Survivors 

Little or no competition Entry cases Dogfi ghts begin Shake out happens Souls with sustainable 

advantage 

- Railways - Electricity - Organised Retailing - Automobiles 

distribution 

- Oil and Gas - Airlines 

- Insurance business - Cellulars 

- Mutual Funds 

Source: Self constructed by the author 

Note: The industry placements are in Indian contexts while the stages are applicable generally


Stage-2: You’ve Got Company 

try even in the context of fi ve forces model of Michael Porter. 

The markets may be opened up and pricing freed. To smoothen The industry has consolidated itself, with each player having 

the process an independent regulator may be appointed. Private carved out a niche for itself. Costs are squeezed and prices set 

players may be allowed but with restriction like equity caps, no under the optimum infl uence of 3C’s – cost, customer, and 

foreign participation, etc. This also means, however, that under competitor. Having earlier ventured adventurously into territo- 

the euphoric feeling of a (false/limited) sense of freedom the ries unfamiliar, most incumbents now choose to come back to 

players fail to fully appreciate the impending perils of change; their core customers. Market itself is the regulator now; it is 

some of them at least are lulled into complacency either because 

they have joined this stage from being earlier in Stage-1 (mo- 

regulation by exception. 

nopoly/regulated oligopoly) and have not yet overcome their Stage-5: Darwinism Rules, Truly! 

sense of invincibility, or they are new to the industry with little Only competition rules the entire market place. Prices are 

appreciation of all the dimensions of the working. Euthanasia fl exible under the dynamics of forces of demand and supply. 

begins, or is it hara kiri? 

Proactive companies alone grow; reactionaries have no role once 

the revolution has taken place! So the marketplace is ever 

Stage-3: Commoditization Reappears 

evolving to meet the changing needs and preferences of custom- 

Due to gradual deregulation competition spreads deep and wide. ers. The competition is more global than local. Regulators retire 

Products and services proliferate and customers are spoilt with 

alternative offerings at very heavily discounted prices. Currently, 

into oblivion! 

the airline industry, mutual funds industry, and even cement Time to Let Go? Well, Yes and No 

industry is in this stage. Individual market shares decline, newer While everyone agrees that market failures, which are as 

and more nimble players emerge which fi rst take on the best and ubiquitous as the presence of the market itself, are ground 

then the rest, and fi nances, talent pool, and all resources face enough for the government to intervene with regulations, 

crunch situation. While there are more births (new entries), actually the latter are required even when the markets work 

numbers of those dying (exiting) in not so distant a future is likely perfectly. Even competition needs to take place within a frame- 

to surpass the newborns. 

work of rules. The protectors of law must remain within the 

range of vision, even if they are not required to galvanize into 

Stage-4: There is Room for Few Only 

action at a given point of time. Competition yes, unfair competi- 

By now the market is almost completely deregulated; competition no. 

tion is formidable. The customers are very well informed and By one estimate, America, the supposed land of the unfet- 

know their mind. The select few players who have been able to tered, has nearly 78,000 pages of regulation, and 2.41 lakh 

survive have gained critical mass and well ensconced in the indus- employees to ensure their enforcement. A McDonald burger has 

to follow 80 different regulation before 

Table 3: The Regulator: Ideal vs. Indian 

a customer bites into it. 

But then there is such animal as an 

Ideal Indian 

ideal regulator who is very different 

- Statutory backing, with clearly defi ned - Statutory backing, but relevant laws from an Indian incarnation. We have, 

powers 

- Independent, free from bureaucratic 

interference 

may remain unamended 

- Dependent, heavy interference 

interalia, regulators for aviation, 

broadcasting, cellulars, disinvestment, 

- Accountable only to legislative - To Parliament and to the Ministry insurance, petroleum and natural gas, 

- Funding from independent sources - Budgetary support 

ports, power, roads, telecom, and 

- Independent secretarial for technical 

support 

- Transparent functioning. Consultative 

- Relies on Ministry for such support 

- Not very transparent, through con- 

(proposed for) water. However, all of 

them suffer from certain inherent 

discussions 

sultative 

weaknesses, the biggest one of which is 

Source: Business Today (August 7 lack of independence. 

th ,1999): The Dependent Regulator 


13

O PEN WORLD 

14 

Regulatory arbitrage infact causes as much economic losses 

to the country as do the poor decisions by the Executive or the 

misdemeanours of the market players. India has failed on one 

hand in regulating capacity building and on the other from a 

weak regulatory oversight. Thus instead of appointing competent 

and committed professionals, these positions are used for 

parking retired bureaucrats and judges. And with shorter 

Parliament sessions there remains a very limited scope for 

Parliament’s Executive oversight. 

Following a predictable pattern the government may 

announce setting up of an independent regulatory authority 

but it is not notifi ed or constituted for quite sometime (recall 

about the authorities for pension regulation or competition). 

When appointed these regulators lack independence and 

autonomy. Most regulators thus may be dependent and/or 

lacking independent powers. 

Table 4: 

Where Are We 

What Are the Issues 

Involved 

What Are Regulators 

Expected to Do 

Source: Self constructed by the author 


allow interference by the Ministry concerned. For 

example, does the Ports Trust Authority set only tariffs 

or is it responsible for everything else too? In an ideal 

scenario, violated of course in India, in a general policy 

framework the regulators are empowered to implement 

the rules. Finally, granting operational autonomy helps 

insulate the reform process from bureaucratic interference. 

2. Independent Regulators 

Must Have Independent Funding 

One who pays the piper calls the tunes. The government 

controls the purse strings, and keeps the regulators on a 

tight leash. Thus both fi nancial autonomy and fi nancial 

incentive to work effi ciently are lost. And, to be sure, 

independent funding in no way should axiomatically 

No Regulation through Active Regulation to Regulation by Exception 

State Ownership 

(Railways) 

- Subsidies 

- Falling effi ency 

- Nothing; there is no regulator 

According to Swati Kamal, while writing in Business 

Today, an effective regulatory body is possible only 

when at least four rules are followed. What does our 

experience in India tell us? Well, 


Must Have Clearly Defi ned Powers 

For this the underlying Act must be worded unambiguously. 

Yet, in most cases, the provisions have been 

ambiguous, ensuring that the foundation itself is shaky. 

For example, the CERC Act does not defi ne the relationship 

between the CERC and the SERCs, leaving 

enough scope for confl ict. Besides, ambiguities can 

Privatization 

(Cellular Industry) 

- Subsidy cuts 

- Price increases 

- Inter-connection problems 

- Tariff bsetting 

- Fixing inter-connection 

charges 

- Disputes regulation 

- Monitoring of quality, safety 

etc. 

Competition 

(Financial Intermediaries) 

- Price competition 

- Consolidation 

- Customer Choices 

- Monitoring of inter-connection 

issues 

- Dispute resulation 

- Monitoring competition 

- Monitoring of quality, safety 

etc. 

mean a compromise with accountability. Simple auditing 

of accounts can ensure this. 


Must Be Independently Staffed 

Likewise, there is a clear cut interference of the concerned 

ministry in matters of appointment of the 

chairman and members of the body. Worse, they in turn 

lack independence in selecting their juniors. To be fair, 

however, some degree of independence is being provided 

now. 

4. Independent Regulators Must Be Able to Deal With

Independent Operators 

India has the unique distinction – but dubious at that 

– of the same person being in a dual position of being a 

regulator and being the regulated (examples, at least 

earlier, from telecom, insurance, and so on). Obviously, 

when both the operator and the policy maker are same, 

friction is bound to occur. Besides, when the incumbent 

player/policy maker faces competition (as in case of civil 

aviation) the policies will be designed to protect monopoly 

status. In India where the government is thus 

both service provider and policy maker this linkage 

needs to be severed. Why not corporatize the SEBs, for 

example? 

Conclusion 

Indian marketplace is in a transition phase. For a 

developing India if we are conceiving a blueprint for 

sustaining effi cient growth and investments for the next 

periods, cracking the problem of an often dysfunctional 

system is crucial. Else, we will be condemned to suffer 

huge economic losses. There is a need to defi ne and 

implement the fundamental rights for citizens as well as 

businessmen. And then ensure that no one violates each 

others’ rights. 

References and Additional Thinking Thinking 

B. G. Verghese: Why Honesty Doesn’t Pay (in) 

Business world, 24th August, 2009 

Binu Kwatra: The Hidden Costs of Business (in) 

Business world, 24th August, 2009. 

Business world editor: The Fundamental Rights of 

Business (in) Business world, 24th August, 2009. 

BW editorial team: Time to Rebuild the Nation (in) 


Chandrajit Banerjee: Make Hire and Fire Easier (in) 


D. Thankappan: Workers Need More Security (in) 


ET Editorial Team: Why Markets Need Regulators 

(in) The Economic Times, 18th February, 2002. 

Girish Vanvani & Saloni S. Khandelwal: Making the 

Right Cut (in) Business world, 24th August, 2009. 

Hari Shanker Subramaniam: Notes on Tax Freedom 

(in) Business world, 24th August, 2009. 


Harish Salve: Getting it Right (in) Business world, 

24th August, 2009. 

J. K. Mitra: The Right Chapter (in) Business world, 

24th August, 2009. 

Jagdish N. Sheth, Allvine, Uslay & Dixit: Deregulation 

and Competition. Response Books (2007). 

Jayant Sinha: Time to Let Go (in) Outlook Business, 

19th September, 2009. 

Michael Porter: Competitiveness and Micro – Economics 

(in) Business Today, 22nd September, 1998 

Rajeev Chandrashekhar: Regulatory Dysfunction (in) 

Business world, 31st March, 2008. 

Ranbir Roy Choudhury: Doing Business in India (in) 

Business Line, 21st September, 2009. 

Rohit Saran: The New Political Economy (in) Business 

Today, February 7th-21st , 1998. 

Rukmani Parthasarthy & Swati Kamal: For the 

Reforms (in) Business Today, 22nd September, 1999. 

Rukmani Parthasarthy: Freedom in Fetters (in) 

Business Today, 7th April, 1999. 

S. Gopalakrishnan: Cut the Red Tape (in) Business 

world, 24th August, 2009. 

Sandeep Biswas: Surviving Deregulation (in) Business 

Standard, 11th December, 2001. 

Sanita Aggarwal: Airport Regulator Pushes for 

Financial Autonomy (in) Indian Express, 22nd September, 

2009. 

Shalini S. Sharma: Turning Burden into Boom (in) 


Sreevalson Menon: Tangled in Red Tape (in) Business 

world, 24th August, 2009. 

Swaminathan S. A. Aiyar: Regulating the Regulators 

(in) The Economic Times, 13th February, 2008. 

Swati Kamal: The Dependent Regulator (in) Business 

Today, 7th August, 1999. 

World Bank: World Development Report, 1997 (by) 

World Bank, Washington. 

Y.C. Halan: The State and the Corporate (in) The 

Financial Express, 6th April, 2002. 

Y.V. Reddy: State and Market (in) Economic & 

political Weekly, October 16th-23rd , 1999. 

(The views expressed in the article are personal and do not 

refl ect the offi cial policy or position of the organisation). 


15

O PEN WORLD 

India’s Bits-Network 

Attracting Investment for 

Realizing Development 

Benefi ts* 

16 


Elisabeth Tuerk 

Senior Legal Expert, International 

Agreements Section, 

UNCTAD DIAE, Geneva

In August 2009 India and the Republic of Korea signed a 

bilateral agreement containing a chapter with substantive 

provisions on the promotion and protection of 

investment. The agreement also sets out pre-establishment 

national treatment. 1 Counting both, bilateral trade or 

cooperation agreements and bilateral investment treaties 

(BITs), the India–Republic of Korea agreement is the 82nd international investment agreement (IIA) India has signed. 

The agreement with the Republic of Korea is also the third 

agreement with investment provisions that India has signed 

during the last twelve months. 2 

Over the last years India has become one of the most 

active countries in signing IIAs, 3 a development which could 

also be a refl ection of India’s increasing role as a capitalexporting 

country. 4 While IIAs can offer 

an important tool for realizing the 

development benefi ts expected from 

increasing inward and outward investment, 

care has to be given to avoid 

unintended side-effects of such agreements, 

including the reduction of domestic 

policy space and unexpected or 

unwarranted exposure to Investor-State 

Dispute Settlement (ISDS) cases. 5 

This essay offers a brief sketch of 

India’s approach to IIAs. It commences with some background-information 

on the country’s FDI trends; it then 

looks at the evolution of India’s IIA network over time; 

followed by an overview of the country’s BITs (based on the 

analysis of twenty two selected BITs). 

1. Background: FDI Flows to and from India 

In 2008, Indian inward FDI stock reached a substantial 

US$ 123.3 billion, while outward FDI stock reached US$ 

61.8 billion. This turns India into the 24th most important 

destination for FDI, and into the world’s 31st largest outward 

investor. 

Inward FDI fl ows into India had begun to emerge in 

signifi cant amounts during the mid-1990s. Though volatile, 

inward FDI fl ows have been on the increase. A sharp jump 

occurred in Indian inward FDI fl ows in 2006, when Indian 

inward FDI rose from US$ 7.6 billion in 2005 to US$ 20.3 

billion a year later (almost three times higher than 2005). In 

that year, the country received more FDI than ever before, 

Similar to inward 

FDI, outward 

FDI flows also 

experienced a 

jump, from $3 bn. 

in 2005 to $14.3 

bn. in 2006 


I NDIA ARRIVING 

equivalent to the country’s total infl ows during the period 

2003–2005. The year 2008 saw a further rise in inward FDI 

fl ows to US$ 42 billion. Rapid economic growth which has 

led to improved investors confi dence might be amongst the 

many reasons for these developments. Similarly, sustained 

growth in income has made the country increasingly 

attractive to market seeking FDI. Numerous US and 

Japanese TNCs (ranging from GM, IBM, Toyota and 

Nissan) and private equity fi rms were playing an important 

role in this context. 6 

Outward FDI from India emerged at signifi cant levels at 

the turn of the century, hence somewhat later than respective 

inward FDI. Since 2000, outward FDI fl ows continued to 

increase year-on-year. Similar to inward FDI, outward FDI 

fl ows also experienced a jump between 

2005 and 2006, from US$ 3 billion in 2005 

to US$ 14.3 billion in 2006, constituting 

an almost four times increase just in one 

year. Outward FDI fl ows rose to US$ 17.2 

billion the following year. 7 So far, the 

amount of inward FDI fl ows/stock has 

always been substantially larger than 

outward FDI fl ows/stock. 

With the global fi nancial and economic 

crisis came a signifi cant decrease in global 

FDI fl ows. However, developing countries are very likely to 

be strong engines for FDI growth in the coming rebound. 

This is confi rmed by UNCTAD’s recent World Investment 

Prospects Survey (WIPS) 2009–2011, which places the 

so-called BRIC countries (Brazil, the Russian Federation, 

India and China) among the top fi ve most favoured destinations 

for future FDI activities by large TNCs worldwide. 8 In 

addition to a general economic stimulus package, India 

enacted several policy measures dealing with the entry, 

facilitation, and operation of FDI9 and India also continued 

to sign new BITs. In comparison to other countries, overall 

prospects for inward FDI in India are positive. 

2. India’s Network of IIAs: Overview and Trends 

An IIA is an international agreement – or treaty – between 

two or more countries that addresses issues relevant to 

cross-boarder investments. The most common types of IIAs 

are bilateral investment treaties (BITs) and preferential trade 

and investment agreements (PTIAs), with investment 

17

O PEN WORLD 

provisions. Countries may conclude IIAs with a view to 

protecting their investors abroad or with the aim of attracting 

foreign investors to their economy (e.g., investment promotion). 

Through the protection, increased security and 

certainty under international law that an IIAs offers to 

investors (companies and individuals) from contracting 

parties who invest or set up a business in 

other countries party to an agreement, 

IIAs can indirectly promote FDI. 10 

Allowing foreign investors to settle 

disputes with the host country through 

international arbitration, rather than only 

through the host country’s domestic 

routes, is considered an important aspect 

in this context. However, the increasing 

number of international investment 

disputes emerging from such agreements, 

as well as the costs and challenges associated with them (e.g., 

fi nancial implications, costs of litigation and inconsistent 

awards), have given rise to increasing concerns from policy 

makers, academia and affected stakeholders. 11 

By the end of 2008, the total number of BITs worldwide 

rose to 2,676 and the total number of IIAs other than BITs 

and DTTs amounted to 273. 12 To date, India had signed 82 

IIAs. 13 nomic Cooperation Agreement (CECA) of 

2005 and the 2009 Comprehensive Economic 

Partnership Agreement (CEPA) between India 

and the Republic of Korea are examples for the 

latter type of agreements. 

Compared to other countries, India started 

negotiating BITs relatively late, with the conclusion 

of its fi rst BIT (with the United Kingdom) 

in March 1994, 

75 of these agreements are BITs and seven are 

other international agreements containing investment 

provisions. The India–Singapore Comprehensive Eco- 

14 briefl y afterwards followed by 

a BIT with Russia. In 1995 alone, India signed 

seven BITs. With ten new agreements, 1997 was 

the year with the largest number of agreements 

concluded, followed by an average of fi ve 

agreements per year between 1998 and 2008. 15 

Despite the fact that India only signed one 

agreement in 2004 and no agreement in 2005, 

the country is still one of the most active BITs 

negotiators in the world. In 2008, India concluded six new 

BITs, continuing an earlier trend with fi ve new BITs in 2006 

and six in 2007. 16 In 2009, the country has already signed 

two BITs – with Bangladesh and Mozambique – and one 

other IIA (CEPA with the Republic of Korea). India also 

completed BITs negotiations with Colombia (2009) 17 and 

with Canada (2007). 18 

Figure 1: Indian Inward and Outward FDI Stock: 1990–2007, 

US$ Million 

45000 150000 

36000 

125000 

27000 

100000 

75000 

18000 

50000 

9000 

25000 

0 

0 

1995 1997 1999 2001 2003 2005 2007 

FDI outfl ow 

Inward FDI stock 

FDI infl ow 

Outward FDI stock 

An interesting characteristic of India’s 

In 2008, India BITs network is the diversity of its partner 

concluded six new countries. India has signed BITs with all 

BITs, continuing regions of the world, albeit with a different 

focus over time. During its early years 

an earlier trend 

of BITs negotiations, India signed 

with five new BITs agreements mainly with developed 

in 2006 and six in countries in Europe (Germany, Italy, 

year 2007 Denmark and the Netherlands in 1995). 

Today, 24 (30%) of India’s BITs are with 

developed countries. More recently, India has concluded 

more agreements with other developing countries (fi ve BITs 

in 2008). Today 38 (51%) of India’s BITs are South-South 

agreements, possibly refl ecting both the country’s increasing 

role as an outward investor and an increasing focus on 

strengthening South-South partnerships. 

In terms of geographical diversity, much of India’s more 

recent negotiating activity has focused on other Asian 

countries. Out of 38 BITs it signed with other developing 

countries, 23 (60%) were concluded with Asian countries. 

Flows 

18 


Stock

Figure 2: Number of Indian BITs Concluded, Annual and Cumulative, 

1994–2009 19 

Annual BITs 

12 

10 

8 

6 

4 

2 

0 

1994 

1995 

1996 

1997 

1998 

1999 

2000 

2001 

Years 

Annual BITs 

Cumulative BITs 

India has signed nine BITs with West Asia, four BITs with 

East Asia, nine BITs with South-east Asia and two with 

South Asia. India has also paid considerable attention to 

developing countries in other regions. It has signed eleven 

BITs with African and four BITs with Latin American 

countries. India has also signed fourteen BITs with partners 

in the transition economies. While so far a notable absentee 

in the range of Indian BITs partners is the United States, 

India is in negotiations on a BIT with the United States. 20 

Another key characteristic of India’s BITs policy relates 

to the country’s concerted move to 

ratify agreements. By December 2008, 

more than 90 percent of Indian BITs 

were ratifi ed. 21 

In parallel to BITs, India has also 

signed other economic cooperation 

agreements that contain substantive 

investments provisions as well as framework 

agreements that aim at strengthening 

cooperation on investment issues or 

pave the way for negotiating substantive 

investment rules in the future. India has concluded such 

agreements with a number of regional groupings (e.g., 

ASEAN, the Gulf Cooperation Council (GCC), MERCO- 

SUR) as well as individual countries (e.g., Republic of 

Korea). In total, India signed seven such IIAs. After initially 

signing an agreement with the European Community (1993), 

India then focused on other developing countries, mainly in 

Asia. In addition to the conclusion of one CEPA in the fi rst 

eight months of 2009, India is currently negotiating a number 

of IIAs, including the ASEAN–India FTA; 22 the India– 

2002 

2003 

2004 

2005 

2006 

2007 

2008 

2009 

A rather 

interesting 

characteristic 

of India’s BITs 

network is the 

diversity of its 

partner economies 

80 

60 

40 

20 

0 

Cumulative BITs 



Japan Comprehensive Economic 

Partnership Agreement (CECA) 23 

and the India–GCC FTA. 24 Furthermore 

India has started negotiations 

on a CEPA with Canada. 25 

3. India’s Network of BITs: 

A Brief Sketch 

Based on a brief review of twenty 

two sample BITs signed by India, 

this section aims to sketch some of 

the key characteristics of the 

country’s BITs network. 

A fi rst threshold crucial for the scope and breadth of a BIT 

relates to the defi nitions of “investor” and “investments”. 

These defi nitions set out the coverage of protected persons 

and assets under the IIA. Most BITs cover foreign direct 

investment (FDI) and portfolio investment, but some exclude 

the latter. Typically, BITs have used asset-based defi nitions in 

investor/investment protection agreements (the fi rst generation 

BITs) and transactional defi nitions in investment 

liberalization agreements. Asset-based defi nitions basically 

imply that the BIT embraces a large scale of assets of 

economic value, virtually without limitations. 

The general defi nition is followed 

by an illustrative list of the main categories 

of investment to be protected. 33 The 

Indian BITs reviewed all include this type 

of defi nition. 

A second threshold question is whether 

the agreement grants post- or also 

pre-establishment rights. This question 

relates to the stage in the investment process 

to which the agreement’s protections 

apply. Under a post-establishment BIT, only investors (and 

their investments) that have already established inside the 

country are protected. A pre-establishment BIT, in turn, 

grants rights (e.g., regarding access and establishment, 

guarantees of treatment or promises of liberalization) also to 

prospective investors. None of the Indian BITs reviewed 

contains commitments with regards to pre-establishment 

treatment of foreign investment. 34 

Another set of key question relates to the type of substantive 

protections that are offered to those investors that 

19

O PEN WORLD 

Figure 3: Total Number of Indian BITs Concluded 

by Country Group End 2009 (Percent) 

qualify for protection under a country’s IIAs. Amongst these 

are so-called relative standards (i.e., National Treatment 

(NT) and Most-Favoured-Nation (MFN) treatment) as well 

as absolute standards (e.g., Fair and Equitable Treatment 

(FET)). 

National Treatment (NT) in a BIT context implies that the 

obligation of contracting parties to grant 

investors/investments of the other 

contracting party treatment no less 

favorable than the treatment they grant to 

their country’s own investors/investments. 

The effect is to create a level playing fi eld 

between foreign and domestic investors in 

the relevant market. 35 The twenty two 

Indian BITs reviewed grant NT (on a 

post-establishment basis). Hence, once 

they have already established in the India, 

foreign investors are guaranteed the same treatment as 

domestic investors. 

The Most-Favoured-Nation (MFN) standard is another 

core element of BITs. It requires a host country to accord 

treatment to a covered foreign investor/investments which is 

no less favorable than that accorded to an investor/investment 

of a third State. The MFN standard offers foreign 

investors/investments a guarantee against certain forms of 

discrimination by reason of nationality and is therefore also 

crucial for establishing a level fi eld. 36 Similarly as with NT, all 

20 

5% 

31% 

15% 

Transition Economy 

Europe 

Africa 

Latin America and the Caribbean 

Asia and Oceania 


19% 

30% 

With respect to 

full protection and 

security, Indian 

government’s 

approach varies 

considerably 

across its BITs 

22 BITs reviewed contain the same basic MFN provisions. 

MFN clauses in Indian BITs reviewed all contain two kinds 

of exceptions: new obligations cannot be imported from 

agreements establishing Regional Economic Integration 

Organizations (REIOs) (e.g., ASEAN); and MFN treatment 

does not apply to tax measures. 

An example of the second type of substantive provisions 

typically stipulated in IIAs are the FET standard, the 

guarantee of Full Protection and Security or Minimum 

Standard of treatments. 37 Moreover, BITs frequently deal 

with the issue of expropriation or damages to an investment, 

determining that – and in what manner – compensation be 

paid to the investor in such a situation. These concepts have 

been subject to a wide array of interpretations, giving rise to 

concerns about the consistency of such interpretations and 

the attendant development implications. Since there is no 

universally recognized defi nition of the meaning of some of 

these principles, some countries have aimed at detailing the 

scope of protection granted to investments by some of these 

principles (e.g., minimum standard of treatments). 38 

With respect to minimum standard of treatments, Indian 

BITs have not set themselves such an ambitious rule making 

agenda and have stuck with basic provisions such as the 

following: "Investments or investors of 

each Contracting Party shall at all times 

be accorded fair and equitable treatment". 

39 With respect to full protection 

and security, India’s approach varies 

considerably across its BITs. Nine of the 

twenty two Indian BITs examined provide 

for full protection and security, but 

thirteen do not offer such a guarantee. 

Interestingly, full protection and security 

does not appear in the model BIT that 

India uses to negotiate with other countries. 40 

With respect to expropriation, 41 in recent years the 

question of indirect expropriation or regulatory taking has 

come to the forefront. All of India’s BITs reviewed recognize 

that indirect expropriation that is "measures having 

effect equivalent to nationalisation or expropriation", 42 is 

expropriation. As a response to arbitral awards, some 

countries have – over the last years – aimed to clarify BIT 

obligations with a view to ensuring that legitimate regulatory 

conduct at the national level would not be considered

Figure 4: Indian Economic Cooperation Agreements, 1993–2009 

expropriation. India’s approach to international investment 

rule making has however so far stopped short of spelling out 

in more detail what does and does not qualify as being 

'equivalent to expropriation'. 43 

Finally, most Indian BITs also contain a specifi c exception 

that allows parties to derogate from treaty obligations in the 

case of a threat to national security or other emergency 

situations. 44 Most of the Indian BITs 

reviewed refer to "a state of national 

emergency", while the recent BIT between 

India and Mozambique explicitly 

draws on "the protection of its essential 

security interests" and "circumstances of 

extreme emergency". 

Besides the above, there are numerous 

other substantive treaty protections that 

would merit attention (e.g., the extent to 

which IIAs rule out performance 

requirements, provisions on free transfer of funds, exceptions 

for balance of payments problems). Of key importance, 

however, are also procedural issues: dispute settlement 

under BITs is characterized by the availability of 

Investor State Dispute Settlement (ISDS). 45 This allows 

investors to submit Host State decisions and actions to an 

authority – independent from the host country administrative 

and judicial system – for examination. 46 All of India’s 

BITs reviewed grant this right. 

Over the years, investors have increasingly resorted to the 

Adequate 

attention to 

environmental, 

social and poverty 

related issues 

is crucial in the 

current context 



India – European Community Cooperation Agreement between the European Community and the Republic 

of India on Partnership and Development 

199326 India – ASEAN Framework Agreement on Comprehensive Economic Cooperation Between 2003 

the Republic of India and the Association of South East Asian Nations 

27 

India – MERCOSUR Framework Agreement between the MERCOSUR and the Republic of India 200328 India – GCC Framework Agreement on Economic Cooperation Between the Republic of 2004 

India and the Member States of the Cooperation Council for the Arab States 

of the Gulf 

29 

India – Chile Framework Agreement to Promote Economic Cooperation Between the 

Republic of Chile and the Republic of India 

200530 India – Singapore Comprehensive Economic Cooperation Between the Republic of India and 2005 

Singapore 

31 

India – Korea Comprehensive Economic Partnership Agreement (CEPA) between the 

Republic of India and the Republic of Korea 

200932 dispute settlement mechanisms included in BITs, leading to a 

growing number of treaty-based ISDS cases brought to 

international arbitration. 47 This raises considerable challenges 

for host countries, including cost-related challenges 

(cost of litigation, costs for awards), challenges regarding a 

country’s reputation as an attractive FDI destination and 

capacity-related challenges, particularly for developing 

countries. 48 A particular problematique 

arise when ISDS cases challenge legitimate 

domestic policies. It is therefore of 

utmost importance that host countries 

have the capacity to manage – and to the 

extent possible avoid – such ISDS proceedings. 

Preventive measures, including 

better treaty language and effective 

means of dispute avoidance, are important 

in this regard. 49 

4. Concluding Remarks 

With today’s global crisis, and the attendant nosedive of FDI 

fl ows, effective promotion of foreign investment is needed 

more than ever, both for developed and developing countries. 

Accordingly, there is a call for intensifi ed investment promotion 

efforts, both as regards inward and outward investment. 

This includes the dismantling of visible and hidden investment 

obstacles, as well as a special focus on retaining existing 

investment in times of crisis. 

The worldwide signature of 25 new BITs and six other IIAs 

21

O PEN WORLD 

during the fi rst six months of 2009, points to a continued 

reliance – in spite of the ongoing global economic and 

fi nancial crisis – on the conclusion of IIAs as a means to 

promote foreign investment so as to fi nance the recovery and 

boost growth and stability. 50 India, with six (BITs) and three 

(two BITs and CEPA) IIAs it concluded in 2008 and 2009 

respectively, is also part of this trend. 

BITs negotiations are driven by the expectation that these 

agreements play an important role in enhancing the fl ow of 

FDI to signatory countries (e.g., by improving the investment 

climate, by reducing regulatory barriers to international 

investment, and by providing greater security, certainty and 

opportunities for investment and investors in signatory 

countries). 51 This positive link between IIAs and FDI fl ows is 

stronger when IIAs contain effective and operational 

provisions on investment promotion. 52 

Generally, countries aim to attract FDI with a view to 

reaping attendant development benefi ts. This includes 

economic and social benefi ts (e.g., through employment 

creation, technology transfer or increasing tax receipts). 

While the role of FDI in economic growth and development 

is widely acknowledged, the exact relationship between FDI 

and development and the manner in which FDI contributes 

to – or sometimes detracts from – the growth and welfare of 

developing countries has been subject to continuous debate 

22 


in academia and policy circles. 53 

Today’s global economic and environmental crises raise 

further questions about the type of policies that are needed 

to maximize the potential of FDI to contribute to economic 

and social development. Adequate attention to environmental, 

social and poverty related issues is crucial in this context 

and today’s key question is how IIAs can better deliver on 

their potential to contribute a sustainable and equitable 

growth – including in the context of a global recovery. 

Revisiting some aspects of IIA rule making could offer an 

opportunity to address today’s development challenges. 

Endnotes 

1 th On 7 August, 2009 India signed a Comprehensive 

Economic Partnership Agreement (CEPA) with the 

Republic of Korea, see http://commerce.nic.in/trade/ 

INDIA%20KOREA%20CEPA%202009.pdf 

2 Between August 2008 and August 2009, India signed BITs 

with Bangladesh and Mozambique. 

3 For offi cial documents on trade and investment agreements 

by the Republic of India: http://commerce.nic.in/ 

trade/international_ta.asp?id=2&trade=i 

4 UNCTAD (2009). Recent Developments in International 

Investment Agreements (2008–June 2009). IIA MONI- 

TOR No. 3 (2009). http://www.unctad.org/en/docs/webdiaeia20098_en.pdf 

5 UNCTAD (2003). World Investment Report 2003. FDI 

Policies for Development: National and International 

Perspectives. United Nations Publications. Sales No. E.03. 

II.D.8. New York and Geneva. P. 114 ff. http://www.unctad. 

org/en/docs/wir2003_en.pdf 

6 UNCTAD (2007). World Investment Report 2007. 

Transnational Corporations, Extractive Industries and 

Development. United Nations Publications. Sales No. 

E.07.II.D.9. New York and Geneva. P. 43. http://www. 

unctad.org/en/docs/wir2007_en.pdf 

7 UNCTAD (2007). World Investment Report 2007. 



E.07.II.D.9. New York and Geneva. P. 44 

8 UNCTAD (2009). World Investment Prospects Survey. 

http://www.unctad.org/Templates/meeting.asp?intItemID=20 

68&lang=1&m=17872 See also Pradhan, Jaya Prakash 

(2009). Indian FDI falls in global economic crisis: Indian

multinationals tread cautiously. Columbia FDI Perspectives, 

No. 11, August 17th , 2009. 

http://www.vcc.columbia.edu/pubs/documents/IndianOFDI- 

Final.pdf 

9 UNCTAD (2009). Investment Policy Developments in 

G-20 Countries. 

http://www.unctad.org/en/docs/webdiaeia20099_en.pdf 

10 UNCTAD (forthcoming 2009). The Role of International 

Investment Agreements in Attracting Foreign Direct 

Investment to Developing Countries. UNCTAD Series on 

Issues in International Investment Agreements. United 

Nations publication. New York and Geneva. 

11 UNCTAD (2009). Report of the Multi-year Expert 

Meeting on Investment for Development on its fi rst 

session. Held at the Palais des Nations, Geneva, from 10th - 11th February, 2009. http://www.unctad.org/en/docs/ 

ciimem3d3_en.pdf 

12 For regional and country specifi c trends in IIA rule 

making (BITs and other IIAs) see UNCTAD (2009). 

Recent Developments in International Investment 

Agreements (2008–June 2009). IIA MONITOR No. 3 

(2009). P. 3. http://www.unctad.org/en/docs/webdiaeia20098_en.pdf 

13 For a comprehensive list of the country’s BITs see Annexure-1 

of this article. 

14 The fi rst countries that signed a BIT were Germany and 

Pakistan in 1959. 



TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/ 

webdiaeia20098_en.pdf 



TOR No. 3 (2009). P. 3. http://www.unctad.org/en/docs/ 

webdiaeia20098_en.pdf 

17 The BIT with Colombia is called a Bilateral Investment 

Promotion and Protection Agreement (BIPA). 

http://www.thaindian.com/newsportal/india-news/indiacolombia-to-sign-bipa-to-increase-investmentfl 

ow_100212609.html 

18 The BIT with Canada is called a Foreign Investment 

Protection and Promotion Agreement (FIPA). 

http://w01.international.gc.ca/MinPub/Publication. 

aspx?lang=eng&publication_id=385226&docnum=82 



19 Data for 2009 is preliminary, including Indian BITs up to 

August 2009. 

20 The BIT with the United States is called Bilateral Investment 

Promotion and Protection Agreement (BIPA). http:// 

www.bilaterals.org/article.php3?id_article=11154 

http://economictimes.indiatimes.com/News/Economy/ 

Foreign-Trade/India-America-talk-up-bilateral-investments-/ 

articleshow/4887737.cms 

21 On the distinction between the conclusion, signature and 

the entry into force of a BIT and on the importance of 

ratifi cation, see UNCTAD (2006). The Entry into Force 

of Bilateral Investment Treaties (BITs). IIA MONITOR 

No. 3 (2006). http://www.unctad.org/en/docs/webiteiia20069_en.pdf 

22 The negotiations on the ASEAN-India FTA were concluded 

on 7th September, 2009, but an agreement has not 

yet been signed, see http://iitrade.ac.in/news-archive. 

asp?news=1026 

23 For details, see http://commerce.nic.in/trade/international_ 

ta_current_details.asp 

24 For details, see http://commerce.nic.in/trade/international_ 

ta_current_details.asp 

25 http://w01.international.gc.ca/MinPub/Publication. 

aspx?lang=eng&publication_id=386756&docnum=16 

26 http://ec.europa.eu/world/agreements/downloadFile.do?fullT 

ext=yes&treatyTransId=790 

27 http://commerce.nic.in/trade/international_ta_ framework_ 

asean.asp 

28 http://commerce.nic.in/fl ac/FRAMEWORK%20AGREE- 

MENT%20BETWEEN%20THE%20MERCOSUR%20 

AND%20India.pdf 


gcc.asp 

30 http://commerce.nic.in/trade/ta/india_chile.pdf 


ceca.asp 

32 http://commerce.nic.in/trade/INDIA%20KOREA%20 

CEPA%202009.pdf 

33 For a discussion of issues related to the scope and defi nition 

of IIAs, see UNCTAD (forthcoming 2009). Scope 

and Defi nition. UNCTAD Series on Issues in International 

Investment Agreements. United Nations publication. 

New York and Geneva. 

34 A typical formulation is found in the India – Mauritius 

23

O PEN WORLD 

BIT which refers to the "management, maintenance, use, 

enjoyment or disposal of investments" – leaving aside 

issues such as "establishment and acquisition". It has to be 

noted however, that the recent CEPA investment chapters 

that India has concluded with the Republic of Korea 

covers the national treatment of foreign investors in the 

pre-establishment phase. 

35 UNCTAD (2007). Bilateral Investment Treaties 

1995-2006: Trends in Investment Rulemaking. P. 33. 

http://www.unctad.org/en/docs/iteiia20065_en.pdf 

36 UNCTAD (forthcoming 2009). Most-favoured-Nation 

Treatment. UNCTAD Series on Issues in International 

Investment Agreements. United Nations publication. New 

York and Geneva. 

37 UNCTAD (2007). Bilateral Investment Treaties 

1995-2006: Trends in Investment Rulemaking. P. 28. 

http://www.unctad.org/en/docs/iteiia20065_en.pdf 

38 For a more detailed discussion see UNCTAD (2007). 

Bilateral Investment Treaties 1995-2006: Trends in 

Investment Rulemaking. PP. 28-33. http://www.unctad.org/ 

en/docs/iteiia20065_en.pdf 

39 See India–Australia BIT, Art 3.2. 

http://www.unctad.org/sections/dite/iia/docs/bits/australia_ 

india.pdf 

40 See Indian Model BIT, particularly Art 3.2. 

41 BITs and other international instruments for the protection 

of foreign investment virtually always contain 

provisions prohibiting the taking of foreign investors’ 

assets by public authorities, except if done for a public 

purpose, on a non-discriminatory basis, against payment 

of compensation, and, in many cases, with due process of 

law. UNCTAD (2004). Key Terms and Concepts in IIAs: 

A Glossary. UNCTAD Series on Issues in International 

Investment Agreements. United Nations Publication. 


unctad.org/en/docs/iteiit20042_en.pdf 

42 See Indian Model BIT, Art 5.1. 

43 Yet, in the CEPA between India and Korea, indirect 

expropriation is also dealt with (P. 233). http://commerce. 

nic.in/trade/INDIA%20KOREA%20CEPA%202009.pdf 

44 For a discussion of issues related to such national security 

exceptions, see UNCTAD (2009). The Protection of 

National Security in IIAs. United Nations Publication. E. 

09.II.D.12. New York and Geneva. 

24 


45 UNCTAD (2004). Key Terms and Concepts in IIAs: A 

Glossary. UNCTAD Series on Issues in International 



unctad.org/en/docs/iteiit20042_en.pdf 

46 During the early stages of IIA rule-making, this has been 

controversial, as it is a clear break from the Westphalian 

model of international public law as governing only the 

relationship between states without recourse for private 

parties. 

47 UNCTAD (2009). Latest Developments in Investor– 

State Dispute Settlement. IIA MONITOR No. 1 (2009). 




session. Held at the Palais des Nations, Geneva, from 10th - 11th February, 2009. P. 6. http://www.unctad.org/en/docs/ 




session. Held at the Palais des Nations, Geneva, from 10th - 11th February, 2009. P. 2. http://www.unctad.org/en/docs/ 

ciimem3d3_en.pdf See also UNCTAD (forthcoming 

2009). Exploring Alternatives to Investment Treaty 

Arbitration and the Prevention of Investor-State Disputes. 

United Nations publication. New York and Geneva. 

50 Also during 2008, the network of IIAs has continued to 

expand: BITs (59) and other IIAs (16) – in sum – a 

development that further strengthens and expands the 

current international investment regime. 

51 UNCTAD (forthcoming 2009). The Role of International 


Investment to Developing Countries. UNCTAD Series 

on Issues in International Investment Agreements. 


52 For the time being, however, IIAs do not contain commitments 

by capital-exporting countries other than vague 

language relating to investment promotion and do not 

give any protection to developing countries against 

policies restricting outward investment. Investment 

insurance and other home country measures encouraging 

outward investment are cases in point where continued 

international cooperation can be useful. 

53 Moran, Theodore H. / Graham, Edward M. / Blomstöm,

Magnus (2005). Does Foreign Direct Investment promote 

development? Institute for International Economics. 

Washington. http://www.piie.com/publications/chapters_ 

preview/3810/14iie3810.pdf. UNCTAD (2005). Economic 

Development in Africa. Rethinking the Role of Foreign 

Direct Investment. http://www.unctad.org/en/docs/gdsafrica20051_en.pdf. 

References and Additional Thinking 

Moran, Theodore H. / Graham, Edward M. / Blomstöm, 

Magnus (2005). Does Foreign Direct Investment promote 

development? Institute for International Economics. 

Washington. http://www.piie.com/publications/chapters_ 

preview/3810/14iie3810.pdf 

Pradhan, Jaya Prakash (2009). Indian FDI falls in global 

economic crisis:Indian multinationals tread cautiously. 

Columbia FDI Perspectives, No. 11, August 17th , 2009. 

http://www.vcc.columbia.edu/pubs/documents/IndianOFDI- 

Final.pdf 

UNCTAD (forthcoming 2009). Exploring Alternatives to 

Investment Treaty Arbitration and the Prevention of 

Investor-State Disputes. United Nations publication. New 

York and Geneva 

UNCTAD (forthcoming 2009). Most-favoured-Nation 

Treatment. UNCTAD Series on Issues in International 

Investment Agreements. United Nations publication. New 


UNCTAD (forthcoming 2009). Scope and Defi nition. 

UNCTAD Series on Issues in International Investment 

Agreements. United Nations publication. New York and 

Geneva. 

UNCTAD (forthcoming 2009). The Role of International 


Investment to Developing Countries. UNCTAD Series 

on Issues in International Investment Agreements. 


UNCTAD (2009). Investment Policy Developments in 

G-20 Countries. http://www.unctad.org/en/docs/webdiaeia20099_en.pdf 

UNCTAD (2009). Latest Developments in Investor– 

State Dispute Settlement. IIA MONITOR No. 1 (2009). 


UNCTAD (2009). Recent Developments in International 




TOR No. 3 (2009). http://www.unctad.org/en/docs/webdiaeia20098_en.pdf 

UNCTAD (2009). Report of the Multi-year Expert 


session. Held at the Palais des Nations, Geneva, from 10th to 11th February, 2009. http://www.unctad.org/en/docs/ 


UNCTAD (2009). The Protection of National Security in 

IIAs. United Nations Publication. E. 09.II.D.12. New 


UNCTAD (2009). World Investment Prospects Survey. 

http://www.unctad.org/Templates/meeting.asp?intItemID=2 

068&lang=1&m=17872 

UNCTAD (2007). Bilateral Investment Treaties 

1995-2006: Trends in Investment Rulemaking. P. 33 http:// 

www.unctad.org/en/docs/iteiia20065_en.pdf 

UNCTAD (2007). World Investment Report 2007. 



E.07.II.D.9. New York and Geneva. 

http://www.unctad.org/en/docs/wir2007_en.pdf 

UNCTAD (2006). The Entry into Force of Bilateral 

Investment Treaties (BITs). IIA MONITOR No. 3 (2006). 

http://www.unctad.org/en/docs/webiteiia20069_en.pdf 

UNCTAD (2005). Economic Development in Africa. 

Rethinking the Role of Foreign Direct Investment. http:// 

www.unctad.org/en/docs/gdsafrica20051_en.pdf 

UNCTAD (2004). Key Terms and Concepts in IIAs: A 

Glossary. UNCTAD Series on Issues in International 


E.04.II.D.31. New York and Geneva. http://www.unctad. 

org/en/docs/iteiit20042_en.pdf 

UNCTAD (2003). World Investment Report 2003. FDI 

Policies for Development: National and International 

Perspectives. United Nations Publications. Sales No. 

E.03.II.D.8. New York and Geneva. http://www.unctad.org/ 

en/docs/wir2003_en.pdf 

(* This paper was prepared by a team led by Elisabeth Tuerk. 

The contributors include Amare Bekele, Hamed El-Kady, Jan 

Knoerich, Matthew Levine, Diana Rosert, Astrit Sulstarova 

and Elisabeth Tuerk. The views expressed are those of the 

authors and do not refl ect the views of the UNCTAD secretariat 

or its member States.) 

25

O PEN WORLD 

Total Indian BITs (1994–2009) 

Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed 

Argentina 20-Aug-99 12-Aug-02 

Armenia 23-May-03 30-May-06 

Australia 26-Feb-99 4-May-00 y 

Austria 8-Nov-99 1-Mar-01 

Bahrain 13-Jan-04 5-Dec-07 

Bangladesh 9-Feb-09 

Belarus 26-Nov-02 23-Nov-03 

Belgium and Luxembourg 31-Oct-97 8-Jan-01 y 

Bosnia and Herzegovina 12-Sep-06 13-Feb-08 

Brunei Darussalam 22-May-08 18-Jan-09 

Bulgaria 29-Oct-98 23-Sep-99 

China 21-Nov-06 1-Aug-07 

Croatia 4-May-01 19-Jan-02 y 

Cyprus 9-Apr-02 12-Jan-04 

Czech Republic 11-Oct-96 6-Feb-98 y 

Denmark 6-Sep-95 28-Aug-96 y 

Djibouti 19-May-03 

Egypt 9-Apr-97 22-Nov-00 y 

Ethiopia 5-Jul-07 

Finland 7-Nov-02 9-Apr-03 

France 2-Sep-97 17-May-00 

Germany 10-Jul-95 13-Jul-98 

Ghana 18-Aug-02 y 

Greece 26-Apr-07 10-Apr-08 

Hungary 3-Nov-03 2-Jan-06 y 

Iceland 29-Jun-07 16-Dec-09 

Indonesia 10-Feb-99 22-Jan-04 y 

Israel 29-Jan-96 18-Feb-97 

Italy 23-Nov-95 26-Mar-98 

Jordan 30-Nov-06 22-Jan-09 

Kazakhstan 9-Dec-96 26-Jul-01 y 

Korea, Republic of 26-Feb-96 7-May-96 

Kuwait 27-Nov-01 28-Jun-03 

Kyrgyzstan 16-May-97 10-Apr-98 

Lao People’s Democratic Republic 9-Nov-00 5-Jan-03 

Libyan Arab Jamahiriya 26-May-07 25-Mar-09 

Macedonia, TFYR 17-Mar-08 17-Nov-08 

26 


ANNEXURE - 1


Partner Country Date of Signature Date of Entry into Force BITs Text Reviewed 

Malaysia 1-Aug-95 12-Apr-97 

Mauritius 4-Sep-98 20-Jun-00 y 

Mexico 21-May-07 23-Feb-08 

Mongolia 3-Jan-01 29-Apr-02 

Morocco 13-Feb-99 22-Feb-01 y 

Mozambique 19-Feb-09 y 

Myanmar 24-Jun-08 8-Feb-09 

Netherlands 6-Nov-95 1-Dec-96 y 

Oman 2-Apr-97 13-Oct-00 y 

Philippines 28-Jan-00 29-Jan-01 

Poland 7-Oct-96 31-Dec-97 

Portugal 28-Jun-00 19-Jul-02 y 

Qatar 7-Apr-99 15-Dec-99 

Romania 17-Nov-97 9-Dec-99 

Russian Federation 23-Dec-94 5-Aug-96 

Saudi Arabia 25-Jan-06 20-May-08 

Senegal 3-Jul-08 

Serbia and Montenegro 31-Jan-03 24-Feb-09 

Slovakia 25-Sep-06 27-Sep-07 

Spain 30-Sep-97 15-Dec-98 

Sri Lanka 22-Jan-97 13-Feb-98 y 

Sudan 22-Oct-03 

Sweden 4-Jul-00 1-Apr-01 y 

Switzerland 4-Apr-97 16-Feb-00 y 

Syrian Arab Republic 18-Jun-08 22-Jan-09 

Taiwan Province of China 17-Oct-02 28-Nov-02 

Tajikistan 13-Dec-95 14-Nov-03 

Thailand 10-Jul-00 13-Jul-01 y 

Trinidad and Tobago 12-Mar-07 7-Oct-07 

Turkey 17-Sep-98 18-Nov-07 y 

Turkmenistan 20-Sep-95 27-Feb-06 

Ukraine 1-Dec-01 12-Aug-03 

United Kingdom 14-Mar-94 6-Jan-95 y 

Uruguay 11-Feb-08 

Uzbekistan 18-May-99 28-Jul-00 

VietNam 8-Mar-97 1-Dec-99 

Yemen 1-Oct-02 10-Feb-04 

Zimbabwe 10-Feb-99 


27

O PEN WORLD 

Policy Transparency and 

Evaluation for Economic 

Growth in India 

Valentin Zahrnt 

Research Associate, 

European Centre for International Political 

Economy (ECIPE), Belgium 

Good governance, in its broadest sense, means 

selecting the right policy objectives together with the 

appropriate instruments to attain them. And it 

means implementing the policies effi ciently, without waste, 

delay or corruption. India wrestles with both challenges, and 

this weakness of governance from the commanding heights 

down to the lowlands of local administration explains why 

India fails to realize its economic potential more fully. This 

article addresses the fi rst challenge, that of policy-making. It 

argues that India cannot expect improvements in this area as a 

byproduct of economic development but needs to strengthen 

domestic and international mechanisms for transparency and 

policy evaluation. 

Examples of Bad Policy-Making Abound Abound 

There is a rough correlation between the level of development 

and the effi ciency of policy implementation, and the OECD 

countries have generally learned to execute their policies 

decently well. Efforts to introduce a service culture, to fl atten 

hierarchies, and to employ information technologies have 

further enhanced administrative effi ciency in the developed 

world during the last decade. But even the most developed 

countries continue to commit to policies whose aims are blurry 

to the point of being indiscernible, to policies whose objectives 

28 

THE IIPM THINK TANK

are incongruent, and to policies whose ends contradict any 

reasonable vision of the public good. Similarly, examples 

abound in OECD countries where policy instruments are, by 

their very nature or design, ineffective or even harmful for the 

espoused targets. What strikes the observer is that good 

policy-making does not come with economic develop- 

N AKED ECONOMICS 

ment. The case of EU agricultural policy can illustrate this 

claim. The EU pays about € 55 billion of farm subsidies per 

year, an amount corresponding to more than 40% of its budget. 

Furthermore, tariffs on agricultural products average 18% 

– over four times more than charges on other goods. All EU 

tariffs greater than 100% relate to agricultural products, with 

isoglucose hit hardest by a staggering 604% duty. These 

policies are disastrous. The benefi ts are distributed arbitrarily 

and unfairly among farmers, helping poor farmers little. 

Consumers are harmed through higher food prices, hitting 

especially poor households who spend a relatively high proportion 

of their income on food. At the same time, the agricultural 

policies fail to stimulate rural development in disadvantaged 

regions, to motivate environmentally friendly farming practices, 

or to support food security. What they do achieve is 

distortion of the economy and increased vulnerability to 

criticism from the EU’s trading partners. 

Poor governance practices have contributed to this absurd 

outcome. Vice versa, politicians and bureaucrats have become 

dependent on the opacity created by their poor governance 

practices in order not to be held accountable for the results. 

The EU is caught in a trap of bad policy practices and outcomes. 

One key mechanism employed to avoid accountability 

has been to never seriously defi ne the objectives of the EU’s 

agricultural policies. They were briefl y enumerated in the 1957 

Treaty of Rome and have since then been repeatedly extended 

without any sense of precision or prioritization. Other mechanisms 

include the dispersion of responsibility across numerous 

committees; a repelling degree of legislative complexity; 

secrecy of data about farm incomes and subsidy recipients; 

superfi cial and politically biased policy evaluation through the 

implementing agency, the Directorate-General for Agriculture 

and Rural Development; fostering a supportive policy community 

through the commissioning of ‘independent’ studies and 

close cooperation with external experts; not publishing sensitive 

in-house and commissioned analysis; and a monolithic 

European Commission discourse with minimal internal dissent 

combined with the disciplining of critical external stakeholders. 

These opacity mechanisms have worked so well that policies 

that endanger EU long-term food security – for instance by 

depleting water and soil resources – are commonly justifi ed by 

the very need to ensure food security (which is not seriously 

threatened in the EU anyway). And the EU’s agricultural 

policies are generally credited with providing consumers 


29

O PEN WORLD 

healthy food at affordable prices though consumers actually 

pay more due to tariffs, production quotas, and export subsidies. 

The same pattern can be observed in the EU’s policy 

against dumped imports. Antidumping measures have little to 

do with threats to competition on the EU market stemming 

from foreign suppliers striving for excessive market power. 

They lack any welfare rationale. Instead, they are deeply 

political, driven by industry lobbying and electoral populism. 

Once again, bad policies go hand in hand with poor policymaking: 

consumer interests are relegated to the backseat, 

economy-wide analysis is not undertaken in anti-dumping 

procedures, examination of the link between dumping and 

damage to the domestic industry is perfunctory, and the 

calculations of dumping margins are kept secret. 1 

The Australian Case Case 

Examining the OECD countries demonstrates 

that being a rich democracy is not a 

suffi cient condition for having sound 

policy-making processes let alone for 

making sensible policies. Importantly, this 

judgment does not depend on preferences 

for particular (liberal) policies. The 

benchmark is structural weakness, notably 

lacking coherence among objectives and 

between objectives and instruments, that 

are condemned by experts across the board. 

This does not imply that rational policy-making is a hopeless 

case. The most important exception – one might say the 

world’s showcase for policy transparency and evaluation – is 

Australia’s Productivity Commission. 2 This body started with a 

narrow trade focus and became responsible for analyzing issues 

as diverse as railway and shipping services, competition on the 

telecommunication market, nursing home subsidies, and cost 

recovery by government agencies. Several features of this 

institution deserve highlighting. 

High-Quality, Comprehensive Analysis: The Productivity 

Commission assesses the impact of policy options on economic, 

social, and environmental objectives. It also calculates the net 

effects of various policies on the sector level. This shows how 

some sectors that enjoy protection are harmed even more 

strongly by protection of other sectors. Higher input prices or 

reduced demand for the sector’s output through protection in 

other parts of the economy can overwhelm the more visible 

30 


Anti-dumping 

measures have 

little to do 

with threats to 

competition and 

lack any sort of 

welfare rationale 

benefi ts a sector receives from state intervention. Disentangling 

and netting out the manifold distributional effects of 

policies can thus create support for less intrusive and more 

effi cient solutions. 

Transparent and Participative Inquiry Process: The Productivity 

Commission invites the public to contribute to its inquiries 

through introductory issue papers. It receives submissions, 

meets stakeholders, and holds public hearings. Draft reports 

are published as well as all subsequent comments. Final 

reports are written in an accessible language and actively 

disseminated, in line with the objective ‘to promote public 

understanding of matters relating to industry, industry 

development and productivity’. 

Right to Be Heard: The government is free to engage the 

Productivity Commission in an inquiry or not, but fi nal inquiry 

reports must be tabled in the Parliament within twenty fi ve 

sitting days. Furthermore, the Productivity 

Commission publishes an annual report 

with economy-wide analysis. 

Independence: Members are appointed for 

up to fi ve years based on qualifi cations and 

experience. Strong safeguards protect them 

against being removed from their offi ce. 

They accept strict limitations on outside 

employment and requirements to disclose 

their interests. Furthermore, ministerial 

responsibility is assigned to the Treasury, a 

ministry with an inherently economy-wide perspective unlikely 

to sponsor sectoral interests. 

Continuity: The Productivity Commission goes back to the 

Tariff Board, established in 1921. Though its affi liation, rights, 

resources, and methods have changed considerably over time, 

the institution has remained recognizable over time. It could 

thus build up its expertise and reputation. 

These features must not be perceived in isolation for they 

interact in benefi cial ways. For instance, the Productivity 

Commission’s independence rests not only on the explicit 

provisions to this end but also on various other characteristics. 

Thanks to its continuity, its high-quality research, and its 

transparent and participative inquiry process, the Productivity 

Commission has built up public support that shields it from 

government infringements in its inquiries and attempts to 

undermine its institutional functioning. The Productivity 

Commission has thus been able to wield signifi cant infl uence

on numerous specifi c policies. It has been widely credited for 

its role in Australia's remarkable unilateral liberalization from 

the 1970s to the 1990s. More importantly, it has shaped the 

public discourse in the long run towards more rational policies 

and fostered high expectations regarding the transparency and 

scientifi c soundness of policy-making. 

The Lesson for India 

The lesson for India is that it cannot rely on a virtuous circle of 

economic development and better economic governance. India 

needs to actively create sound institutions that enhance 

transparency, conduct analysis, and stimulate debate. As 

Narayan (2009) notes, ‘An important aspect of the unfi nished 

[reform] agenda should therefore be wide dissemination of 

information and debate about the necessity of reforms …’ This 

must not be confounded with activism. India has long been 

swamped by committees and councils that 

assess policies and propose alternatives. 3 

These bodies have been placed with the 

Planning Commission, various ministries, 

and the prime minister; they have whitewashed 

failures or laid them bare; they 

have been ignored or supported by the 

government. Here and there, they have 

infl uenced policies. But neither the 

Economic Advisory Council, nor the 

Programme Outcome and Response 

Monitoring Division, nor the Programme Evaluation Organization 

have created a culture of evaluation. A multiplicity of 

government-dependent and ad-hoc commissions produces 

piecework which politicians can discard or reinterpret as 

political opportunism dictates. 

What is needed is not more evaluation mechanisms but 

fewer and better ones. The Australian Productivity Commission 

can serve as a model in terms of the kind and quality of 

reports, transparency and public participation, independence 

and rules of engagement, and institutional stability. The 

objective should be to inspire a culture that pervades all of 

policy-making, creating expectations that scientifi c advice will 

be duly considered and that policies be justifi ed by the standards 

of applied science. In addition to a public but independent 

transparency institution, India should also foster private think 

tanks that analyze policies and propose alternatives. All this 

can be especially powerful in India, a functioning democracy, 

The lesson for 

India is that it 

cann't rely on a 

virtuous circle 

of economic 

development and 

better governance 


where the electorate can punish policy failure. And unlike 

many other developing countries, India has the expertise and 

capacity to set up such institutions. 

Domestic institutions with local ownership and close ties to 

local stakeholders and processes must be the cornerstone of a 

system for policy transparency and evaluation. Still, India 

would be well advised to endorse complementary international 

mechanisms. First, an international mechanism can guarantee 

that a review of certain quality and coverage is undertaken with 

certain frequency. The minimum level of transparency thus 

ensured is valuable as there is no guarantee that the Indian 

government will establish and maintain sound transparency 

mechanisms domestically and entrust them with regular 

reviews of all relevant matters. (Even the Productivity Commission 

in Australia is at times sidelined by the government on 

sensitive issues.) 

Second, an international mechanism can 

support domestic transparency institutions. 

It accustoms governments to tolerate 

reviews, stakeholders to contribute to the 

review process, and the media to use the 

results. Furthermore, international reviews 

can report on the quality of domestic 

transparency institutions, drawing attention 

to persistent shortcomings and acute 

governmental encroachments. Such 

reporting could include information on the 

mandate, resources, and independence of the domestic 

mechanisms; on the issues they have covered since the last 

international report; and on the integration of their results 

into policymaking. 

Third, an international mechanism can serve not only as a 

backup and prop for domestic institutions but deliver its own, 

unique contribution. Namely, it facilitates country comparison 

through standardization. An international mechanism can ask 

the same questions for all countries, analyze the matter with 

consistent methods, and apply a similar standard of rigor in its 

conclusions. Information on where the own country stands in 

international comparison is a powerful tool to mobilize 

stakeholders and infl uence policy debates. 

International Transparency Mechanisms 

Several international organizations provide regular reviews of 

countries’ economic policies. The World Bank maintains 


31

O PEN WORLD 

various measures, such as the Doing Business, the World 

Governance, the Logistics Performance, and the World Trade 

Indicators. The IMF conducts an annual ‘Article IV Consultation’, 

a very uncompromising analysis of a country’s macroeconomic 

developments and policies. The international transparency 

mechanism for economic policies with the greatest 

potential, however, is the WTO’s Trade Policy Review Mechanism 

(TPRM). 

According to its mission, ‘the review mechanism enables the 

regular collective appreciation and evaluation of the full range 

of individual Members’ trade policies and practices and their 

impact on the functioning of the multilateral trading system.’ 

The TPRM was provisionally established in 1989 and was made 

defi nitive in 1995. The Secretariat fi rst sends one or two 

questionnaires to the country under review and collects 

information from various sources. Members of the Trade Policy 

Review Division of the Secretariat then 

travel to the country to discuss outstanding 

questions with the government and other 

stakeholders. The Secretariat drafts a 

report and sends it to the country under 

review for verifi cation. The fi nal report, 

together with a policy statement from the 

country under review, is circulated to the 

member states before the review meeting. 

All documents, including the minutes of the 

meeting, are made public. 

Regrettably, the current TPRM is beset with striking 

weaknesses. TPRs are cumbersome to read and clogged with 

compendium-style information. They are analytically superfi - 

cial and relentlessly uncritical. They differ in their coverage and 

approach one from another. The procedures for preparing and 

discussing TPRs lack effi ciency and public participation. It is 

therefore unsurprising that TPRs are deemed to have no 

discernible effect on trade policies. Improvement is necessary 

in four areas. 

Objective: TPRs should be resolutely aimed at shaping 

domestic politics rather than informing bureaucrats in Geneva. 

TPRs should focus the attention of domestic constituents and 

the media on their country’s trade policies. They should make 

trade policies comparable across countries and time and 

highlight their trade and welfare effects. And they should spell 

out their criticism. The latest TPR of India notes, for instance: 4 

Tenancy laws do not give well-defi ned rights to tenant 

32 


Regrettably, the 

current Trade 

Policy Review 

Mechansim 

(TPRM) is beset 

with many striking 

weaknesses 

farmers, who make up a signifi cant share of agricultural 

producers, and therefore they lack the incentive to develop 

the land. Other factors of low productivity include regulation 

of agricultural markets and the movement of major 

crops, which has dissuaded the private sector in general from 

investing in the sector, and relatively low levels of research 

and development. … The Government's policy of providing 

key inputs at subsidized prices has also resulted in a growing 

subsidy bill to the detriment of public investment in infrastructure 

and research and development. 

Such statements should be found more frequently and be 

underpinned more systematically with independent analysis. In 

this way they could convince readers of the benefi ts of liberal 

reform and serve as a reference in domestic policy debates. 

Reports: TPRs should follow a standardized analytical grid. 

This would make TPRs easier to read, facilitate comparison 

across time and countries, and assure that 

reports are complete. It would also secure 

consistency in the severity of criticism, 

making reports more acceptable to 

governments who care about their relative 

standing and treatment. Regarding their 

content, TPRs should rely much more 

strongly on existing analysis that shows the 

economy-wide costs of protectionism and 

identifi es winners and losers on a sectoral 

basis. Besides, they should scrutinize not 

only trade policies but also policy-making processes. TPRs 

should compare actual processes to best practices and summarize 

available analysis on the quality of policy-making. 

Process: The process of how TPRs are prepared, discussed, 

and disseminated should be reformed. The drafting of the 

Secretariat’s report should be more transparent and allow for 

greater stakeholder participation. A further step in the attempt 

to transform TPRs from a diplomatic exercise in Geneva into 

an event in members’ domestic politics should be to present 

and debate TPRs in the country under review. To realize these 

more ambitious objectives, the budget of the WTO Secretariat 

should be substantially increased. 

Frequency: According to current rules, the four countries with 

the largest share of world trade are to be reviewed every two 

years, the next sixteen every four years, and the rest every six 

years. The last reviews of India have been in 2007 and 2002. 

This is insuffi cient to infl uence domestic politics. TPRs should

e conducted more frequent to deliver up-to-date information 

and remain in stakeholders’ minds. 

Political Feasibility of TPRM Reform 

The political climate is propitious for a strengthening of the 

TPRM. The blockade of the Doha Round has demonstrated 

the need to address various systemic issues. Since the Uruguay 

Round, trade has become increasingly contested at the 

domestic level. The ‘club model’ of multilateral cooperation 

that isolated the trade ministry from involvement by other 

ministries and the general public has come to an end. Convincing 

a broader audience of the benefi ts of free trade – e.g. 

through TPRs – is therefore increasingly important if further 

liberalization is to succeed. 

Accordingly, Pascal Lamy, the WTO’s Director General, 

and the Secretariat have been successfully pushing transparency 

mechanisms as a complement to negotiations and dispute 

settlement. Most notably, they introduced a new review 

mechanism of preferential trade agreements, 5 and they started 

reporting to the Trade Policy Review Body on recent trade 

developments associated with the fi nancial crisis. Governments 

appear to be slowly learning this lesson, too. The last 

fi ve-yearly self-appraisal by the Trade Policy Review Body did 

not produce strong conclusions. 6 But it showed that major 

players (with the EU and Japan in the fi rst place) promote 

changes to give the TPRM greater bite. Since then, the 

fi nancial and economic crisis has created momentum for 

fundamental re-thinking and reform of international institutions. 

In particular, it has sparked concerns about insuffi cient 

monitoring of trade policies. 

The next WTO ministerial meeting, planned for the end of 

November 2009 and explicitly dedicated to systemic issues 

outside of the Doha Round, offers a venue for initializing 

thorough TPRM reform. India has submitted suggestions for 

enhancing the WTO’s transparency function: a database 

with non-tariff measures shall be established, the Secretariat 

shall make ‘factual presentation on developments in various 

members’ in the respective working committees, and the 

transparency mechanism for regional trade agreements shall 

be made permanent. 7 These are reasonable proposals, not 

very ambitious but enough to position India in the vanguard 

of the reform movement. India should go further and 

become a champion of transparency in trade policy. This 

would be a much more constructive approach to its new 


leadership role than the obstruction of multilateral negotiations 

practiced in the past. 

Endnotes 

1 See Davis (2009) and Hindley (2009). 

2 See Productivity Commission (2003) on the history of the 

institution as well as the Productivity Commission Act 1998. 

In the meantime, the Australian government was able to 

abolish the obligation to seek public advice from the 

Productivity Commission before granting new or increased 

assistance to any industry. In the wake, the Productivity 

Commission was by-passed on important issues in favor of 

more controllable bodies. 

3 th See Arun Shourie’s speech on ‘New Beginnings’ on 8 June, 

2009 at http://www.indianexpress.com/news/newbeginnings/476900/0. 

4 WTO (2007), pp. 100. 

5 See WTO (2006). 

6 See WTO (2008). 

7 India (2009). 


Davis, Lucy. 2009. Anti-dumping Investigation in the EU: 

How Does It Work? : ECIPE Working Paper No. 04/2009. 

Hindley, Brian. 2009. Cause-of-injury Analysis in European 

Anti-dumping Investigations: ECIPE Working Paper No. 

05/2009. 

India. 2009. Strengthening the WTO: Communication from 

India: WT/GC/W/605. 

Narayan, S., ed. 2009. The Political Economy of Trade 

Reform in Emerging Markets. Edited by P. Draper, P. Alves 

and S. Razeen. Cheltenham: Edward Elgar. 

Productivity Commission. 2003. From Industry Assistance 

to Productivity: 30 Years of 'The Commission': Productivity 

Commission, Canberra. 

WTO. 2006. Transparency Mechanism for Regional Trade 

Agreements: WT/L/671. 

–. 2007. Trade Policy Review: India - Report by the Secretariat: 

WT/TPR/S/182/Rev.1. 

–. 2008. Third Appraisal of the Operation of the Trade 

Policy Review Mechanism: WT/TPR/229. 

(The views expressed in the article are personal and do not refl ect 

the offi cial policy or position of the organisation.) 


33

O PEN WORLD 

Regulating Markets in the 

Post-Crisis World 

There are few precedents for the current global fi nancial 

meltdown. Not surprisingly, the crisis has already led to 

much soul-searching in both the policy-making and 

academic circles. Established orthodoxies are being questioned as 

never before, not only to better understand the roots of the crisis, 

but also to formulate policies in order to mitigate the current 

economic toll and dislocation and prevent future crises. Even as 

the dust settles, the process of drawing lessons from the great 

global credit crisis of 2008-09 has begun with earnest. While we 

do not know all the answers yet, the one unambiguous answer is 

34 


that the hands-off American or “Anglo- Saxon” model of regulation 

or (“regulation-lite”) needs to be replaced with a more 

vigorous and effective regulation of fi nancial institutions and 

markets. Yet, what will this regulation entail? Of course, the devil 

is in the details and there is no consensus on that. The following 

sections fi ll in some of the gaps. It suggests that although greater 

regulation is necessary, we must be careful not to cross the line 

where regulations become too restrictive and an impediment to 

innovation and entrepreneurship. 

First, an important caveat should be noted: that the globally

Shalendra D. Sharma* 

Professor, Department of Politics, 

University of San Francisco 

linked fi nancial markets are inherently unstable and prone to 

excess. Even as global capital markets allocates money more 

effi ciently than domestic ones, and helped spread capital and 

wealth more widely than ever before (and in the process enabled 

millions to better their lives), the fi nancial system is also extremely 

fragile – prone to boom and busts. Eichengreen and Bordo have 

identifi ed some 139 fi nancial crises between 1973 and 1997 (of 

which 44 took place in high-income countries), compared with a 

total of only 38 between 1945 and 1971. 1 This is because with 

globalization, markets have become even more volatile and 

unpredictable, and may not always work effi ciently due to externalities, 

coordination failures, information asymmetries, including 

well-placed fi rms and individuals using their power and privileged 

access for private gain. 

Thus, although open global fi nancial markets provide tremendous 

rewards by lowering the cost of capital, it is also clear that 

more effective regulation is needed to realize 

this potential. After all, fi nancial markets can 

only function effi ciently when there is 

symmetry of information available to both 

buyers and sellers. Since effective disclosure 

and transparency is fundamental to wellfunctioning 

markets, a core role of market 

regulators is to reduce information asymmetries. 

This is essential now because 

fi nancial innovation and integration have 

increased the speed and extent to which shocks are being transmitted 

across asset classes and economies throughout the world. 

Yet, regulation and supervision remain largely geared at individual 

fi nancial institutions and do not adequately factor-in the 

systemic and international implications of domestic institutions’ 

actions. As a result (and as we now know) many highly structured 

products were far from transparent and the disclosure of their 

originators often lacking. Given these challenges, regulatory 

oversight that places constraints on imprudent individual behavior 

and prevent the build-up of dangerous speculative bubbles 

makes sense. This failure has been most vividly and tragically 

demonstrated during the current crisis where weak regulatory and 

supervisory frameworks in the United States (but, also in other 

Unprecedented 

pace of change 

makes it difficult, 

if not impossible, 

for regulation and 

supervision to 

keep pace 

P OWER AND CONTROL 

advanced economies), failed to prevent excessive risk-taking by 

market participants. 

The current crisis also underscores that current macro-prudential 

tools do not suffi ciently take into account business and 

fi nancial cycles. This has led to an excessive build up of leverage. 

Although a feature that the current crisis shares with previous ones 

is the apparent procyclicality of the fi nancial system (with a 

build-up of leverage in good times when investors tend to underestimate 

risk, and the subsequent unwinding of this leverage when 

conditions deteriorate), this crisis is also unique for the key role of 

assets that are held off banks’ balance sheets and the extent to 

which credit problems have affected the liquidity of the entire 

fi nancial system. This not only means that credit rating agencies 

need to more clearly differentiate structured products from more 

standard fi nancial instruments in their assessment of risks, market 

participants need more information and transparency to better 

price risk and reduce uncertainty at times of market disruption. 

Thus, it is essential to put into place rules and institutions that 

reduce systemic risks and improve fi nancial intermediation without 

imposing unnecessary red-tape. In particular, more transparent 

capital and liquidity requirements would make fi nancial institutions 

(especially those that are highly 

interconnected) more resilient to risk, and 

making accessible data on over-the-counter 

derivatives (to migrate those peer-to-peer 

transactions to a tradable and public market), 

and to introduce minimum capital requirements 

that cover all fi nancial assets and 

organizations would be a great help. It also 

means that the supervisory and regulatory 

frameworks should be more globally coordinated 

to ensure effective supervision, including more transparent 

disclosure and reporting rules. Such an approach would also 

provide better information to market participants regarding 

assessments of systemic risks. 

Yet, this crisis has also underscored that protecting the global 

fi nancial system from the recurrent bouts of speculative excesses 

and painful contractions is not going to be easy given the internationalization 

of markets. The unprecedented pace of change 

makes it diffi cult, if not impossible, for the bureaucratic world of 

regulation and supervision to keep pace. While the conventional 

view (not surprisingly promoted by politicians) blames deregulation 

for the current problem, it is important to keep in mind that 

the U.S. fi nancial services industry is not without its fair share of 


35

O PEN WORLD 

regulations and red-tape. In fact, numerous laws and regulations 

are already on the books and a plethora of government agencies, 

notably the Securities and Exchange Commission (SEC) in 

America and its British equivalent, the Financial Services Authority 

(FSA), have signifi cant powers to implement and supervise 

these rules. Clearly, more bureaucratic red tape is not the answer. 

Yet, a regulatory backlash is almost certain to follow the government 

bailout. However, what must be avoided is politically driven 

legislation and overregulation. It must be underscored that that a 

market system can never be fully tamed and there will always be an 

element of risk. To make markets completely safe would mean an 

end of innovation and pervasive stagnation. 

Rather, targeted supervision in the area of intermediation to 

guarantee effective reconciliation of the economic needs of 

businesses and individuals for long-term credit on predictable 

terms is critical. To the authorities in charge of banking regulations 

this means that if a bank is “irresponsible,” 

they should require the bank to take immediate 

corrective measures, and if it does not, 

they must close the bank, and if the bank is 

too large to fail, it should be taken over by the 

authorities. This will go a long-way in instilling 

confi dence. Similarly, policymakers must 

avoid indiscriminate regulations. Rather they 

need to double their efforts to identify the 

core market imperfections that gave rise to 

the incentives for excess risk taking. Strengthening and streamlining 

the prudential oversight of fi nancial and capital markets and 

enhancing transparency of market instruments and transactions 

will go a long way to mitigate problems. Specifi cally, in the United 

States and elsewhere there needs to be greater regulatory oversight 

over the nation’s fi nancial system, including strict federal rules for 

hedge funds, credit rating agencies and mortgage brokers, as well 

as transparency over the use of the complex fi nancial instruments 

that helped spawn the current crisis. At a minimum, this must 

mean the elimination of confl icts of interest at credit rating 

agencies that gave top investment grades to the ultimately shaky 

fi nancial instruments. 

It was most encouraging when on November 15th , 2008 meeting 

of the “Summit on Financial Markets and the World Economy” in 

Washington, D.C., the G-20 leaders recognized the serious 

challenges facing the global economy, especially the fi nancial 

markets, and renewed their commitments to enhance cooperation 

to restore global growth based on the market principles of open 

36 


It must be 

understood that 

a market system 

can never be fully 

tamed and there 

will always be an 

element of risk 

trade, transparency and accountability. This was an explicit 

recognition on the part of the G-20 that well-regulated fi nancial 

markets foster the dynamism, innovation, and entrepreneurship 

that are essential for economic growth, employment, and poverty 

reduction. The fact that the G-20 agreed to strengthen and 

empower institutions like the World Bank and the IMF to aid the 

transition and developing countries, especially the poorest “least 

developed countries” (LDCs) who are reeling under the crisis they 

had no part in creating, further underscores that a global effort is 

needed to combat this global crisis. 

However, making a commitment is one thing, following through 

is another. For example, institutions like the World Bank and the 

IMF are to be effective their lending capacity needs to be enhanced. 

In fact, John Lipsky, the IMF’s Deputy Director has called 

for a doubling of the Fund’s lending capacity to $500 billion – albeit, 

interestingly a number of developing countries see this 

request as too modest and have called for a 

tripling of the resources. This may seem 

counterintuitive as developing countries have 

long accused the IMF of having too much 

power and infl uence. However, this crisis has 

made strange bedfellows. Specifi cally, as the 

resultant global credit crunch has literally 

dried up private capital fl ows to developing 

countries, monies from agencies like are IMF 

and the World Bank is once again in big 

demand. Facing a real prospect of being shut out of international 

capital markets, for many developing countries, especially the 

LDCs, their only option may be the fi nancing from these multilateral 

fi nancial institutions. Nevertheless, the IMF’s major shareholders 

(the rich nations) must make sure that these multilateral 

fi nancial organizations do more than simply dole out money, but 

be proactive in preventing the build-up of global fi nancial imbalances 

that has contributed to this crisis (i.e. the huge international 

reserves in emerging countries and massive defi cits in rich nations). 

It is also in the common interest of the G-20 to counter the 

growing forces of protectionism and nationalism. Among other 

things, this means that the United States, the EU, China, India and 

Brazil put aside their largely narrow differences and salvage the 

Doha round of trade negotiations. The failure of Doha has the 

potential to reduce world trade by $1 trillion, especially if countries 

abandon the voluntary tariff restraint. India and to a lesser extent, 

China who bear much responsibility for bringing the Doha round 

to a abrupt in summer of 2008 by insisting on protecting their

farmers through tariffs will need to be more fl exible if Doha is to 

be concluded. It also means that the Obama administration, in 

charge of the world’s largest economy, end the ambivalence, 

indeed, stop sending mixed signals regarding its commitment to 

free trade. Acknowledging on one hand the benefi ts of trade, while 

on the other, criticizing free trade is counter-productive when 

protectionist sentiments are running high. The U.S. administration 

can allay these concerns by declaring unambiguously that any U.S. 

government bail-out and subsidies will be WTO-consistent. Failure 

to do this, especially with the “Buy American” provisions in the 

economic stimulus program has the potential to lead to the kind of 

tit-for-tat protectionism that helped deepen the Great Depression. 

More substantively, for Doha to progress, the U.S. must make 

meaningful reductions in its support of trade distorting agricultural 

subsidies. Of course, this is now a challenge as governments 

throughout the world are forced to increase support payments to 

farmers with the collapse of global commodity 

prices. In addition, in the spirit of cooperation, 

governments’ can better coordinate their 

stimulus packages. At a minimum, stimulus 

packages must be built around common 

principles of multilateralism and openness to 

trade, even if they differ in the details. Indeed, 

U.S. backing for a successful end of Doha will 

not only underscore its commitment to free 

trade, an institutionalized rules based trading 

system under the WTO will also mitigate the 

more subtle tricks, if not, insidious protectionism countries use 

such as health and safety standards, including technical barriers, 

especially licensing and certifi cation requirements to protect 

domestic industries. 

Finally, the cost of fi ghting the crisis has been unprecedented. 

Public debt is rising as governments around the world hemorrhaging 

red ink. The massive stimulus programs coupled with the 

upfront costs of fi nancial rescues, including the recapitalization of 

banks, guarantees for troubled assets, not to mention the tax 

revenues lost from growing unemployment, and falling output 

and asset prices means that fi scal defi cits will increase. The IMF 

expects OECD countries’ combined fi scal defi cit to rise to seven 

percent of GDP in 2009 (from less than two percent in 2007), 

while emerging economies will see their budget surpluses grow 

into a defi cit of 3 percent of GDP. There is general agreement 

that such massive defi cit spending is needed to help revive the 

economy from recession -- because prolonged recessions can have 

Free markets 

will not always 

'self-correct' and 

state intervention 

is necessary 

to protect the 

capitalist system 

P OWER AND CONTROL 

far more serious consequences than the fi scal bailouts designed to 

combat them. Nevertheless, public debt can only rise so much 

without any implications. In the United States the cost of the 

stimulus packages and the bailouts for the fi nancial system has 

already resulted in “trillion-dollar defi cits.” In the short term, if 

the government debt ratios increase sharply it could lead to a 

sharp drop in the value of the currency and infl ation -- with real 

consequences for many who have already seen their nest-eggs 

disappear. Over the long-term, it could potentially lead to a 

perpetual debt burden on future generations. 

John Maynard Keynes, during the depths of the great depression 

warned that free markets will not always “self-correct” and 

government intervention is necessary to protect the capitalist 

system against its own excesses. No doubt, we are witnessing a 

crisis of confi dence in capitalism forcing champions of laissez-faire 

to implement policies and programs that were simply unthinkable 

just weeks ago. Who could have imagined 

that the government of the United States 

would have intervened in markets by bailingout 

private banks through recapitalizations, 

or buy assets directly from private fi rms with 

tax-payer dollars and provide blanket 

guarantees to bank deposits. 

Nevertheless, as Milton Friedman pointed 

out long ago: government intervention must 

be strictly regulated because over the 

long-term markets are far more effi cient at 

allocating capital than bureaucrats. We can also add that we live in 

an economically interconnected. As such, fi nancial crises cannot be 

contained within borders and that international cooperation is 

essential to address the immediate and long-term challenges posed 

by the crisis. 

Endnotes and Additional Thinking 

1 Eichengreen, Barry and Michael D. Bordo, 2002, “Crises Now 

and Then? What Lessons from the Last Era of Financial 

Globalization?,” NBER Working Paper No. 8716. 

(Author of: China and India in the Age of Globalization: A Comparative 

Political Economy. New York: Cambridge University Press 

(2009).http://www.cambridge.org/us/catalogue/catalogue. 

asp?isbn=9780521731362 The views expressed in the article are 

personal and do not refl ect the offi cial policy or position of the 

organisation.) 


37

O PEN WORLD 

Market 

Failure and 

the Need for 

Regulation 

Abstract: 

38 


Anjan Panday 

Ph.D. candidate , 

The American University, Washington, DC 

During the current global fi nancial crisis, nations around the 

world took unprecedented steps in bailing-out failing industries 

and rescue the economy. Proponents of market system 

advocate liquidating insolvent fi rms. In reality, though, the 

situation was different, especially in the fi nancial industry, 

because of the systemic threat to the entire market. The 

self-serving market system could not foot-hold during this 

time. The housing bubble that predated the current crisis is an 

example of market limitation. In this paper, the idea of 

market failure is revisited and, for all the reason it deserves, 

an effective regulation is argued vital at this time. 

Introduction: 

The current global fi nancial crisis has opened a fl oodgate of 

discussions on the fragility of largely unregulated fi nancial 

sector and the subsequent infl uence on the broader economy. 

Many have drawn analogy of the current crisis as second only

M ISSING MARKETS 

to the Great Depression of 1930s, something observed once in 

a generation. The “Roaring Twenties” came to an end with 

the collapse of stock market in 1929 and the years thereafter 

witnessed one of the great sufferings and miseries of mankind. 

It later became clear that the stock market during the time 

was buoyed by speculative investment, often manipulated by 

few large participants, in absence of any meaningful regulation 

in the Wall Street. What started as a stock market crash 

quickly spread to the banking sector wiping out savings of 

many and had an unprecedented impact on the economy. A 

quick fact check of the current crisis holds some resemblance. 

In the years since, a number of regulatory frameworks and 

institutional setups were put in place with an aim to prevent 

market failure and minimize the potential of a catastrophic 

crisis1 . However, by the end of the millennium, the deregulation 

phenomenon was sweeping over much of the fi nancial 

industry. To a signifi cant extent, the belief on rational agents 

and self-regulating market mechanism swayed much of the 

policy orientation. The critics, however, have argued that the 

fi rst two crises of the 21st century—stock market and realestate 

led—have undermined the market rationality and 

points to, inter alia, a lack of sensible regulation behind the 

market collapse. There is a near consensus among economists 

that some of the fundamental beliefs behind market rationale 

failed to hold true. The great confi dence on rational agents 

and in their judgment demonstrated only perverse result. At 

the core is the idea that the market participants often either 

fail to recognize their best interest due to several limitations 

or are motivated to act otherwise. This microcosmic effect in 

aggregation leads to a disruption of market and is demonstrated 

through failure in price adjustment. 

This paper will revisit the concept of market failure, its role 

in current crisis, and a possible intervention in the market 

through regulation. To provide balance to the discussion, this 

paper will draw on some theoretical notion of market failure 

while highlighting the application side of regulatory framework. 

A brief summary on traditional notion of market 

failure and the behavioral dimension is presented. For its 

proper role, some of the key deregulation measures will be 

discussed. The regulatory aspect will highlight the perverse 

incentive problem while arguing for adequate capital provisioning 

and related preventive measures in the fi nancial 

institutions. To conclude, a cautionary note in designing 

regulatory system is presented. 


39

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2. Market Failure and Causes: 

As introduced above, the case for market failure involves some 

sort of market distortion that impedes adjustment of prices in 

the market. The consequences of failure to adjust prices are 

many. This section will briefl y present some of the concepts of 

market failure. 

A traditional notion of market 

failure entails obstacle in achieving 

effi cient production and distribution in 

a Pareto optimal sense. Various types 

of market imperfections illustrate the 

idea of ineffi ciency in production and 

distribution. The immediate ramifi cation 

is on prices of goods and services. 

A textbook example of this would be 

the case of a monopoly producer or a 

monopsony buyer. A large supplier 

can alter the market prices favorably 

by manipulating production. By 

restricting supply, it can effectively 

raise the market price above the 

competitive equilibrium which 

inevitably results in loss of effi ciency, 

commonly referred as dead-weight loss. In 

a similar vein, a large buyer can squeeze 

price below the competitive equilibrium, 

again resulting in a dead-weight loss. 

Industry-wide price cartel is the most 

commonly observed form of market 

imperfection that leads to market ineffi - 

ciency. As Kenneth Arrow suggested 

market failure often results from the 

absence of competitive market. 

Another area of ubiquitous discussion on market failure 

features the case of externality. When a mutually consenting 

transaction between two parties has an adverse consequence 

on a third party unrelated to the act, the case of negative 

externality is invoked. Environmental degradation due to 

industrial pollutant is strongly argued as a cost on general 

public. The point is that the private cost fails to incorporate the 

societal cost and is not refl ected in prices of industrial output. 

Market as generally perceived fails to capture cost to society. 

In yet another related discussion, the case of public goods is 

often cited as an example of market failure. The nonexcludabil- 

40 


The housing 

bubble that 

predated the 

current economic 

crisis is an 

example of 

market limitation 

ity feature of the public good avails benefi t to the users without 

having to compensate for it. 

The idea of market failure has evolved from these conventional 

notions. Its relevancy in the present crisis pertains to 

market distortion whereby prices diverge greatly from its true 

or fundamental value, as observed during bubble formation. 

The fundamental value is invariably 

based on some kind of expected 

revenue stream over the life time of 

asset. A common characterization of 

price changes during bubble formation 

entails investors’ reaction today based 

merely on the expectation of further 

price rise in future. Such expectation, 

however, is not grounded on economic 

reality. There is a plethora of evidence 

to suggest bubble formation in past 

crises. Before the crash in 1929, there 

was a general feeling of unsustainable 

price rise on Wall Street. The same was 

true with the dot-com bubble earlier in 

this decade. Moreover, prior to the 

sub-prime debacle of 2007, there were 

alarming calls out on the un-sustainability 

of house prices. Author Robert J. Shiller in 

his book “The Subprime Solution” 

documents the evidence of out-of- sync 

prices in the housing market. The bottom 

line is that market prices fail to represent 

real worth of an asset during bubble. 

Finally, the current crisis also illustrated 

one more episode of market distortion. It 

is clear that the current global crisis is rooted in the US housing 

market which exploded after the collapse of sub-prime mortgage 

market. The degree to which crisis in one sector of the 

economy diffused to a global scene has been viewed in light of 

sophisticated network of interconnected and interwoven 

fi nancial system, spread globally. Financial innovation of 

roughly two decades offered investors with an array of state-ofthe-art 

products. The idea of securitization was a breakthrough 

for investors as well as borrowers. Transactions in complicated 

derivatives and asset-backed securities were thought to provide 

investors with comforting choices. However, the level of 

sophistication proved costly in that proper asset valuation

mechanism was trampled. Gorton(2008) argues that in course 

of repeated packaging of the asset-backed securities, the 

system made it virtually impossible to penetrate the chain backwards 

and value the asset based on the underlying mortgaged 

property. The crucial information on future payoff was lost as a 

result of added complexity. A number of commentators2 have 

highlighted the fact that the complexity in the 

fi nancial market hampered price discovery 

mechanism and contributed to market arket distortion. 

Inadvertently it may be but the market arket 

adjustment was laid dysfunctional. . 

2.1 Market Limitation: 

In the preceding section, we briefl flyy 

presented some conditions under 

the neo-classical tradition of 

characterizing market failures. 

The broad distinction is either 

the lack of effective competition 

or non-existent market. In 

a sharp contrast, the behaviorists’ 

explanation alludes to a 

more fundamental limitation in human 

behavior. 

As pointed before, the neo-classical argument 

for market adjustment rests on the 

idea of rational market guided by self 

interest of market participants. A rationally 

motivated individual is suffi ciently 

equipped to make best decision in the 

market place. Many believe that this faith 

in the market formed the intellectual basis 

for deregulation in the fi nancial market and an off-hand 

approach in the policy orientation of recent decades. In the 

aftermath of current crisis, the all too- powerful rational 

market argument is perhaps debated vigorously than any time 

before. Economists, however, have for long pointed to the 

limitation of rational market. 

Herbert A. Simon is credited with bringing the notion of 

bounded rationality to the forefront. He argued that agents 

face uncertainty in decision making and gathering all kind of 

information can be prohibitively costly. Therefore, people 

often make decision based on “satisfi cing” rather than deciding 

optimally. This limitation in human behavior is well grounded 

According to 

Kenneth Arrow, 

market failure 

often results 

from the absence 

of competitive 

markets 


on behaviorists’ explanation of bubble, panic and other 

irrational behavior in the market. They argue that noneconomic 

factors do motivate decision making, which explain the 

anomalies observed in the market. Authors Akerlof and Shiller 

(2009) write that panic in the market spreads quickly and 

“fear” sets in motion the speed of contagion. They point that 

investors' psychology dominates decision making 

under panic situation and it quickly overwhelms the 

market. There are evidences of this type of nonrational 

behavior in past crises3 . It is quite 

clear that the massive bail-out scheme 

offered by the governments’ 

world-wide, during current 

crisis, is driven to a large extent 

by the concern to contain the 

possible contagion and help 

soar-up market confi dence. 

Prior to the current crisis, a 

number of studies tried to 

analyze signs of bubble formation 

in the US housing market. 

Case and Shiller(2003) reported—based 

on the survey of homeowners 

response—that there was a strong indication 

of bubble in the market4 . Further, 

Shiller(2008) provides a well thought-out 

narrative of bubble formation and investors’ 

reaction in run-up to the US housing 

crisis. The author argues that humans often 

respond in emotion, unpredictably, and 

wildly. There is a tendency to exaggerate 

good news while downplay bad ones. 

Moreover, investors are often biased in their decision. For 

instance, home buyers often prefer investing in their home 

town/city/state which often locks-out from exploring locations 

preferable from the stand point of living comfort. In the run-up 

to the housing bubble that predated current crisis, the author 

notes that people believed and reacted to “word of mouth 

communication”. A price-story-price loop generated feedback 

mechanism for further price rise. Investors psyche prevailed 

over market rationale. To sum up, there are numbers of factors5 under panic situatio 

market. There are 

rational be 

clear that 

C 

that motivate our psychological perception, in good times or 

bad times. And, these factors feature prominently in our 

decision making. They often take over market rationality. 


41

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Table 1: Total Political Contribution in the USA by Finance/Insurance/Real-Estate Industry 

Year Amount USD Year Amount USD 

1990 60,613,414 2000 309,119,703 

1992 117,126,447 2002 233,061,144 

1994 103,174,435 2004 340,099,037 

1996 175,517,301 2006 259,437,470 

1998 155,005,805 2008 474,857,391 

Source: opensecrets.org 

3. Deregulation and Market Failure: 

Based on the discussion so far, a reasonable case for some kind 

of market intervention seems indispensable. Insofar to address 

market imperfections or the limitations in human decision 

making, there is a role for some regulatory mechanism to 

ensure market smoothness. In the years 

after stock market crash of 1929, a series of 

regulatory measures were put in place in 

the US fi nancial system. The relatively 

stable period of much of the remaining 20th century may be rightfully attributed to the 

check and balance that these regulations 

provided. Some, however, argued against 

what was perceived as too much encroachment 

in the market during this time. 

Towards the end of the 20th century, the evil 

of big government—and to that extent the regulatory set-ups— 

had all but put to rest. The period also concur with an era of 

greater integration of economies and market worldwide. 

Finance and capital fl ows proved crucial for global economic 

growth. As a capital of global fi nance, the consequences in the 

US fi nancial system continue to have global ramifi cations. A 

brief summary of deregulation efforts in the US fi nancial 

market is presented as a contextual description relevant in the 

current crisis. 

In their book, “Bailout Nation”, authors Barry Ritholtz and 

Aaron Task discuss three crucial deregulation measures of last 

decade that connects importantly to the current crisis. First, 

they argue that the repeal of the Glass-Steagall Act, 1933, by 

Gramm-Leach-Bailey Act, 1999, expanded the scope of 

traditional banking into a much larger center for fi nancial 

services. The banks benefi tted from economies of scale and 

innovations in the fi nancial market while consumers found a 

convenient location to meet all of their fi nancial-services need. 

42 


As a capital of 

global finance, the 

consequences in 

the US financial 

system continue 

to have global 

ramifications 

Sounds a perfect match until the reality of “too-big-to-fail” 

type institution6 emerged. Second, in 2000, under intense 

pressure of different lobbying groups, the Commodities 

Futures Modernization Act was passed. The legislation 

provided for almost no regulation of derivative transaction 

including the catastrophic Credit Default 

Swap (CDS) which the fi nancial institutions 

had amassed to a critical level during 

the current crisis. Third, the Net Capital 

Rule that originally allowed for debt to 

equity ratio of 12:1 often got higher 

reaching up to 40:1, again under the 

infl uence of strong lobby. It is no coincidence 

that the complex derivative transactions 

became acceptable norm in the 

industry nor is it any accident that the 

fi nancial institutions were critically leveraged. 

The deregulation-era policy orientation drew upon the 

intellectual philosophy of competent market capable of serving 

its best interest, especially to maintain safety and soundness of 

the system. In the aftermath of the crisis, this argument is 

highly contested. Market imperfection resulted, to a large 

degree, under the infl uence of interest groups which were 

unable to see their own long-term interest. Table 1 shows example 

of business-politics connection. It is reasonable to doubt if 

the business interest had a natural pathway to policymaking 

through political contribution. 

4. Market Intervention through Regulation: 

Designing a workable regulatory framework is perhaps the 

biggest challenge that policymakers face. It is well known that 

incentivizing corrective action, or, equivalently, promoting 

preventive measures, best solves many issues that market fails 

to accommodate. In retrospect, it is quite clear that the

deregulation-era policy measures provided little incentive for 

check and balance. The incentive system in the fi nancial 

industry resulted perverse outcome. Nobel Laureate Paul 

Krugman often takes to the point that the pay-and-performance 

system in the fi nancial industry promoted more risk taking 

behavior. While no one is arguing to restrict the ingenuity and 

innovative power of the private market, there is defi nitely a 

realization to bridge the big void left in the regulatory system. 

One lesson the current crisis has made clear is the cataclysmic 

nature of risk to the entire system. The fragility of global 

fi nancial system was exposed in the events following collapse 

of the US sub-prime housing market. A sectoral impact 

quickly turned into an industry-wide credit crisis and had a 

signifi cant spillover effect on the real economy. The greater 

interconnectedness of markets in the new millennium also 

meant that the crisis spread quickly to a 

global scale. It is in response to this global 

nature of crisis that nations world-wide are 

coordinating in establishing effective 

regulatory mechanism and also working in 

concert to stimulate economies. The 

following statement made at the recently 

concluded G-20 summit succinctly identifi 

es the problem: 

“At the same time, weak underwriting 

standards, unsound risk management 

practices, increasingly complex and opaque fi nancial products, 

and consequent excessive leverage combined to create vulnerabilities 

in the system. Policy-makers, regulators and supervisors 

in some advanced countries, did not adequately appreciate 

and address the risks building up in fi nancial market…or 

take into account the system ramifi cations of domestic 

regulatory actions.” 

It is quite clear that the reform measures to stabilize the 

fi nancial market will be aimed at preventing the systemic risk 

and to avoid situations of panic calls, typical during crisis. 

4.1 Pertinent Issues in Regulatory Mechanism: 

In discussing practicality of the regulatory system, it is imperative 

to fi nd appropriate balance between stability and effi ciency. 

Again, the following phrase from the G-20 meeting puts this 

squarely in context: 

“…while ensuring that regulation is effi cient, does not stifl e 

innovation, and encourages expanded trade in fi nancial 

The pay-andperformance 

system in the 

financial industry 

promoted more 

risk taking 

behavior 


products and services.” 

To fully appreciate the various dimension of regulatory 

mechanism is out of the scope of this paper. Nonetheless, some 

important considerations that the upcoming regulatory system 

needs to address are presented. 

Mussa (1986) in writing on regulation of depository institutions 

argued that the safety and soundness of the institution 

should be the core objective. In pointing defi ciencies of the 

existing system, the author notes that the government policies 

tended to discourage adequate capital holding. Indeed, the 

safety of institutions greatly relies on solvency of its fi nancial 

position. The former Fed-chief Alan Greenspan wrote in a 

guest article in the Economist magazine that the banking 

system needs “much thicker capital cushions” than they had 

enjoyed before the crisis. 

Second, some of the big banks which 

took on a role of multi-service center are 

now recognized to pose a systemic threat, 

especially with hefty short-term leveraging. 

Kenneth Rogoff of Harvard University 

writes7 that systemically important banks 

need to be placed under stricter control on 

short-term borrowing. Others have argued 

that there should be some mechanism to 

prevent banks from becoming “too big to 

fail”. Yet some other view that independently 

each of the banks can make the same mistake and 

therefore individual entity should be brought under an umbrella 

of regulation. 

Third, there needs to be some reconciliation to address the 

adverse incentive system of rewarding based on short-term 

performance, something that has become industry standard in 

recent years. The compensation practice in the fi nancial 

industry is lately under serious debate given what many view as 

a tendency to privatize profi t while socialize loss. This has been 

true in light of numerous bailout actions by governments in 

attempting to prevent free-fall of the economy. While the 

fi nancial industry continues to oppose this as infi ltration in 

their territory, there is a sense of urgency to address the pay 

system and streamline the incentive. 

Fourth, although proper risk evaluation entails technical 

analysis and objective evaluation, there is enough room for 

subjective judgment in performance monitoring. Transparency 

and accountability are related features of regulation which 


43

O PEN WORLD 

complements healthy market operation. To this effect, regulatory 

bodies have a big role to play in remaining vigilant on 

activities in market to prevent any fraudulent scheme or 

predatory-type lending. 

Finally, it is necessary to acknowledge complexity in designing 

effective regulation. History shows how the interest groups 

and lobbying pressure can undermine the effectiveness of the 

system. It will be hard to keep the business-politics nexus away. 

Besides, managing the regulatory system should not become a 

bureaucratic nightmare. In all, regulation should pave for 

healthy competition in the market and not become a recipe for 

another disaster—i.e., failure of the government. 

5. Conclusion: 

This paper is an attempt to present a summary of theoretical 

notion of market failure, relating the discussion to the current 

global fi nancial crisis. It is clear that the crisis originated from a 

sector in the US housing market which spread to the domestic 

economy and eventually escalated to a global scene. Therefore, 

the events in the US fi nancial system are central to the paper 

which nonetheless has global ramifi cations. 

The traditional notion of market failure suggests failure in 

price adjustment due to some sort of market distortion. This is 

different from dominant role of investors’ perception in 

decision making during bubble formation. A better understanding 

of the kind of limitation in rational thinking was 

offered through behavioral exposition. In analyzing the 

deregulation-era policy measures, it became clear that a great 

deal of market imperfection resulted under infl uence of 

interest groups. 

On the second part of the paper, a case for effective and 

effi cient regulatory mechanism was argued. Our experience 

with market shows that proper regulation complements and 

enhances safety and soundness of the system. Although 

diffi cult to achieve, it can stem untoward incidents while 

promoting healthy competition. The current crisis made aware 

of the risks in the fi nancial system that can potentially threaten 

stability of the entire market. Current debate on avoiding 

system risk is a right step toward fi nancial market stability. 

Some of the key concerns to this effect were discussed. 

Endnotes 

1 Here, we characterize a major crisis as the one that can 

potentially overwhelm the entire industry and is a threat to 

44 


overall economy 

2 Note that Warren Buffet in 2003 warned complex derivatives 

as fi nancial weapons of mass destruction. 

3 One example the authors cite is the ensuing bank run after 

the suspension of currency payments by New York’s 

Knickerbocker Trust in 1907. 

4 It is indeed noteworthy that many of the studies failed to 

provide any conclusive evidence, worthy of necessitating 

policy response. 

5 Refer Akerlof and Shiller(2009) 

6 The authors indicate that some of the US banks have 

outgrown to lose effi ciency, even becoming too big to 

manage. 

7 th Financial Times article dated August 18 , 2009 

References 

Akerlof, George A. and Shiller, Robert J. 2009. “Animal 

Spirits: How Human Psychology Drives the Economy, and 

Why it Matters for Global Capitalism”, Princeton University 

Press. Princeton and Oxford. 

Case, Karl E. and Robert J. Shiller.2003. “Is There a Bubble 

in the Housing Market? An analysis”, Brooking Paper on 

Economic Activity, 2. 

G-20. Declaration. Summit of Financial Markets and the 

World Economy. November 15th , 2008 

Gorton, Gary B. 2008. “The Subprime Panic”, NBER 

Working Paper Series, Working Paper 14398 

Greenspan, Alan. “Banks Need More Capital”. The 

Economist. December 18th , 2008. 

Mussa, Michael. 1986. “Safety and Soundness as an Objective 

of Regulation of Depository Institutions: Comment on 

Kareken”, The Journal of Business, Vol. 59, No. 1, pp 

97-117. 

Ritholtz, Barry and Task, Aaron. 2009. “Bailout Nation”, 

John Wiley & Sons, Inc. 

Rogoff, Kenneth. “Why we need to regulate bank sooner, 

not later”. Financial Times. August 18th , 2009. 

Shiller, Robert J. 2008. “The Subprime Solution: How 

Today’s Global Financial Crisis Happened, and What to Do 

about It”, Princeton University Press. Princeton and 

Oxford. 


the offi cial policy or position of the organisation).

O PEN WORLD 

46 4 

Trade Liberalisation and 

Indian Farm Sector: 

Understanding the 

Situation from 

Available Evidence 

THE TH THE T THE TH T THE TH THE T THE TTH THE T TTHE T HE H HE H HE H HE H HE H E IIPM II I II I III I PM P PM PPM P M TH THI TH THI TTHI T THI TH THI TTHINK HHI 

HHI 

H NK K TANK TAN TA TAN TA TAN TA TAN TA TTA T AN A N K

Subrata Dutta 

Associate Professor, Sardar Patel Institute of 

Economic and Social Research, Ahmedabad 

Market Liberalisation with Faulty Price Policy 

Let us fi rst try to understand the concern about how agricul- 

tural trade liberalisation has often been affecting our food 

security issue via the hike in prices. The rise in wheat price 

in last few years in India has been mainly the result of trade 

liberalisation. It is true that due to rising population growth 

supply of wheat fell short of what has been demanded after 

2004-05, but in the last seven years signifi cant market 

reforms, resulting in increasing the participation of the 

private sector in foodgrain trade, have been mostly responsible 

for the rise in wheat price. Ramesh Chand (2007) has 

analysed the case in a well manner. A number of big companies 

(including multinationals), e.g. ITC, 

Cargill, Australian Wheat Board, 

Britannia, Con Agro, Delhi Flour Mills 

and some others, are now operating in 

foodgrain trade, holding sizeable stocks 

and playing with their inventories to 

cause increases in price and to take 

advantage of the same. In case the 

government had a reasonable stock it 

could keep a check on any abnormal 

increase in prices. But the government 

has a faulty price policy. Every year the minimum support 

price (MSP), which remains fi xed for the whole particular 

season, is announced and thereafter the government starts 

procuring commodities like wheat and rice either at the MSP 

or by adding a bonus to the MSP. This fi xed price policy does 

not fi t in the open market system and thus inhibit the 

government in procuring the required quantity of produce. 

The procurement either falls short or exceeds what is needed 

to be purchased by the government. However, there is 

another concept called procurement price (PP), but virtually 

in practice the MSP turns out to be the fi xed PP (sometimes 

with added bonus, as said earlier). It allows the private sector 

to outstrip government agencies by offering a little more 

than the procurement price. In such a situation, the government 

becomes a helpless witness since the procurement 

When the market 

price of a grain is 

higher than theh 

MSP, the PP must 

follow the market 

norms and offer 

market prices 

F ROM COLUMBUS TO CONA GRA 

offi cer cannot pay even a single penny more than what is 

already fi xed. According to Chand (2007), this is the sole 

reason for the failure of the government to achieve its 

procurement target and objective. This practice also puts the 

government in an embarrassing situation when it has to meet 

its needs through purchasing wheat from the multinationals, 

which are hoarding the grains, (or through imports) by 

paying high prices than those paid to domestic producers. 

Chand (2007) emphasises that there is an urgent need to 

follow a dual price system in order to procure grain at 

required quantity and thus stabilise the market price of 

grain. The government should immediately differentiate 

between the MSP and PP and the latter should be higher 

than the former while at the same time the PP should also 

be kept fl exible, meaning, for example, that the PP can be 

declared on a weekly basis. The MSP has an objective to 

save farmers by ensuring remunerative prices to them for 

their produces on the basis of the Commission for Agricultural 

Costs and Prices (CACP) recommendations 

while prices fall below the 

level fi xed by the CACP. Such MSPs are 

fi xed at incentive levels so as to induce 

the farmers to make capital investment 

for the improvement of their farm and to 

motivate them to adopt improved crop 

production technologies to step up their 

production and thereby their net income. 

However, how far these objectives are 

met through the MSPs is questionable 

and that is why the PP should be given substantial importance. 

When the market price of a grain is higher than theh 

MSP, the PP should follow the market norms and offer 

market prices. 

The Crises in Farm Sector 

There are a large number of small and marginal farmers in 

India. They have been suffering from adverse effects of 

uneven liberalisation in international agricultural trade. In 

consequence, several small and marginal farmers have 

committed suicide in various states in India in last half-adecade 

for the reason that they had been heavily indebted to 

the private non-institutional moneylenders and at the same 

time they had been unable to get the proper price for their 

produces. Rural institutional credit supply failure is clearly 


47

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Table 1: Agriculture Subsidies in India during 2000-01 to 2004-05 (Current Price) 

Item 2000-01 2001-02 2002-03 2003-04 2004-05 

1. Fertilizer 13800 12595 11015 11847 16127 

2. Electricity* 6056 9342 7354 NA NA 

3. Irrigation** 

4. Other subsidies given to marginal farmers and 

13465 13164 15012 11142 12990 

farmers' cooperative societies in the form of seeds, 

development of oilseeds, pulses etc. 

2686 3041 3133 4018 NA 

5. Total 36007 38142 36514 27007 29117 

Notes: * Includes all subsidies to Electricity Boards and Corporations. Separate estimates of subsidies on Electricity exclusively provided to agriculture sector are not available. 

** The rates for supply of water to farmers are kept low as a matter of policy, resulting in losses to the government irrigation system. The excess of operating costs over the gross 

revenue is treated as imputed irrigation subsidy. 

NA stands for "not available". 

Source: Directorate of Economics and Statistics, Ministry of Agriculture, Government of India. 

one of the responsible factors for farmers' misery, but the 

most serious concerns are the distortionary tariff and price 

policies adopted by the developed countries. The huge 

subsidies which are given to the farmers in the developed 

countries have been artifi cially reducing the prices of their 

produces and simultaneously destroying the comparative 

advantage of the farmers of developing countries. While 

the developed countries are protecting their farmers 

through conservative measures (by imposing tariffs on 

imported agricultural produces and 

providing subsidies to their farmers) on 

the one hand, they are demanding for, 

and also forcibly implementing, market 

liberalisation in developing countries to 

the larger market. For such forcible 

implementation of liberalised policies in 

developing countries, the developed 

countries are taking help from the World 

Bank and the International Monetary 

Fund (IMF) on which the developing 

countries are dependent for loans. Table 1 presents an 

illustration of agricultural subsidies in India from 2000-01 

to 2004-05. Fertilizer subsidy experienced a downward 

trend till 2002-03, except a marginal increase in 2003-04. 

In 2004-05, it has increased signifi cantly due to the fact that 

the government realised that sluggish growth in agriculture 

was going to hamper the overall GDP growth of the country. 

As regards subsidy in power sector, one can hardly 

fi gure out about how much is exclusively going to the 

farmers as electricity subsidy since the Ministry of Agricul- 

48 


Fertilizer subsidy 

experienced a 

downward trend 

till 2002-03, 

except a marginal 

increase in the 

year 2003-04 

(Rs. in Crore) 

ture itself fi nds lack of clarity in this regard (see the note 

just below Table 1). Irrigation subsidy fi gure is clearly lower 

in 2004-05 than that in 2000-01. Seed and other subsidies 

have experienced an increasing trend though, the overall 

picture is not impressive. 

Two opposing schools of thought are found in the literature 

on correlation between liberalisation and agriculture 

(Vakulabharanam, 2005). One school stresses that there is a 

policy bias against agriculture in LDCs, keeping output 

prices artifi cially low (as compared to the 

international prices) by maintaining 

subsidies on inputs. This school suggests 

removal of incorrect price incentives, i.e. 

input subsidies, from agriculture and 

making agricultural market more open to 

global trade. As for example, Khan (2004) 

argued that input subsidies led to misuse 

or over-use of inputs. However, the 

second school of thought offers an 

argument, among others, saying that 

subsidies that the farmers of developed countries receive are 

much signifi cant than that received by the farmers of 

developing countries (see, among others, Anderson, 1992; 

Tangermann, 2006), thereby resulting in unfair competition 

in international market. Bardhan (2006: 1395) argued that, 

in exports, the major hurdle the small producers face “is 

often due to not more globalisation but less.” In 2000, the 

producer subsidy in OECD countries was US$ 330 billion 

-- equal to Africa’s entire annual GDP (Albert and Springer- 

Heinze, 2006). The protectionist policies of developed

Table 2: Import Trend of Raw Cotton Lint in India 

Year Import 

Quantity (in 

metric tonne) 

Import Value 

(in 1000 

US$) 

Unit Price of Import 

(in US$ per metric 

tonne) 

1990 167 311 1862 

1996 8795 2850 3086 

2003 241787 333282 1378 

Source: Philip and Jenniah (2006) 

countries in agriculture are highly distorting and impose 

substantial costs on farmers in developing countries (Ismail, 

2006). Recent estimates by International Food Policy 

Research Institute (IFPRI) suggest that protectionism and 

subsidies in industrialised countries cost developing countries 

about US$ 24 billion in agricultural and agro-industrial 

income (cited in Pal, 2006). If all dynamic and spill-over 

effects are taken into account, the fi gure will be much 

higher. In the EU and USA, the subsidy level is very high for 

wheat, sugar and rice (Naik 2005, Chakraborty and Singh 

2006). Sugar and cotton, along with some other items, which 

receive the highest level of subsidies in the EU or USA, are 

very important export commodities in the world market. 

Subsidies on these items are undermining 

the export potentials of many developing 

countries. The trade opportunities of 

developing countries are being negatively 

affected both by the domestic support (on 

production or output) and export support 

in developed countries. Philip and 

Jenniah (2006) argued that the removal 

of subsidies by the US, EU and China 

would increase the world price of cotton 

by 18 percent. They also argued that a 

small change in subsidy could create a phenomenal impact 

on the cotton production of some countries like the US and 

EU, to the extent of 15 and 32 percent respectively. This, in 

turn, would result in supply shifts. Subsidies given in cotton 

at the global scale averaged US$ 5 billion and the extent of 

subsidies prevailing in the global level is close to 13 percent 

of the total value of cotton produced in India. US subsidy to 

cotton farmers is in the form of direct assistance to farmers 

through marketing loan assistance and market loss assistance. 

Stiglitz (2003: 206) commented that “[T]he U.S. 

The extent of 

cotton subsidies 

prevailing in the 

global level is 

close to 13% of 

the total value 

produced in India 


pushed other countries to open up their markets to areas of 

our [the USA’s] strength … but resisted efforts to make us 

reciprocate”. Tangermann (2001) points out that, as regards 

reduction in export subsidies, the EU has created main 

problems since their share in total worldwide export subsidy 

on many agricultural products is very high. Naik (2005) 

states that the world prices of sugar now are below the costs 

of production of some of the most effi cient producers. “In 

fact in some cases, such as cotton in India, the effi cient 

producers are unable to compete in their own domestic 

market. Cotton imports in India have increased substantially 

due to the availability of cheap US cotton, as a consequence 

of the subsidies provided by the US to their farmers” (Naik 

and Singh, 2003: 60). Cotton farming occupies a signifi cant 

place in the Indian economy as a means of employment to 

over one million farmers in the primary sector. It is also 

offering direct employment in the textile industry that 

signifi cantly contributes to an extent of 14 percent of the 

country’s industrial production, 30 percent of the country’s 

export earning and four percent of the GDP. Let us refer to 

Philip and Jenniah (2006) for the Indian cotton-case in 

liberalised era. Cotton imports were liberalised in 1991. 

With this the monopoly of Cotton Corporation of India was 

terminated and imports were placed 

under the open general license, allowing 

unrestricted imports by private traders. 

The import duty was originally set to zero 

and there was a surge in imports in the 

late 1990s (see Table 2). On account of 

this surge, domestic prices too witnessed 

a major decline, resulting in incidents of 

suicides committed by cotton farmers. 

The situation forced the government to 

impose fi ve percent tariff in 2000. Still 

this could not provide cotton farmers with a major remedy. 

As we already said, liberalisation has caused several 

Indian cotton farmers to commit suicide. Narayanamoorthy 

(2006) observed that profi ts have been declining particularly 

since late 1990s, because of a substantial increase in the cost 

of cultivation. He asserts that farmers need remunerative 

prices for their crops because their income from crop 

cultivation is not enough to even cover their consumption 

expenditure. Moreover, the farmers have been indebted to 

moneylenders, traders etc. for they had taken loans from 


49

O PEN WORLD 

these non-institutional sources. There is another concern in 

cotton farming. Let us refer to the observations of Narayanamoorthy 

and Kalamkar (2006). Cotton’s productivity in 

India is one of the lowest in the world mainly due to attacks 

by pests/insects and low coverage of irrigation facility. In 

spite of using pesticides, farmers are unable to control the 

bollworm -- the key pest in cotton -- that ravages up to 80 

percent of crop output. In India, Bt (which stands for 

Bacillus Thuringiensis) cotton was introduced in March 

2002 for commercial cultivation. This variety can protect 

itself from the bollworm. Although the productivity and 

profi t from Bt cotton cultivation is substantially higher than 

the conventional hybrid cotton varieties, the seed cost of Bt 

cotton is very high as compared to non-Bt hybrid varieties. 

At least as a short term measure, direct subsidy should be 

provided for Bt cotton seed, but liberalization is standing in 

the way of such measure. 

Shah (2006) analyses the effect of 

WTO on Indian dairy industry. Milk is 

such a product using which (as input) a 

number of by-products (e.g. butter, different 

kinds of sweets, ghee, paneer etc.) 

have grown (or even can further grow in 

the future) in the rural agro-industrial 

sector in India. The success of milk 

producers’ unions/cooperatives, like 

AMUL, is well-known in India. But let us 

not forget that millions of small farmers who produce 

nominal quantity of marketable surplus of milk (only a litre 

or two) are majority in this industry. Landless labourers in 

India account for 21 percent of the total rural households. 1 

Though they do not have any share in the total landholding, 

they own 12 percent of the milk produced. At current prices, 

the value of livestock products in the country in 2003-04 is 

estimated at Rs. 164,509 crores with milk and milk products 

accounting for 67 percent. Indian dairy industry has the 

potential to capture a considerable part of the world market 

but, as Shah (2006) argued, currently this industry is 

adversely affected by distorted world prices of dairy products 

due to export subsidies extended by the EU and US. 

Moreover, developing countries cannot participate in 

international trade because their products are barred from 

entry into rich countries by trade barriers, restrictive trade 

policies and stringent health and sanitary standards. 2 Even 

50 


The share of 

Indian handicrafts 

exports in 

the overall 

manufacturing 

exports has risen 

from 2% to 5% 

if Indian dairy producers could initially afford to pay EU 

tariffs of 144 percent on butter and 76 percent on milk 

powder, it could hardly compete in Europe with domestic 

producers, half of whose income is derived from subsidies 

(Oxfam, 2002a). At the same time, India’s efforts to export 

milk and other dairy products to new net dairy-importing 

markets in countries in South-East Asia, the Gulf, and the 

southern Mediterranean are being hampered by unfair 

competition from subsidised European dairy exports 

(Oxfam, 2002b). On the other hand, as Shah noted, Indian 

milk producers are rather worried because an increase in 

cheap imports of milk products, particularly milk powder, 

would further adversely affect their milk production by 

lowering the price of the milk they sell. 

Globalisation, on the other hand, has created some 

positive effects on Indian economy as we have seen that 

through the 1990s the share of handicrafts 

exports in the overall manufacturing 

exports of India has risen from two 

percent to fi ve percent (Leibl and Roy, 

2003). But Basu (2006), while visiting to 

the village of Jakorta in a remote corner 

of Gujarat and talking to the villagers 

who were engaged in earning their 

livelihood largely from handicrafts and 

mainly embroidery work on textiles, 

found “double-edge sword of globalisation”. 

What is that? On the one hand, the villagers had 

benefi ted in the last decade because of globalisation by 

selling their products to other countries. On the other hand, 

they feared that their livelihood could get wiped out by 

competition from some international producers who decide 

to export to India. Basu emphasises that the villagers are still 

poor enough since end of prosperity for them could mean 

poverty, destitution and even starvation. The producers 

cannot avoid this double-edge sword of globalisation. 

Another example can be relevant here. While elimination of 

subsidies from agriculture in developed countries can benefi t 

farmers of countries like India and China, removal of trade 

distortions in India and China in the case of groundnut trade 

would substantially benefi t the African countries through 

increasing their export volume and thus income (Beghin et 

al., 2006). Their groundnut needs to be promoted but there 

is another concern as well. The issue now becomes more

complex when we see that many low-income food-defi cit 

countries depend on import of food to survive. According to 

the FAO, there are currently 86 low-income food-defi cit 

countries (for further details, see Grote and Wobst, 2006). 

Let us take the example of Senegal in which food production 

has doubled in absolute terms since 1960 (the year of 

independence), but, due to the country’s high level of 

population growth, per capita food production has fallen by 

almost 50 percent. As a result, Senegal is heavily dependent 

on import of food item, especially broken rice. 3 Senegalese 

people have developed this consumption pattern probably 

due to availability of broken rice in suffi cient quantity during 

the colonial and post colonial period. Broken rice is imported 

in order to keep food prices under control and at the same 

time groundnut is exported as Senegal’s main export product 

(Brüntrup et al., 2006). Since currently rice imports account 

for seven to eight percent of total imports and pose a major 

burden on the country’s trade and foreign exchange balance, 

increase in groundnut export alone would not be of great 

help for the country to grow as a whole. As a remedial 

measure, it needs to restrict import and also substantially 

improve agricultural productivity, and this can change the 

consumption pattern gradually. Only 10 percent of farms 

occupy irrigated land, whereas the rest 90 percent are 

rainfed, which offer little potential for more intensive 

farming (Brüntrup et al., 2006). Extremely weak agriculture 

sector cannot be a base for economic prosperity. That is why 

the industrialisation strategy adopted earlier had yielded 

very little in the internationally competitive environment. It 

should start from its agriculture and, for that, within WTO 

there should be adequate scope for a country like Senegal 

for adopting conservative rice import policy while at the 

same time it should take advantage of trade liberalisation 

and promote their groundnut in other countries. This case 

proves that WTO needs to take a very careful look at the 

country specifi c cases while trying to pursue trade liberalisation 

in the world. 

Although China has made impressive progress in economic 

development and improving social well-being, it is 

facing many challenges while liberalising its economy and 

after WTO accession. The main challenge is to fi nd employment 

for millions of people who are being displaced from 

farm jobs as a result of WTO accession. In China, the 

majority of the labour force is still in agriculture, traditional 


low and medium technology industries, and low skill 

services. One of the reasons of the poor productivity rates 

of these sectors is the lack of new technologies and management 

effi ciencies. Zeng (2005) suggested that dissemination 

of new technologies and advanced management practices 

throughout the rural economy may be of some help in the 

days to come. Zeng argued that small and medium enterprises, 

especially those in the urban areas and also belonging 

to the tertiary sector, have become an increasingly 

important source of job creation. But the majority of the 

village enterprises have limited technological and human 

resources to become internationally competitive. This is the 

headache for China even while the remarkable growth of its 

national economy has drawn much attention of the international 

community. 

Endnotes 

1 Oxfam (2002b) has noted that India has now become the 

world’s largest dairy producer, producing 84 million 

tonnes of milk. Its dairy sector includes a network of 

cooperatives serving more than 10 million farmers in over 

80,000 villages. 

2 Albert and Springer-Heinze (2006) argues that although 

stringent regulatory requirements contain risks, the rural 

producers in developing countries should consider such 

requirements as opportunities which would allow them to 

meet rising quality demands of consumers throughout the 

world. 

3 Broken rice is a by-product of rice processing. In the 

international market, broken rice is considered an inferior 

product and is therefore much cheaper than whole rice. 


• Albert, Helmut and Andreas Springer-Heinze (2006): 

“Value-Added Chains and Agricultural Trade”, Agriculture 

and Rural Development, Vol. 13, No. 1, pp. 15-17. 

• Anderson, Kym (1992): “International Dimensions of the 

Political Economy of Distortionary Price and Trade 

Policies.” In Ian Goldin and L. Alan Winters (eds.), Open 

Economies: Structural Adjustment and Agriculture, pp. 

290-310, Cambridge: Cambridge University Press. 

• Bardhan, Pranab (2006): Globalisation and Rural Poverty”, 

World Development, Vol. 34, No. 8, pp. 1393-1404. 

• Basu, Kaushik (2006): “Globalisation, Poverty, and 


51

O PEN WORLD 

52 

Inequality: What is the Relationship? What can be 

Done?” World Development, Vol. 34, No. 8, pp. 1361- 

1373. 

Beghin, John, Diop Ndiame, and Holger Matthey (2006): 

“Groundnut Trade Liberalisation: Could the South Help 

the South? World Development, Vol. 34, No. 6. pp. 

1016-1036. 

Brüntrup, Michael, Thao Nguyen, and Christian Kaps 

(2006): “The Rice Market in Senegal”, Agriculture and 

Rural Development, Vol. 13, No. 1, pp. 22-25. 

Chakraborty, Debashis and Yashika Singh (2006): 

“Agricultural Subsidy: The Major Hurdle to Free Trade.” 

In Dipankar Sengupta, Debashis Chakraborty and Pritam 

Banerjee (eds.) Beyond the Transition Phase of WTO: An 

Indian Perspective on Emerging Issues, pp. 75-107, New 

Delhi: Academic Foundation (in association with Centre 

de Sciences Humanities). 

Chand, Ramesh (2007): "Wheat Import and Price Outlook 

for 2007-08: Separating the Grain from the Chaff", 

Economic and Political Weekly, Vol. XLII, No. 31, August 

4, pp. 3196-3199. 

Grote, Ulrike, and Peter Wobst (2006): “What do Liberalised 

Agricultural Markets mean for food-importing 

developing countries?” Agriculture and Rural Development, 

Vol. 13, No. 1, pp. 18-21. 

Ismail, Faizel (2006): “Mainstreaming Economic Development 

in the Trading System.” In Simon J. Evenett and 

Bernard M. Hoekman (eds.) Economic Development & 

Multilateral Trade Cooperation, pp. 213-228, Washington 

and New York: The World Bank and Palgrave Macmillan 

(a co-publication). 

Leibl, M., and T. Roy (2003): “Handmade in India: 

Preliminary Analysis of Crafts Producers and Crafts 

Production”, Economic and Political Weekly, Vol. 38, 

December 27th . 

Naik, Gopal (2005): “Expiry of Peace Clause in WTO’s 

Agriculture Agreement: Implications.” In Ramesh Chand 

(ed.), India’s Agricultural Challenges: Refl ections on 

Policy, Technology and Other Issues, pp. 47-77, New 

Delhi: Centre for Trade and Development (Centad), 

established by Oxfam GB. 

Naik, Gopal and Yashika Singh (2003): “Doha Round 

Negotiations: Agriculture,” Working Paper No. 217, 

Indian Institute of Management Bangalore, November. 


Narayanamoorthy, A. (2006): “Relief Package for Farmers: 

Can It Stop Suicides?” Economic and Political 

Weekly, Vol. XLI, No. 31, August, pp. 3353-3355. 

Narayanamoorthy, A. and S.S. Kalamkar (2006): “Is Bt 

Cotton Cultivation Economically Viable for Indian 

Farmers? An Empirical Analysis”, Economic and Political 

Weekly, Vol. XLI, No. 26, June, pp. 2716-2724. 

Oxfam (2002a): “Europe’s Double Standards: How the 

EU should Reform Its Trade Policies with the Developing 

World”, Oxfam Briefi ng Paper 22, Oxfam International. 

Oxfam (2002b): “Stop the Dumping! How EU Agricultural 

Subsidies are Damaging Livelihoods in the Developing 

World”, Oxfam Briefi ng Paper 31, Oxfam International. 

Pal, Parthapratim (2006): Development Boxed! Analysing 

Box Shifting and Other Issues of Domestic Subsidies in 

WTO Agricultural Negotiations, New Delhi: Oxfam. 

Philip, Linu Mathew and Aldas Jenniah (2006): The 

Indian Cotton Dilemma: Caught in the International 

Cotton Mesh, New Delhi: Oxfam. 

Shah, Deepak (2006): Milked Away by Developed 

Countries: Plight of Indian Dairy Farmers in WTO 

Regime, New Delhi: Oxfam. 

Stiglitz, Joseph (2003): The Roaring Nineties. New York: 

W.W. Norton. 

Tangermann, Stefan (2006): “The WTO Negotiations: 

What Interests are the OECD Countries Pursuing?” Agriculture 

and Rural Development, Vol. 13, No. 1, pp. 7-9. 

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New Bottles?” In Klaus Günter Deutsch and Bernhard 

Speyer (eds.), The World Trade Organisation Millennium 

Round: Freer Trade in the Twenty-First Century, pp. 

199-212, London and New York: Routledge. 

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a South Indian Peasant Economy during the Era of 

Economic Liberalisation”, Journal of Development 

Studies, Vol. 41, No. 6, August, pp. 971-997. 

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World Bank Policy Research Working Paper 3522, 

February. 


refl ect the offi cial policy or position of the organisation.)

O PEN WORLD 

The Harmful Impact of 

Protectionism 

Rok Spruk* 

Economist, Slovenia 

There is a general agreement among economists that 

free trade is good for the economy. Polls have suggested 

that more than 90 percent of economists in the 

U.S believe free trade is benefi cial for the economy and society 

as a whole. Ever since the beginning of the fi nancial crisis, the 

policymakers around the world exerted strong pressure to 

enforce the protectionist trade policy. In the United States, 

American Federation of Labor openly opposed free-trade 

agreement between the United States and 

Columbia. In France, the policymakers 

suggested the introduction of carbon tariffs 

on countries which refuse to cut carbon 

emissions. Before the Great Depression of 

1929, the U.S Congress enacted Smoot- 

Hawley Act which sharply raised tariffs on 

foreign exports. In spite of hefty rethoric 

about the benefi ts of trade protection, the 

cost of trade protection exceeds the benefi ts 

of trade protection shared by the few. The 

beginning of the fi nancial crisis of 2008/2009 that led to the 

recession initiated a set of trade policies that promote protectionism. 

According to IMF; in 2009, emerging market economies 

expect 8.8 percent decline in the import of goods and 

services and six percent decline in the export of goods and 

services. In 2008, imports of goods and services in developing 

economies grew by nearly 11 percent. India and other emerging 

market economies are on the crossroad between pursuing free 

trade policy or imposing protectionist trade policy. The 

54 


India is at 

the crossroad 

between pursuing 

free trade policies 

or imposing 

protectionist 

trade policies 

empirical evidence overwhelmingly supports the notion that 

free trade is an economic benefi t for the nation, regardless of 

country’s level of development. In this article, I discuss the 

harmful impact of trade protectionism and why free trade 

should be the key priority of economic policies worldwide. 

Trade Protection in International Trade 

Policymakers imposing policies that restrain trade often point 

out the necessity of domestic market protection against foreign 

competition. The economic history offers numerous examples 

of trade protection. Back in 1930, the U.S Congress adopted 

Smoot-Hawley Act which raised tariff rates on over 20,000 

imports entering the U.S. The adoption of high tariffs on 

imports restrained foreign trade. Between 1929 and 1932, the 

world trade diminished by 66 percent. Back in early 2002, 

President George W. Bush placed tariffs on 

imported steel, arguing it would protect the 

U.S steel industry. Immediately after the 

enactment of steel tariffs, World Trade 

Organization declared tariffs unjustifi ed 

and highly protectionist. Before 2002, 30 

U.S steelmakers declared bankruptcy, seeking 

effective tariff rates up to 40 percent. 

After steel tariffs were introduced, 

European Union announced it would 

impose retaliatory tariffs. The economic 

effects of imposing tariffs on steel imports were disastrous. In 

the long run, empirical evidence suggests, the demand for steel 

is highly inelastic, ranging from -0.2 to -0.3. This suggests that, 

as the price per unit of steel increased by one percent, the 

long-run demand for steel would decrease by -0,2 to -0,3 

percent. On the other hand, empirical estimates of price 

elasticity of steel supply show that the long-run coeffi cient of 

elasticity does not exceed 3.0 - a very elastic supply, indeed 

curve. This suggests that as per unit price of steel increases by

P ROTECTION’ S PRICE 


55

O PEN WORLD 

one percent, the quantity of supplied steel goes up by three 

percent. In the situation of inelastic demand and elastic supply, 

the introduction of tariffs on steel imports reduced consumer 

surplus. Thus, the effect of tariff levied into higher producer 

surplus. The effective tariff rate on steel, which ranged from 

eight to 30 percent, reduced the consumption of steel imports 

and raised the equilibrium price in the world steel market. 

Economists Joseph Francois and Laura M. Baughman estimated 

the effects of the introduction of steel tariffs. According to their 

estimates, a 10 percent increase in the price of steel, reduced the 

employment in steel industry by 0.64 percent. Each saved job 

cost the U.S economy 445.497 USD on 

average. In December 2002, increase in per 

unit price of steel led to 197,000 employment 

in U.S steel industry. So the question is what 

to choose - higher steel prices and fewer jobs 

or a vibrant and competitive steel market? 

The economic effects of trade protection 

clearly contradict the notion that protectionism 

is good for the economy. 

Back in 1941, Paul A. Samuelson and 

Wolfgang Stolper formulated Stolper-Samuelson 

theorem. Assuming perfect competition and constant 

returns of scale, the theorem states that “a rise in the relative 

price of good will lead to the rise in the return to that factor 

which is used more intensively in the production of the good, and 

conversely, to a fall of the return to the other factor.” The 

theorem has important implications for international trade. 

Samuelson and Stolper wrote: 

“Second only in political appeal to the argument that tariffs 

increase employment is the popular notion that the standard of 

living of the American worker must be protected against the ruinous 

competition of cheap foreign labor… In other words, whatever will 

happen to wages in wage good (labor intensive) industry will 

happen to labor as a whole. And this answer is independent of 

whether the wage good will be exported or imported.” 1 

The powerful version of Stolper-Samuelson theorem states 

that the international trade between two countries leads to the 

situation in which at least one factor of production faces a 

decline in the real income. The rigorous version of Heckscher- 

Ohlin-Samuelson theorem states that international trade is a 

consequence of difference in relative factor abundance. It means 

that countries abundant with labor will incompletely specialize 

in the production of labor-intensive good while countries 

56 


A ten percent 

increase in the 

price of steel, 

reduced the 

employment in 

the steel industry 

by 0.64 percent 

abundant with capital will incompletely specialize in the 

production of capital-intensive good. The international trade 

will, hence, reduce the reward to the scarce factor of production. 

Since developed countries are usually capital-abundant, there 

are signifi cant pressures from less abundant factor (labor) to 

impose tariff protection. 

Back in June 2009, American Federation of Labor (AFL) 

exerted a signifi cant pressure on Obama Administration not to 

enact U.S-Columbia free trade agreement (FTA). The AFL 

stated that Columbian government has no respect for labor 

rights. The AFL further stated that FTAs contributed to U.S 

trade defi cit, job losses and lower wages. 

However, the real argument for eliminate 

the FTA between the U.S and Columbia 

came from the opposition of the scarce 

factor of production to international trade. 

The openness of protected labor-intensive 

industries to trade reduces the real reward 

to labor in the short run. However, the 

reduction in real reward to labor is more 

than compensated by a long-run increase in 

purchasing power enabled by lower prices of 

imports. A research paper by economists Christian Broda and 

John Romalis of the University of Chicago investigated the 

effects of price dispersion on welfare of U.S consumers. The 

authors found that between 1994 and 2005 non-durable infl ation 

for households in 10th percentile of income distribution was 7.3 

percent lower than non-durable infl ation for households in the 

90th percentile of income distribution. A study by economists 

Gary C. Hufbauer and Kimberly A. Elliot estimated the cost of 

trade protection in the United States. The authors estimated that 

the restriction of foreign imports cost $199,000 for each job in 

the textile sector and $1,376,000 in the benzenoid chemical 

industry. There is even more additional evidence that free trade 

promotes welfare by reducing domestic infl ation. Andreas 

Fischer and Raphael Auer (2008) showed that import competition 

from low-wage countries dampens the US producer price 

infl ation for manufactured goods by more than two percentage 

points annually. 

Economic Effects of Trade Liberalization: 

Evidence from India 

The World Trade Organization (WTO) has recognized India’s 

trade liberalization efforts and remaining barriers to trade.

The WTO wrote: 

“Recognizing the importance of continuing its economic reform 

and especially its trade aspects, India has pushed ahead with 

further reductions in the tariff: the overall applied MFN rate fell 

from 32.3% to 15.8% between 2001/02 and 2006/07… While 

import barriers have been falling, India's export regime continues 

to be complex. Export prohibitions and restrictions are largely 

unchanged since India's last Review. However, in order to reduce 

the anti-export bias inherent in India's import and indirect tax 

regime, a number of duty remission and exemption schemes are 

in place to facilitate exports.” 2 

The empirical evidence of the economic 

effects of trade liberalization shows that 

lower barriers to trade and foreign market 

access have stimulated regional trade. In 

studying the effects of trade liberalization 

on wage inequality Mishra and Kumar 

(2005) have estimated that India’s 1991 

trade liberalization has boosted productivity 

growth at the fi rm level and increased 

wage premiums for skilled and non-skilled 

workers. The authors suggest that trade 

liberalization has reduced wage inequality. There are, of 

course, other features that affected lower wage inequality. 

Acharyya (2006) estimated the effects of trade liberalization 

on income inequality and poverty. The author emphasized 

rising income inequality - measured by the Gini coeffi cient - 

as a result of robust growth in manufacturing imports and 

exports. During 1990s, the high-tech manufacturing sector 

experienced robust growth in exports. Since high-tech 

manufacturing sector is skill-intensive, the shift toward 

skill-intensive exports is a plausible explanation of higher 

income inequality. 

There is another example of the benefi cial effect of free 

trade. Prior studies by Deaton and Dreze (2002) showed that 

urban and rural poverty rates decreased in the periods 

between 1993 and 2000. The urban poverty rate fell from 17.8 

percent to 12 percent while the rural poverty rate fell from 33 

percent to 26.3 percent of the population. In another study of 

the effect of trade liberalization on foreign direct investment, 

Goldar and Banga (2007) presented their results. They found 

that between 1980 and 1998, the effective rate of trade protection 

fell from 99.5 percent to 41 percent. Applied tariff rates 

and non-tariff barriers declined as well. Using panel data for 

India has pushed 

ahead with further 

reductions in the 

tariff. The overall 

applied MFN rate 

fell from 32.3% 

to 15.8% 

P ROTECTION’ S PRICE 

78 industries after the period of trade liberalization and 

cross-section data for 2,500 fi rms in 16 Indian states, they 

found that trade liberalization had a favorable effect on FDI 

infl ows in Indian manufacturing industries and that higher 

cross-border trade has attracted higher foreign direct investment 

(FDI) into manufacturing industries. They also showed 

that regions having great involvement in international trade 

are able to attract greater amount of FDI. A study by Topalova 

(2004) found that reduced trade protectionism led to higher 

levels and growth of fi rm productivity, having the strongest 

effect on private companies. 

The Cost of Protectionism 

In the annual assessment of economic 

freedom, Index of Economic Freedom 

critically evaluated India’s trade policy. 

It says: 

“India's weighted average tariff rate was 

14.5 percent in 2005. Large differences 

between bound and applied tariff rates, 

import and export restrictions, services 

market access restrictions, import taxes and 

fees, complex and non-transparent regulation, onerous standards 

and certifi cations, discriminatory sanitary and phytosanitary 

measures, restrictive licensing, domestic bias in government 

procurement, problematic enforcement of intellectual property 

rights, export subsidies, inadequate infrastructure, counter-trade 

policies, and complex and non-transparent customs add to the 

cost of trade.” 3 

The existence of non-tariff barriers stimulates lobbying 

groups who seek profi t opportunities by exerting pressure on 

policymakers to protect markets by imposing tariffs against 

foreign competition. Non-tariff barriers add to the cost of 

trade. If tariff and non-tariff barriers persist, trade fl ows are 

diverted while welfare gains from trade are diminished. There 

is no better engine of poverty reduction than free trade. High 

tariff and non-tariff barriers to trade decrease the real 

purchasing power of consumers. It often happens that pressures 

for tariff protection come from small and infl uential 

lobbying groups. Lobbying for trade protection from foreign 

competition results in unproductive rent-seeking activities. 

These activities are unproductive because they provide 

anticipated profi ts for those who lobby but do not create any 

valuable output for consumers. 


57

O PEN WORLD 

Table 1: India’s Major Trade Partners in 2007 

Trading Partner Share of Exports (in %) Trading Partner Share of Imports (in %) 

European Union 21.7 European Union 14.8 

United States 13.8 China 11.2 

United Arab Emirates 9.9 Saudi Arabia 7.6 

China 6.5 United States 6.5 

Singapore 4.4 United Arab Emirates 5.4 

Others 43.7 Others 54.5 

Source: World Trade Organization, India Trade Profi le (2009) 

Pillars of Free-Trade Policy 

In recent decades, India’s economy has grown at the robust 

pace, averaging over seven percent between 2001 and 2007. In 

2009, the economic growth rate is expected to reach 4.5 

percent. By 2014, the Indian economy is expected to increase 

by eight percent annually. The emergence of India as one of the 

leading economic powers in the world is likely to increase its 

infl uence in world markets and, hence, in world trade policy. 

Table 1 shows major Indian export and import partners in 2007. 

In recent years, India already signed bilateral trade agreements 

with countries such as Chile, Singapore, Bhutan and Sri 

Lanka. It joined and signed regional free trade agreements 

such as Asia Pacifi c Trade Agreement (APTA) and South 

Asian Free Trade Agreement (SAFTA). Bilateral and regional 

trade agreements are a step in the direction of free trade but, 

from a broader perspective, multilateral free trade is superior 

to regional and bilateral trade agreements. Multilateral free 

trade eliminates all the unnecessary bias that lead to trade 

diversion and distorted allocation of resources. 

The question that remains is what are the pillars of trade 

policy that a fast-growing emerging-market economy should 

pursue? Recent Global Enabling Trade Report 2009 by the 

World Economic Forum assessed the ease of international 

trade around the globe. India ranked 76th out of 121 countries. 

The report found that tariff and non-tariff protection increase 

the economic cost of trade. Since 1991, India has steadily 

deregulated the framework of foreign direct investment. India’s 

small and medium-sized companies comprise 35 percent of 

exports. Protecting small and medium-sized enterprises by 

tariff and non-tariff measures would restrain trade, reduce 

incentives to innovate and diminish welfare gains. To remove 

all the unnecessary barriers to trade, India’s trade policy should 

set the following priorities: 

58 


Elimination of all tariff and non-tariff obstacles to trade 

Ensuring transparency and rigorous enforcement of intellectual 

property rights 

Ending of export subsidies and import restrictions 

Deregulation of customs procedures 

Elimination of all government barriers to market entry 

The economic theory and history teach that trade protection 

is an unproductive benefi t of the few without the valuable gain 

for the rest of the society. If India played the leading role in 

eliminating all tariff non-tariff barriers to trade and investment, 

encouraging the protection of intellectual property rights 

and initiating efforts for multilateral trade liberalization, it 

would emerge as one of the leading economic and political 

giants sooner than current fi gures suggest, and inspire other 

nations to follow India’s pursuit of free trade and robust 

economic performance. 


1 Stolper, Wolfgang F., Paul A. Samuelson (1941), Protection 

and Real Wages, Review of Economic Studies, No. 9, pp. 

58-73 

2 Country Profi le: India, World Trade Organization, August 

2009 

http://stat.wto.org/CountryProfi le/WSDBCountryPFView. 

aspx?Language=E&Country=IN 

3 Index of Economic Freedom 2009, Heritage Foundation, 

Washington D.C 

http://www.heritage.org/index/Country/India 

(* Rok Spruk's main areas of research include macroeconomics, 

international economics and fi nance. The views expressed in the 

write-up are personal and do not refl ect the offi cial policy or 

position of the organisation.)

O PEN WORLD 

Open Economy: 

A Boon or Bane for India? 

Misu Kim & 

Susmita Mitra 

Phd Scholars, Centre for International Trade 

and Development, School of International 

Studies, Jawaharlal Nehru University (JNU), 

New Delhi 

I. Introduction 

The recent global crisis raised a question on the opinions in favour 

of open market and global integration. The high economic growth 

rate of India in an open market structure witnessed in the last few 

years came to a halt as the fi nancial crisis hit the world. Economists 

arguing in favour of free market and withdrawal of protectionism 

in India started giving a second thought to their opinion. 

After more than a decade’s time it cannot be said that opening up 

of Indian economy brought miraculous 

changes for India. This essay analyses some of 

the important macroeconomic indicators like 

trade, investment, and socio-economic factors 

like education, employment, inequality etc. to 

see why India could not achieve the expected 

economic development through open policy. 

However, before we focus completely in this 

area, there is a brief snapshot of the liberalisation 

process of India. 

II. Imposed and Abrupt Economic Liberalisation 

In the early 1960s, India followed protectionist policy as a strategy 

of economic growth. At this stage India’s motive was self-suffi cient 

growth through grand economic theories, such as ‘big push’ theory 

and the Mahalanobis model, which played a major role in the 

60 


Indian economic 

liberalisation is 

distinct in the 

sense that it was 

abrupt, and at 

the same time 

externally imposed 

country’s industrial strategy. These strategies were, however, 

criticised for high social cost in the form of resource waste and 

demand defi ciency (Ahluwalia, 1985; Joshi and Little, 1987, and 

Dhar, 1989). As a way out, the focus of India’s development 

strategy started shifting towards export-led growth from the mid 

1980s. Due to this gradual liberalisation process, macroeconomic 

imbalances viz. fi scal defi cit and balance of payments defi cits 

increased, which in turn made India vulnerable to shocks. The 

sudden increase in oil prices due to the Gulf War in 1990, the drop 

in remittances from Indian workers in the Middle East pushed 

India in a severe crisis of foreign exchange. To deal with its 

external payments problems, the government of India requested 

arrangement from the International Monetary Fund (IMF) in 

August 1991. The IMF support was conditional on an adjustment 

programme featuring structural reforms and trade liberalisation. 

Since then, the Indian economy has been undergoing substantial 

changes. Almost all the areas have been opened to foreign private 

investment; import licensing restrictions on intermediaries and 

capital goods have been mostly eliminated; and tariffs have been 

signifi cantly reduced. Economic liberalisation 

of India is distinct in the sense that it was 

abrupt, and at the same time externally 

imposed rather than consciously decided. 

III. Open Economy in Poor 

Domestic Conditions 

Since 1991 the Indian government has been 

emphasising on export in its economic growth 

strategy. If we simply study the aggregate 

macroeconomic data, then in the post 

liberalisation era, all variables like gross domestic product (GDP), 

per capita GDP, economic growth rate, export, import and 

investment show an increasing trend in nominal value terms. Does 

that really imply that India has achieved economic development 

through free trade? Here we will study the other side of the coin.

G OLDILOCKS GLOBALIZATION 


61

O PEN WORLD 

Diagram 1: Export and Import in India 

Rupee Crore 

Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India 

62 

900000 

800000 

700000 

600000 

500000 

400000 

300000 

200000 

100000 

0 

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006QE 

Diagram 2: Investment in India 

Rupee Crore 

1600000 

1400000 

1200000 

1000000 

800000 

600000 

400000 

200000 

0 

1970 1974 1980 1982 1986 1990 1994 1998 2002 2006QE 

Source: Handbook of Statistics on Indian Economy published by the Reserve bank of India 


Export 

Import 

Gross Domestic Investment 

Gross Foreign Investment

From the mid 1980s export started rising. However, India being 

a developing country needed to import the machines and appliances 

for the production of the main exportables like gems and 

jewellery, pharmaceuticals, chemical and engineering manufactures 

(WTO: Trade Policy Review, 2007). Thus , with an increase 

in export, import also increased as shown in Diagram 1. 

Moreover, since import has always exceeded the export, it gave 

rise to trade defi cit. As the diagram 1 shows, the trade defi cit 

started roaring after 2004. However, invisible infl ow (i.e. income 

from the service sector) and foreign investment infl ow helped to 

maintain the Balance of Payment (BOP) account. From this angle 

one can argue that although there has been trade defi cit in an 

open market for India, the infl ow of foreign investment is obviously 

a positive side of free trade. However, there are fl ip-sides of 

the story as well. 

First of all, if we compare the volume of 

the different forms of investment in India, 

then foreign investment (the sum of foreign 

direct investment and portfolio investment) 

is much less compared to the domestic 

investment (sum of investment from the 

household, private corporate and public 

sector) even in the free trade era. As the 

Diagram 2 shows, the benefi t of foreign 

investment can only have a negligible effect 

due to its low volume. 

Secondly, if we study investments as a share of GDP, then the 

Diagram 3 shows that since 1991 (for the entire decade) foreign 

investment has been rising but domestic investment has been 

falling. It implies that although India is benefi ted by foreign 

investment, it has worked as a substitute to domestic investment 

rather than a complement, a process popularly known as 

crowding-out effect. For a capital scarce country like India, the 

quality of foreign investment also matters along with its 

quantity. The worst case could be when foreign investment 

enters into the host country just to produce for its domestic 

market and in turn displace the local industry (Agrawal and 

Shahani, 2005). The Indian retail sector has been observed to 

be partially hit by this phenomenon. 

Another important question is where and in which form the 

foreign investment is taking place. If investment comes in the form 

of technology or direct capital to establish a new fi rm, then it has 

positive effects for a labour abundant developing country through 

creating new jobs. In contrast, if the investment is in the portfolio 

India lacks the 

capacity to absorb 

sophisticated 

technology and 

still lags behind 

other economies 

in vital spheres 


form (mainly in share markets), then it can have a bubble effect 

without having any fundamental change. Unfortunately, in the last 

few years foreign portfolio investment has been large, making the 

Indian economy more volatile, as shown in Diagram 4. The recent 

boom in the share market (before the global crisis period), was 

largely a bubble (due to huge infl ow of foreign portfolio investment), 

which in turn burst in the time of global crisis, when a large 

amount of foreign money was withdrawn. This is again a major 

drawback of open market. 

Thirdly, there is sector-wise disparity regarding the performance 

of foreign investment. After economic liberalisation, the 

declining trend of primary sector was not reversed by the 

increase in foreign investment. The manufacturing sector 

experienced temporary growth acceleration after economic 

reforms in 1991. However, this trend was reversed from 1995 to 

2000, even though foreign investment stocks 

continued to rise. Foreign investment boom 

was witnessed mainly by the tertiary or 

service sector, but limited to a few services 

only. However, contrary to the widespread 

view that booming foreign investment in the 

service sector was driving the miraculous 

growth in India in the last few decades, 

economists have shown that it was the 

growth of the service sector that attracted 

foreign investment, not the other way round 

(Chakraborty and Nunnenkamp, 2006). 

Coming to the reasons behind low foreign investment in India, 

it can be argued that the country could not create investment 

welcoming environment. Indian infrastructure remained poor 

which acted as a deterrent to the investors. Rapid growth in a 

globalised environment requires a well-functioning infrastructure, 

including electric power, road and railway connectivity, telecommunications, 

air transport, and effi cient ports. After nearly two 

decades of economic liberalisation, India still lags behind other 

developing countries like China, Vietnam, Malaysia etc. in these 

vital spheres. 

Another reason is that, India lacks the capacity to absorb 

sophisticated technology. The volume of foreign investment 

depends on various factors, including absorption capacity and 

local skills, technological spillovers and linkages between foreign 

and local fi rms, and export orientation of the host economy. The 

education system has also not improved in the post-liberalisation 

era with India trailing behind the target of 100 percent literacy 


63

O PEN WORLD 

Diagram 3: The Share of Domestic and Foreign Investment in GDP 

% 

Source: Handbook of Statistics on Indian Economy published by the Reserve Bank of India 

rate. The number of primary schools (primary implies upto fourth 

standard) are relatively high in comparison to the institutions for 

higher education.. This is quite natural, but in case of India, the 

number of higher education institutes is way too low than what is 

required, as shown in Diagram 5. 

The prevailing education system in India led to abundance of 

unskilled labour compared to educated-skilled labour. Obviously 

this acts as a barrier to new technology by multinational companies. 

Indian exports are dominated by simple and undifferentiated 

products where the main competitive advantage lies in cheap 

labour, low level of skill and simple technologies (Lall, 1999). Due 

to other constraints also viz. intellectual property protection, India 

sometimes has not received up-to-date technology (Athreye and 

Kapur, 2001). 

As a result of all the above factors, employment scenario in 

India did not improve much in the post liberalisation era. Lack of 

employment-creating foreign direct investment compared to 

portfolio investment, coupled with the crowding out effect on 

domestic investment, there has not been much increase in the 

demand of employment. On the supply side, the static education 

system is not able to produce a strong base of educated and skilled 

labour force. As a result, employment in the public and organised 

private sectors in India has not increased signifi cantly after 

64 

14 

12 

10 

8 

6 

4 

2 

0 

1970 1974 1980 1982 1986 1990 1994 1998 2002 2006QE 


Domestic Investment 

Foreign Investment 

economic liberalisation as shown in Diagram 6. 

However, employment has been particularly created in the 

electronics and electrical equipment sector, mainly due to 

Information Technology Enabled Services (ITES) and Business 

Process Outsourcing (BPO) growth. However, the global crisis 

proved the vulnerability of these outsourced jobs. Due to the 

international linkages, crisis in source countries can affect these 

jobs. This is another disadvantage of global integration faced by 

India recently. 

Apart from education and employment another important 

socio-economic factor is inequality. In India, inequality issue is 

very important and controversial. NSS data shows that inequality 

has remained more or less similar. Sen and Himanshu (2004) 

analyses NSS data in a different way and found that inequality 

increased in the 1990s both in the rural and urban areas. The ratio 

of poor people shows a downward trend but the absolute number 

of poor people increased due to an increase in population. 

According to Jha (2002), inequality has increased after economic 

liberalisation rather than a decrease. He argued that inequality 

widened because labour intensive industry has been sluggish, 

whereas capital intensive sector has been prosperous since the 

economic reforms. Due to economic liberalisation, economic 

growth rate increased, but the level of poverty remained stubborn

Diagram 4: Foreign Investment in India 

Rupee Crore 

140000 

120000 

100000 

80000 

60000 

40000 

20000 

0 

2000 2001 2002 2003 2004 2005 2006 2007 


(partially because of higher inequality and stagnation in the 

agricultural real wage), although there was some reduction in 

urban poverty. 

To sum it up, it is very diffi cult to conclude whether open 

market is boon or bane for India. 

IV. Lessons from the East Asian Countries 

India lacks the platform to exploit the benefi t of economic 

liberalisation, in contrast, the East Asian governments played a 

strong role behind the export-led-growth model. Along with 

foreign investment different governments have boosted up domestic 

investment simultaneously through different channels. The 

role of government behind the investment boom process is largely 

through increasing the profi ts, because profi ts are an incentive for 

investment, a source of investment and an outcome of investment 

(Akyuz and Gore, 1996). The total process in most of the East 

Asian countries worked in the following way: 

• Government policies pushed profi ts over and above the level 

that could be attained under free market policies. 

• Increase in profi ts was translated into high savings. 

• High rate of domestic savings was transformed into investment 

which played a major role in the exceptionally rapid growth of 

the East Asian countries. 


To enhance corporate profi ts and savings, the East Asian 

governments have provided direct assistance to build export 

industries and fi scal benefi ts like tax rebates, tariff exemptions on 

imports of raw materials, reduced rates for electricity and 

transportation services, export subsidies for exporters. At the 

same time different governments made provisions of fi nancial 

benefi ts like loans at lower interest rate for exporters. 

These policies pushed up corporate profi ts above the levels 

attainable only under free market conditions. This increased the 

savings rate of the region. It was corporate savings in the East 

Asian Countries which played a crucial role in investment boom 

(Stiglitz, 1999). Apart from pushing the corporate profi ts, the East 

Asian governments also performed well in fundamental policy 

areas to increase household savings. By avoiding infl ation, they 

resisted volatility of real interest rates on deposits and also 

guaranteed that the interest rates were largely positive and 

generally higher than other developing countries (Page, 1994). 

Some governments used different interventionist mechanisms also 

to increase savings viz. mandatory provident fund contributions. 

However, simply increasing savings does not guarantee that it 

will be channelised to investment. For that purpose the East Asian 

governments encouraged investment by different means. 

• Governments invested in proper infrastructure and created a 


FDI 

Portfolio 

65

O PEN WORLD 

Diagram 5: Number of Recognised Educational Institutions 

Rupee Crore 


66 

900000 

800000 

700000 

600000 

500000 

400000 

300000 

200000 

100000 

0 

1950 1960 1970 1980 1990 1992 1994 1996 1998 2000 2002 2004 

Diagram 6: Employement in the Public and Private Sector 

20 

15 

10 

Million 25 

5 

0 

1970 1980 1990 2004 


crowding in effect for private investment. 

Tax policies in most of the East Asian countries were such that 

an investment friendly environment is created. 

Financial policies like credit rationing had a major role. 

Thus, government’s fi scal and fi nancial policies increased the 

corporate profi ts which further created a virtuous circle for 

investment as Diagram 7 shows: 


Primary 

Upper 

Primary 

High/ 

Hr. Sec./ 

Inter/Pre. 

Jr.Colleges 

Colleges 

for General 

Education 

Colleges for 

Professional 

Education 

University/ 

Deemed 

Univ./Instt. 

of National 

Importance 

Public Sector 

Private Sector 

At the same time most of the East Asian governments have 

successfully moulded different policies according to the changing 

world scenario as well as the country’s comparative advantage. In 

the 1970s, when Hong Kong was loosing its competitiveness in 

labour-intensive products, it started diversifying the home 

industries by producing and exporting higher quality electronics 

goods. In recent times, most of the exports of Hong Kong are

Diagram 7: Virtous Circle 

Technological 

advancement 

Increase in 

corporate 

profi t 

Increase in 

investment 

Increase in 

savings 

classifi ed as re-exports. In South Korea, the Fifth Five-Year Plan 

(1982-86) moved the emphasis away from heavy and chemical 

industries to technology-intensive industries, such as electronics 

(televisions, videocassette recorders, and semiconductor-related 

products) to serve the increasing demand of the world market. In 

the early 1980s, Malaysia expanded its exports from labour-intensive 

to capital-intensive goods while the Taiwan government 

followed a development programme designed to shift its economy 

away from labour-intensive industries towards the expansion of 

technology-intensive industries. The process can be described as 

the ‘prescription according to the disease’. 

V. Conclusion 

India’s economic liberalisation process was distinct in the sense 

that it was the result of external compulsion rather than a conscious 

decision. At that point of time India’s infrastructural base 

was not suffi cient enough to face the global competition. The 

government neither could change the domestic conditions 

drastically nor could the country grab the benefi ts of the open 

economy much. If India wants to take up some useful lessons from 

the success stories of the East Asian countries, then the fi rst and 

foremost lesson should be to build up a strong base of education 

and infrastructure. These are the platforms on which India can 

build its success. According to Krueger (1990), abundant labour 

and a well-functioning labour market facilitated the export sectors 

of the East Asian countries. Indian labour market is infl exible and 

at the same time education system is such that large population is 

not turning into human resource. 


Reference and Additional Additional Thinking 

• Agrawal, R. and R. Shahani (2005), “Foreign Investment in 

India: Issues and Implications for Globalisation” In: C. Tisdell 

(ed.), Globalisation and World Economic Policies: Effects and 

Policy Responses of Nations and their Groupings. New Delhi 

(Serials Publ.) 

• Ahluwalia, M.S. (1985), “Industrial Growth in Indian Manufacturing”, 

Oxford University Press. 

• Akyuz, Y. and C. Gore (1996), “The Investment-Profi ts Nexus 

in East Asian Industrialisation”, World Development, Vol. 24, 

No. 3. 

• Athreye, S. and S. Kapur (2001), “Private Foreign Investment 

in India: Pain or Panacea?” The World Economy, Vol. 24, No. 3 

• Chakraborty, C. and P. Nunnenkamp (2006), “Economic 

Reforms, Foreign Direct Investment and its Economic Effects 

in India”, Working Paper No. 1272, the Kiel Institute for the 

World Economy (Germany) 

• Dhar, P.N. (1989), “Constraint on Growth: Refl ections on the 

Indian Experience”, Seminar Paper, Institute of Economic 

Growth. 

• Jha, R. (2000) ‘Reducing Poverty and Inequality in India: Has 

Liberalization 

• Helped?’, WIDER Working Paper No. 204, UNU/WIDER: 

Helsinki. 

• Joshi and I.M.D Little (1987), “Indian Macroeconomic 

policies”, Economic and Political Weekly, Vol. 22. 

• Krueger, A.O. (1990), “Asian Trade and Growth Lessons”, The 

American Economic Review, Vol. 80, No. 2. 

• Lall, S. (1999), “India's Manufactured Exports: Comparative 

Structure and Prospects”, World Development, Vol. 27, No. 10 

• Page, J.M (1994), “The East Asian Miracle:” An Introduction”, 

World Development, Vol.22, No.4 

• Sen and Himanshu (2004), “Poverty and Inequality in India II 

– Widening Disparities during the 1990s”, Economic and 

Political Weekly, September 5th • Stiglitz, J. E. (2001), “From Miracle to Crisis to Recovery: 

Lessons from Four Decades of East Asian Experience” in 

Joseph E. Stiglitz and Shahid Yusuf (eds.), Rethinking the East 

Asian Miracle, New York: Oxford University Press, pp.509-26. 

• World Trade Organization (2007), Trade Policy Review: India, 

Geneva: WTO. 

(The views expressed in the article are personal and do not refl ect the 

offi cial policy or position of the organisation.) 


67

O PEN WORLD 

A Model of North- 

South Growth and 

Trade as a Differential 

Game Problem with an 

Empirical Illustration 

T. Krishna Kumar 

Director, 

Samkhya Analytica India Pvt. Ltd, Bangalore 

I. Introduction 

There is considerable literature, mostly theoretical, which 

states that free trade is benefi cial to all the trading partners. 

The theoretical arguments are based on certain assumptions 

such as that all countries have access to the same technological 

choices, there are no transportation costs, all goods are 

tradable, there is perfect competition in product markets, etc. 

Most of these studies examine the autarky situation with a 

free trade situation with just two countries, two products, and 

two factors of production. 1 Some of these results have been 

established even under some relaxed conditions such as a 

deviation from perfect competition. A case is also made for a 

strategic trade policy that takes into account what is good for a 

country in question. 2 

One often wonders what would happen to these results 

when some of the assumptions are relaxed. One also would 

like to know what quantitative impact a particular trade policy 

would have on the overall long-term growth of a particular 

economy. In a competitive world market one must also know 

what counter strategy another country would adopt. It is 

68 


therefore useful to have a quantitative model that is capable of 

providing numerical solutions when one plugs in the realistic 

values of the parameters associated with growth models of 

different countries. In this paper we present such an empirical 

quantitative model. Using this model we examine the emerging 

outcomes associated with two countries adopting trade 

policies such as autarky, free trade, quantitative restrictions 

and tariffs. We assume specifi c dynamic Leontieff production 

structures along with linear consumption, export and import 

functions in the two countries. 

Planning or quantitative policy analysis has been discarded 

in recent years under the assumption that every country ought 

to follow competition policies and free trade policies, thereby 

minimizing the role of the state. Government offi cials of 

different countries are, however, called upon to advise their 

governments, and to represent their government's interests in 


G AME THEORY 

international forums, on commercial policies. There is a need 

to reformulate quantitative economic policy problem to make 

it useful in the newly emerging economic environment. The 

earlier treatment of the economic policy problem as an 

optimization or optimal control problem with a single objective 

function is now obsolete. In the newly emerged global 

economy with trade liberalizations and capital fl ows one must 

consider a new formulation of the economic policy problem 

with multiple objective functions, one for each country. This 

leads to a game theoretic formulation. We can model the 

economies by a system of differential or difference equations 

to capture economic growth. The optimal policy problem then 

becomes one of a differential game problem. 3 

In this paper we take a simple situation by assuming 

that the world can be grouped into less industrially 

developed countries and industrially advanced countries. 

The former are labeled here as the South Country while 

the latter are labeled as the North Country. The quantitative 

economic policy problem of choosing between the 

appropriate trade regimes by the two groups of countries 

for optimal growth and development is then formulated as 

a differential game problem. 

The plan of the paper is as follows. Section II provides a 

dynamic model for growth and trade. Section III presents an 

empirical illustration of the dynamic model and traces the 

autarky and free trade solutions. Section IV widens the scope 

of the policy problem as a non-cooperative differential game 

problem in which the two trading countries have to choose 

between a set of alternate trade policies with quantitative 

restrictions and import tariffs. Finally section V offers 

concluding comments. 

II. A Model of North-South Growth and Trade 

We assume that there are two nations called North and South, 

each being governed by a dynamic Leontieff model with and 

without trade links. The model without trade is called Autarky 

situation and the one with free trade with no quantitative 

restrictions and tariffs is called the Free Trade situation. 4 

The specifi cation of the model is as follows: 

Let y(t) represent the output of country labeled South in 

period 't' while z(t) the output associated with country North. 

We then have the following National Income Identity. 

y(t)= a. y(t)+b. D y(t) + c(t)+e(t) - m(t) ................................. (1) 

69

O PEN WORLD 

Figure 1: The Trajectories of Outputs of the North 

(Green) and the South (Red) Countries: Under 

Autarky Situation 

40 

30 

20 

10 

70 

0 2 4 6 8 10 

Year 

Where: 

D is an operator denoting the fi rst order time derivative, 

'a' is the current input-output coeffi cient, 

'b' is the incremental capital-output ratio, 

'c(t)' is the fi nal consumption in period 't', 

Figure 2: The Trajectories of GNPs of the North 

and the South Countries: Case 1 Under Free 

Trade Situation 

40 

30 

20 

10 

0 2 4 6 8 10 

Year 


'e(t)' is the exports to country North by the South 

country, and 

'm(t)' is imports of the South country from the North 

country. 5 

Similarly, we have the following National Income Identity 

for North Country: 

z(t)=d. z(t)+f. D z(t)+g(t)+m(t)- e(t) .........……………..... (2) 

Where, 

d and f are the current and capital input output coeffi cients of 

the North country, and g(t) is the fi nal demand or consumption 

function of the North country. 6 

We assume that the consumption or fi nal demand equations 

in the two countries are given by: 

c (t) = c + c y(t) .................................................................... (3) 

0 1 

g (t) = g + g z(t) …............................................................... (4) 

0 1 

We assume that the export from country South equals the 

imports of country North, and vice versa. We assume the 

following linear export and import functions: 

e (t) = e + e z(t)…………………...... (5) 

0 1 

m (t) = m + m y(t) ............................ (6) 

0 1 

When we substitute expressions (3)--(6) in equations (1) and 

(2) we get a system of two inhomogeneous differential equations 

of the fi rst order that are linked to each other if there is 

trade. By assuming an initial condition we can solve these two 

equations and determine the dynamic inter-temporal trajectory 

of the total output or income of each country as a 

function of time. 

We assume that the variables are measured in real terms 

measured in, say, billions of US Dollars. We also assume that 

the exchange rate is fl exible to generate zero trade balance for 

each country. 

We can specify all the parameters of the model and solve 

the two differential equations. 

III. Comparison of Autarky and Free Trade Situations 

We assume the following numerical values for the parameters 

for deriving the empirical results: 

a=0.10; b=4.0; c0= -10; c1=0.75; e0=0 (autarky), =1.03 ( free

Table 1: Matrix of Alternate Trade Strategies of North and 

South Countries 

SOUTH 

Free Trade LL LH HL HH Autarky 

N Free Trade 1 2 3 4 5 NA 

O 

R 

T 

LL 

LH 

6 

11 

7 

12 

8 

13 

9 

14 

10 

15 

NA 

NA 

H HL 16 17 18 19 20 NA 

HH 21 22 23 24 25 NA 

Autarky NA NA NA NA NA 26 

Source: Computations made by the author based on assumptions made in the text 

trade); e1=0 (autarky), = 0.20 (free trade) m0=0 (autarky), = 

1 (free trade); m1=0 (autarky), =0.35 (free trade); d=0.30; 

f=3.0; g0=-10; g1=0.65……………………………… (7) 

Autarky Situation: 

Assume that there are no exports and imports, 

i.e., e(t)=m(t)=0. 

The South Country's structure is now characterized by the 

following dynamic Leontieff model. 

4.0*D y(t)-0.15*y(t)-10=0 ............................................. (8) 

The North Country's structure is given by the following 

dynamic Leontieff model: 

3.0*D z(t) -0.05*z(t)-10=0…..………….………………… (9) 

S 

O 

U 

T 

H 


G AME THEORY 

Assume the following initial conditions: 

y(0)=6,z(0)=10; ……………………... (10) 

The dynamic path of the two countries, 

South and North are given by y(t), and z(t) 

respectively as follows: 7 

y(t) = 72.66666667 exp(.03750000000 t) - 

66.66666667..………………………(11) 

z(x)= 209.9999999 exp(.01666666667 t) - 

199.9999999 … (12) 

These solutions are plotted against time in Figure 1. We 

assumed a horizon of 15 years for our comparative analysis 

throughout this study. Throughout this paper the trajectory 

that starts at 10 refers to the North Country while the one that 

starts at 6 refers to the South country. It can be noted that the 

divergence between the two countries widens as time goes on. 

Free Trade Situation: 

Let us now assume that South country's exports are given by e 

(t), which constitutes the imports of North Country. Similarly 

the imports of South Country and exports of North Country 

are given by m (t) as given by equations (5) and (6) with 

parameters as specifi ed in (7). 

Table 2: Pay-off Bi-Matrix Associated with Alternate Trade Strategies of North and South Countries 

Free Trade LL 

NORTH 

LH HL HH Autarky 

Free Trade 227.07+ 268.52+ 334.07+ 269.38+ 334.80+ NA 

271.16* 237.8 184.89 237.1 184.3 

LL 181.96 223.27 289.58 224.04 290.24 NA 

307.66* 274.42 220.9 273.79 220.36 

LH 145.44 186.17 252.37 186.87 252.97 NA 

337.33* 304.53 251.09 303.96 250.6 

HL 181.54 222.88 289.25 223.65 289.91 NA 

308.00* 274.73 221.17 274.1 220.63 

HH 145.06 185.82 252.08 186.52 252.67 NA 

337.64* 304.82 251.33 304.25 250.85 

Autarky NA NA NA NA NA 286.42 

223.64 

Source: Computations made by the author based on assumptions made in the text 

71

O PEN WORLD 

72 

The structure of South Country is now given by: 

4.0 D y(t) - .50 y(t) - 9.97 + .20 z(t) = 0 ……..…………… (13) 

The structure of the North Country is given by: 

3.0 D z(t) - .25 z(t) - 10.03 + .35 y(t) = 0 ………………… (14) 

The initial conditions are assumed to be the same as those 

assumed for the Autarky case, viz. y (0) =6, z (0)=10; It can be 

seen from equations (13) and (14) that the growth path of each 

country depends on the output of the other country. 

The solution for the Free Trade situation is given by: 

-8 

y(t) = 3.45933019* 10 exp (0.1833333333 t) 

+ 84.33157892 exp (0.02499999999 t) 

-7 

+ .4000000000* 10 exp (0.1583333333 t) - 81.79090915 

………………. ........................................................... (15) 

z(t) = 168.6631579 exp (0.02499999999 t) 

- 4.03588519 exp (0.1833333333 t) - 154.6272728 

-8 

- .2000000001* 10 exp (-0.1583333333 t) 

-7 

- .3000000001* 10 exp (0.1583333333 t), 

-8 

+ .1000000000* 10 exp (-0.1583333333 t) ............... (16) 

The Free Trade solutions are plotted against time in Figure 

2. 

As can be seen from Figures 1 and 2 free trade has benefi ted 

the South c ountr y at the ex pense of, the Nor th C ountr y. 

Marginal propensity to export by the North country seem to 

refl ect the kind of situation that could prevail when a small (in 

the sense of GNP) closed economy such as India could be the 

South country while a large export-seeking large country such 

as United States is the North country. 

The usual claim made by the free trade proponents, that 

free trade is benefi cial to both countries does not seem to be 

borne out in this case. We will, however, examine later 

whether the countries fi nd free trade to be preferable to 


autarky. 

If y (t) is the output in US bill $s, is the time discount factor, 

and (0,T) is the time horizon then the integral pay-off for the 

plan horizon can be written as: 

.......................................................... (17) 

Optimal growth theory suggests that one must use a Ramsey 

type objective function that is a strictly concave function of 

consumption. We assume, however, that what is maximized is the 

discounted consumption stream. As the consumption function is 

linear function of income it is a monotonic isomorphic transformation 

of income, and hence the above pay-off function. We fi nd 

the numerical values for the integral pay-offs as follows, assuming 

that the time discount factor is 0.08 and that the plan horizon 

is 15 years: 

Pay-offs for Autarky Situation in US bill $s: (286.42; 223.64) 

Pay-offs for Free Trade Situation in US bill $s: (227.07; 271.16) 

Where the fi rst entry refers to the pay-off to the North and the 

second entry is the pay-off to the South country. 

From this it is obvious that free trade is benefi cial to the South 

and harmful to the North. As a result of free trade the gain to 

the South is 47.52 and the loss to the North is 59.35. The loss to 

the North is more than the gain to the South. Which situation 

will the two countries choose autarky or free trade? We will 

consider a more general situation of a choice by the two countries 

of a trade strategy which involves quantitative restrictions 

and tariffs. 

IV. Choosing Optimal Trade Strategies: 

A Differential Game Formulation 

It must be admitted that the model described above is very 

primitive and highly aggregative. 8 Further the question of 

trade strategies is made somewhat irrelevant as a result of the 

new WTO trade regime. There are certain provisions of WTO 

regime that do permit member countries to use discretionary 

trade policies. Even violations of the trade regime rules are 

subject to disputes and dispute resolution mechanisms that 

take time. 

In this section we reformulate the import and export functions 

with a quantitative restriction dummy variable that shifts the 

intercept term and a tariff dummy variable that would shift the

marginal propensities to export and import. 

The following are the possible trade strategies that the two 

countries are supposed to adopt. Two letters represent the 

strategy. The fi rst letter represents the level of quantitative 

restrictions (QR) or quotas, and the second letter represents the 

level of import tariff (T). 

We assume that the quantitative restrictions (QR) imposed by 

South reduce the intercept of its import function while the tariff 

(T) reduces its slope or the marginal propensity to import. We 

assume two levels for each, labeled low (L) and high (H). For the 

South country QR low equals downward shift of intercept of the 

import function by 0.02, while QR high equals a downward shift 

of intercept of the import function by 0.04. When there are no 

quantitative restrictions the intercept of the import function of 

South is 1.0. When there is Low tariff in the 

South country its MPI is 0.30, while a high 

tariff gives rise to an MPI of 0.20. When 

there is no tariff at all the MPI for the South 

country is assumed to be 0.35. 

The QR imposed by North at low level 

results in an intercept of export function of 

the South country of 1.02 while QR at higher 

level imposed by the North country would 

result in an intercept of the South country's 

exports of1.01. When there are no quantitative 

restrictions imposed by the North Country the intercept of 

the export function of the South country at 1.03. When there is 

low tariff in North the marginal propensity to export of the 

South country is 0.15 and when there is high tariff in North the 

value of this becomes 0.10. 

The matrix of strategy pairs is given below. NA means that 

strategy pair is not applicable. There are altogether 26 pairs of 

strategies. We specify the following values to the parameters: 

a = 0.10, b = 4.0, c0 = -10, c1 = 0.75, e0 =1.03 (N: no QR), e0 = 

1.02(N:LQR), 1.01(N:HQR); e1=0.10(N:HT),0.15(N:LT),0.20( 

N: no-T); m0 =1(S: noQR), 0.98(S:LQR)), 0.96(S:HQR); m2= 

0.20(S:HT), 0.30(S:LT), 0.35(S:no-T); g0 = -10 ; d= 0.30; f = 3.0; 

g1= 0.65. 

The integral pay-offs for the two countries can be calculated 

for each of the 26 combinations of the trade strategies. If we 

assume that the two countries play a non-cooperative game then 

the optimal trade strategies for the two countries are those that 

In a competitive 

world market one 

should also know 

what counter 

strategy another 

economy would 

adopt eventually 


G AME THEORY 

correspond to the Nash-Equilibrium. For each strategy used by a 

country we determine what the best counter strategy of the other 

country is. We call these the best response functions. We then 

defi ne the Nash Equilibrium as the set of strategies that are best 

against the best strategies of the other country. 

We present below in Table 2 the integral pay-offs for all the 

strategy pairs along with the identifi cation of the best responses 

of each country against each of the strategies of the other 

country. The numbers in the top refer to the integral pay-offs of 

the North Country while the numbers below refer to the integral 

pay-offs of the South country. The pay-offs with " * " are the best 

response of the South country while the pay-offs with "+" sign 

are the best responses of the North Country. The trajectories of 

outputs of the South and North countries associated with these 

alternate trade strategies are not shown 

here. Interested readers can contact the 

author for the Appendix to this article that is 

not being printed. 

From the pay-off bi-matrix it is evident 

that Free Trade is the Nash equilibrium 

strategy . The two countries would thus 

choose free trade as the non-cooperative 

solution. However, it can be noted that if 

both countries cooperate they can choose 

either LH and LH each or HH and HH each 

which will give more benefi ts to the North than the loss to the 

South when compared with the Nash equilibrium, The difference, 

the gain over the loss is $5.14 billion in LH, LH case, and 

$5.29 billion in HH, HH case. This gain can be shared between 

the two countries. Thus there can be cooperative solutions that 

are better than the non-cooperative solutions. 

V. Concluding Remarks 

This paper deals with an empirical illustration of the model and 

techniques advocated earlier by the author (Kumar (1998). The 

model presented here is made deliberately very simple. The 

major purpose of the paper is to illustrate the usefulness of 

differential game theory for quantitative and empirical analysis 

of optimal trade strategies. The computer software can easily be 

used for a more realistic and complicated models such as growth 

and trade models with more sectors and more countries. Once 

we introduce two sectors with consumer goods industries and 

capital goods industries we can study the impact of foreign direct 

investment on growth and development. This model can also be 

73

O PEN WORLD 

improved to incorporate increasing returns to scale. 

Endnotes 

1 For a more detailed discussion of these results one may refer 

to an earlier article by the author (Kumar (2003)). 

2 One may see Helpman and Krugman (1985), and Krugman 

(1999). 

3 Nearly forty years ago this author was one among several 

economists who formulated the quantitative economic policy 

problem of economic growth and development as an optimal 

control problem. It was at that time that the author had seen 

the work carried out by Rufus Isaac at the Rand Corporation 

on Differential Games, which fi rst appeared as Rand 

Reports. The author then contemplated on the possibility of 

generalization of economic policy problem from a control 

problem to a differential game problem with the associated 

duality theory. Such a thought was provoked by an excellent 

paper of 1961 by Leonid Hurvicz on programming in linear 

spaces and the close relationships between game theory and 

mathematical programming. There is thus an element of 

nostalgia associated with writing this paper. The author 

thanks George Papavassilopoulos of University of Southern 

California for drawing his attention to some of his own work 

on differential games which motivated the author to return to 

this topic. 

4 The intercept and the slope parameters of the import and 

export functions are assumed to be constant in this and the 

subsequent sections. In section IV we make them depend on 

the trade policies, such as imposing quantitative restrictions 

and import tariffs, to trace the implications of a variety of 

alternate trade policies. 

5 We assume a composite single commodity. Trade is meaningful 

only if there are at least two commodities. I am grateful to 

Panagaria for this comment. It is assumed here that there is 

in fact more than one commodity in the two economies and 

what are modeled are the aggregate outputs and their growth. 

The composite price indices in the two countries differ due to 

differing average costs as refl ected in the technical coeffi - 

cients of the Leontief model. Comparative advantage and 

specialization thus become meaningful. One may even say 

that the composite commodity of one country is different 

from the composite commodity of the other country. 

6 The technical coeffi cients "a", "b", "c", and "d" are assumed to 

differ between the countries. This is equivalent to assuming 

74 


that the two countries have either unequal access to the latest 

technology or that the countries choose different technologies 

depending on their respective factor endowments. 

7 We used Maple 5.1 software of Maplesoft, Canada for 

obtaining the numerical solution of a system of ordinary 

differential equations. 

8 The models presented here can be easily generalized to make 

them multi-sect oral and non-linear. The reader may see 

Kumar (1998) for a generalization of this model to allow for 

several sectors. 

9 This is intuitive. Free trade solution refers to optimization by 

each country under no trade restrictions. As the objective 

function itself does not depend on the trade fl ow an unrestricted 

maximum is larger than a restricted maximum. 


• Helpman, E., and P.R. Krugman (1985), Market Structure 

and Foreign Trade: Increasing Returns, Imperfect Competition, 

and the International Economy, Brighton, Wheatsheaf. 

• Krugman, P.R. (1990), Rethinking International Trade, MIT 

Press. 

• Kumar, T. Krishna (1998), “ Models of North-South Trade, 

Growth, and Development as Differential Game Problems, 

in L. Caccetta, K.L. Teo, P.F. Siew, Y.H. Leung, L.S. 

Jennings, and V. Rehbock ( Editors) Optimization Techniques 

and Applications, Vol.1 , pp204-209.(Proceedings of 

the 4th International Conference on Optimization: Techniques 

and Applications, Curtin University of Technology, 

Perth, Australia, July 1-3, 1998). 

• Kumar, T. Krishna (2003), "On a suitable framework for 

designing trade policies of a developing country in an open 

global economy" in A.K. Bagchi and M. Chattopadhyaya, 

and Ratan Khasnabis ( editors), Economy and the Quality 

of Life, Dasgupta and Company, Kolkota, 2003, pp. 

190-218. 

(It is the birth of the author's granddaughter Saachi that prompted 

the author to write an article on a topic that will be of some 

relevance and signifi cance to her and her generation. The author 

thanks Arvind Panagaria and Gopal Kadekodi for their comments 

on the fi rst draft, although Panagaria did not agree with 

some of the fi ndings and observations made here. The views 

expressed in the article are personal and do not refl ect the offi cial 

policy or position of the organisation).

O PEN WORLD 

Evolution of World 

Trading System and 

Future of Free Trade: A 

21 st Century Experience 

76 


M.S. Goel 

Reader, Department of Applied Economics, 

JNPG College, University of Lucknow 

Introduction: 

Trade in goods is one of the oldest human activities. Trade is 

as old as the fi rst urban settlements which began to emerge 

approximately 6000 years ago in four independent regions of 

the world: 

B OUND TOGETHER 

Mesopotamia 

Northern China 

India 

Central America 

The fi rst records of extensive trading networks in the world 

are from Egyptian, Phoenician, Greek and Roman civilizations. 

Trade Flourished under the Greek city States e.g. 

Athens and Sparta (Around 500 BC) and later on under the 

Roman empire (starting around 300 BC). 

The 17th Century saw the growth of restrictive policies that 

later came to be known as mercantilism. The mercantilist 


77

O PEN WORLD 

hold that economic policy should be nationalistic and aim to 

secure the wealth and power of the State. The concept was 

based on the conviction that national interest are inevitably 

in confl ict. In this condition, gain in trade is possible at the 

expense of other nation. This thinking led the Governments 

to impose price and wages controls, foster national industries, 

promote exports of fi nished goods and encourage 

imports of raw material. 

Industrial Revolution: The 

Beginning of Free Trade 

The landmark work of Adam Smith and David Ricardo in 

the late 18th Century and early 19th century and also emergence of industrial 

revolution laid the foundation stone of 

evolution process of theorizing free trade 

in Great Britain. It saw a great potential 

in freer trade and also possible dominance 

through it in world manufacturing 

and trade. The result was announcement 

by British Government to introduce free 

trade as a government policy in 1846 when 

the British Parliament repealed the Corn 

Law (which placed a high tariff on corn imports). 

During the next 80 years or so, Great Britain advocated for 

trade liberalization while other major trading players have 

generally pursued protectionist policies. 

The Era of Protectionism: (1913-1950) : 

Advent of Great Depression in America in 1929, however, 

began to infl uence the trade policies of Great Britain, United 

states and other leading economies. Element of free trade 

orientation was gradually vaning and protectionism creeping 

into trade policies. 

Most people will argue but the records speak that “the 

period between 1913 and 1950 is noted by economic historians 

as the period with the lowest average economic growth 

rate since 1820, and also the only period over at least 250 

years, where trade grew at a slower rate than Gross Domestic 

Product (GDP). 1 

Infact this period is marked by Great Depression (1929), 

the two world wars and beginning of the end of colonial 

rule, which probably did create confusions in the minds of 

policy makers of leading economies and trading countries 

78 


of that time. 

Great Britain saw 

a great potential 

in free trade and 

also possible 

dominance 

through it in world 

manufacturing 

Protectionism was on its high because of severe unem- 

ployment, need to revive the industrial activities (particularly 

in war ravaged economics) and also fall in movement 

of foreign capital. 

With the exception of U.S.A most other economies, 

therefore, opted for protectionist policies. 

GATT Foundation: 

The Beginning of End of Discrimination 

Free trade contains many positive points in it such, as to 

help better allocation of resources in the country, improving 

wellbeing of the consumers through 

larger and diversifi ed supplies of the 

commodities and services as well, and 

also inducing competitiveness among the 

businesses within and outside the 

country. 

In post world war II era, efforts were 

made again to reintroduce the sorts of 

free trade into global trading. U.S.A. was 

the leading economy at that time and 

also advocate of the policy of free trade. 

U.S. Congress, therefore, swing into action. As a consequence, 

under their leadership General Agreement on 

Trade and Tariff (GATT) was established in 1947 through 

Havana Charter. 

GATT had been instrumental in transforming the world 

trading system to some extent by helping in eliminating 

barriers to trade (see Table-1). 

GATT negotiation resulted into reduction of tariffs on 

industrial goods of 40 percent countries from an average of 

40 percent in the late 1940’s to fi ve percent. Prior to Uruguay 

Round 8 about 79 percent of industrial tariff positions in 

developing countries and 22 percent in case of developed 

countries2 were unbound, which was a cause of instability in 

world trading. 

After the conclusion of the TOKYO Round in 1979, some 

disturbing trends were observed in world trading system. 

Firstly; aggressive expansion of Japanese exports in 

leading sectors such as automotive and semiconductors 

and at the same time keeping the Japanese economy 

mostly closed to foreign suppliers and investors by administrative 

barriers.

Table 1: GATT/WTO Negotiating Rounds 

Secondly; many countries used subtle forms of interven- 

tion instead of utilizing tariffs and circumvent technical 

violation of GATT rules. 

Main achievements of the Uruguay Round may be 

summarized in following manner: 

Acceptance by developed countries to cut tariffs by 

another 34 percent. 

117 countries joined negotiation 

process. 

Reductions in agricultural import 

barriers. 

Commitment for better access to 

developing countries in service sector. 

Textiles and clothing sector receiving 

the cut in quantitation restrictions. 

The transition from GATT to world 

Trade Organisation (WTO) in 1995 is 

thought to be a major driving force in facilitating trade 

negotiations, bringing stability in world economic order and 

introducing effective dispute minimizing process in world 

trade (see Table-2). 

First six years in the life of the WTO suggest its enforcement 

mechanisms are having a positive effect. As of 31st December, 2000, 200 trade disputes were brought to the 

dispute settlement body (DSB). This is a bigger fi gure than 

196 cases which were handled by the GATT during its 46 

years of existence. 

Element of free 

trade orientation 

was gradually 

vaning and 

protectionism 

creeping into 

trade policies 


Round No. and Place/Name Year(s) No. of Parties Subject Covered % Cut in Tariffs 

1. Geneva 1947 23 Tariffs 21 

2. Annecy 1949 13 Tariffs 2 

3. Torquay 1950-195 38 Tariffs 3 

4. Geneva 1956 26 Tariffs 4 

5. Geneva 

(Dillon Round) 

1960-1962 45 Tariffs 2 

6. Geneva 

(Kennedy Round) 

1964-1967 62 Tariffs and anti-dumping measures 35 

7. Geneva 

1973-1979 99 Tariffs, non-tariff measures, multi- 33 

(Tokyo Round) 

lateral , agreements 

8. Geneva 

1986-1994 117 Tariffs, non-tariff measures, agri- 34 

(Uruguay Round) 

cultural, services, textiles, intellectual 

property, dispute settlement 

Source: Adapted from Various GATT/WTO publications 

Growth of Regional Trade: Boon or Bane for 

Developing Countires and Multilateral Trade 

Multilateral trade in said to be a condition in which a 

country enters into trade with other countries as per the 

rules and regulations formulated by a 

multilateral trade agency . Presently 

there is world Trade organisation (WTO) 

which is authorized by the member. 

States to monitor world trade among 

themselves. WTO is doing a good job. We 

still have the memories of the last 

recession of the 1930’s when unilateral 

actions on tariffs led to a decline of world 

trade by as much as 30 percent in those 

days. From all reports, the decline today 

is no longer of that magnitude. The fact that a multilateral 

organisation for trade negotiations exists today is surely a 

contributing factor here. 3 

However, we notice one striking development taking place 

in the world trading system since mid 1990s that there a 

surge in the regional trade agreements (RTA) from about 50 

till 1990, the number of RTAs notifi ed to the WTO has 

crossed 250 in 2003 and more than 300 RTAs have been 

notifi ed to WTO 4 (till march 15 2008). 


79

O PEN WORLD 

Table 2: A Comparative Multilateral Framework of the World Trade Under GATT and WTO 

The Multilateral Framework in GATT The multilateral framework in WTO 

Industrial Tariffs 

· Backstone of the GATT rounds 1 to 7 Tarriffs on indus- · Developed Countries to reduce tariffs by 40% to reach a 

trial goods in developed countries have been progres- range between 1.7% (japan) and 4.8% (Canada) 

sively reduced from 40% in the late 1940s to 5% · India, South Korea and Singapore to reduce tariffs by 

· High proportion of tariffs are ‘unbound’ 

over 50% 

· Developed countries ‘bind’ 99% of tariffs. 

Agriculture 

· High farm subsides and protected markets in United · Export subsidies down by 36% 

States and EC lead to overproduction and dumping · Production subsidies down by 18% 

· New market opportunities for 1.8 m tons of grain and 

0.73 m tons of dairy products 

Services 

· GATT rules do not extend to services Many countries · The setting up of GATS, the fi rst multilateral and legally 

keep high barries in the services sector. 

enforceable agreement on trade and investment in the 

services sector. 

· Post-Uruguay Round agreements. 

· Telecommunications (Feb. 1998) 

· Telecommunications (Feb. 1998) 

· Financial services (March 1980) 

Intellectual Property 

· Standards of protection for patents copyrights, and trade- · Extensive agreements on patents, copyrights and trademarks 

vary widely ineffective enforcement of national marks benefi ting producers of intellectual property and 

laws becomes a growing source of trade friction 

increasing technology transfer. 

Textiles and Clothing 

· Imports of textiles and clothing restricted through bi- · Textiles and clothing restraints under MFA to be phased 

lateral export quotes under the GATT Multi-Fiber Ar- out in 4 steps between 01-01-1995- 01-01-2005 benefi tting 

rangement (MFA) 

exports in developing countries. 

Source: Adapted from Charles Hill, International Business 2001, McGraw Hill and DEAT Reports 

80 

It is notifi ed that this surge in RTAs is largely driven by 

developed countries. Since the failure of the Seattle ministerial 

of WTO in 1999, countries like U.S and European (E.U.) 

have initiated negotiation on a large number of bilateral and 

RTAS. 5 The world Bank (2005) estimates that about 40 

percent of total global trade is done among the regional 

trading partners. 

The economists like Jagdish Bhagwati, Harry Johnson , 

Bela Blassa ,Arvind Pana gariya do not fully endorse the 

RTAs. Harry Johnson claimed that “ many more Regional 

Trade Agreements and custom unions would rise in future. 

However they would all be expected to break up at a certain 

point of time in future. 6 Paul Krugman (1993) opines we still 

need to ask why such regional blocs are, infact, emerging. 

Experience of the past several decades shows that RTA 


experiments in the west, as well as in the third world have 

proved to be stumbling blocks, providing little gain for 

member countries. 7 

It is important to note that the provisions of most North- 

South RTAs go well beyond the WTO rules and are likely to 

impose higher level of restrictions on the developing coun- 

tries. 8 

Bhagwati and Pana gariya (1996) argue by pushing aggressive 

trade treaties on a bilateral basis , developed countries 

are weakening the power of developing countries in multilateral 

trade negotiations. 

If those are few observations about RTAs and an open 

world trading system continues to be our ultimate goal, then 

several important questions arise as to whether we should 

welcome regional trading agreement as a step.

Multilateral Trade Negotiations: 

A 21 st Century Experience: 

Strong mechanism of multilateral trade system is regarded 

as the pre-requisite to make globalization work successfully 

and pave way for free trading among the global economies. 

This becomes even more important in the light of the fact 

that more than 95 percent of global trade takes places 

among WTO members. But advent of 21st Century brought 

no relief to developing countries as important issues like 

agriculture subsidy and non-agriculture market access 

(NAMA) remain unresolved. 

This declaration of Doha (November 2001) did fi x 1st January, 2005 as the date for completing all but these two 

issues through negotiations. But talks are still pending 

covering other issues as well. 

On the insistence of Government of India (Doha Round) 

meet is going to take place in the fi rst week of September 

2009. According to media reports India is to be blamed for 

creating deadlock. 

To negate this impression worldwide, India has taken a 

bold step to organize the meet and invite the bluff off 

countries which accused it of having torpedoed the July 

2009, Geneva meet by not agreeing to lower its demand on 

safe guarding it subistence farmers. Infact, it was not India 

all alone which was steadfast in this issue but china, Brazil 

and eight other counties were also party. 

Though India and European union have joined hands in 

playing a lead role in freeing up the global trade but all 

matters relating to WTO rest on the Capitol Hill, Washington 

DC. Unless the U.S. President has a fast track authority, 

no commitments can be made by other parties. 

The thinking in the US have always been to focus on 

market access and developments of its own businesses. Thus, 

in spite of huge opposition by poor countries , it was successful 

in getting an agreement on intellectual property (TRIP) 

into the text of WTO agreement in 1994-95. 

In historical perspective also, successful Doha Rounds 

have witnessed fi libustering tactics used by developed 

countries to push developing countries to corner. This has 

been seen in cancun meet which was dominated by Singapore 

issue. Thereafter Paris in 2005, Geneva in 2006, 

Potsdam in 2007 and Geneva in 2008 saw the WTO talks 

broke due to intersticing of modalities between farm 

agreement and industrial good negotiations. In each case 


poor were on the defensive. The rich countries never 

realised that a win-lose out come cannot lead to any 

conclusion. 

Therefore for new talks to succeed those suspicions must 

be proved wrong. We do need to strengthen the multilateral 

trade regime in the context of rising protectionist sentiments 

around the globe. 

Endnotes 

1 “ International Trade and Investment –An Asia Pacifi c 

Perspective,” By John Gionea, published by McGraw Hill 

Irwin, 2005 p. 154 

2 Ibid p. 156 

3 WTO talks : Waiting for Godot” an article written by 

Prof. Manoj Pant (J.N.U) published in Economic Times. 

11th September 09. 

4 “Regional Trade Agreements and Improved Market 

Access in developed Countries: The Evidence Written by 

Prof. Parthapratim Pal, published in economic and 

political weekly, November 29, 2008 p. 84. 

5 Ibid p. 84 

6 Quoted from a research paper titled, “ New Institutions 

Asian Monetary Fund, SAFTA, ASEAN, APEC; A new 

Funeral for New Regionalism in this new Century.” 

Written by Rameshwar Tandon. 

7 Written by Prof. Rameshwar Tandon, published at centre 

for Japanese economic studies, Maeguariec Univ. 

8 Opp. Cit. Parthapratim pal p. 91 


• John Gionea (2005) International Trade and Investment, 

Mc Graw Hill Irwin, Australia 

• Josiph Stiglitz (2002) Globalisation And its Discontents, 

Penguin Books. 

• Jagdish Bhagwati (2004) In Defence of Globalization, 

Oxford University Press. 

• Economic Survey, Government of India. 

• International Trade Statistics 2008, Geneva WTO (2008). 

• Comprehensive Tariff Data. World Trade organisation, 

online via: http:/www. Wto.Org./english/tratop-e/ tariffdata-e.htm. 


refl ect the offi cial policy or position of the organisation.) 


81

O PEN WORLD 

Murky Economics— 

Comparative Advantage 

& Free Trade Theory 

82 


John Kozy* 

Retired Professor of Philosophy and Logic

Economics is adrift in a sea of murky concepts, one 

of which is free trade. This murkiness arises from 

two practices common to economists—commission 

of what I call the fallacy of excessive generalization 

and imprecisely defi ned terms. 

Consider the principle of comparative advantage. The 

number of problems with this “principle” is legion, and 

numerous economists have attempted to amend and extend 

it. All the problems and emendations have been discussed 

extensively in economic literature. One writer, Steven M. 

Suranovic [http://internationalecon.com/Trade/Tch40/T40-0. 

php], has reduced comparative advantage to an almost 

useless hypothetical claim about merely possible results: 

"The usual way of stating the Ricardian model results is 

to say that countries will specialize in their comparative 

advantage good and trade them to the other country such 

that everyone in both countries benefi t. Stated this way it is 

easy to imagine how it would not hold true in the complex 

real world. 

A better way to state the results is as follows. The Ricardian 

model shows that if we want to maximize total output in 

the world then, fi rst, fully employ all 

resources worldwide; second, allocate 

those resources within countries to each 

country's comparative advantage 

industries; and third, allow the countries 

to trade freely thereafter. 

In this way we might raise the wellbeing 

of all individuals despite differences 

in relative productivities. In this description, 

we do not predict that a result will 

carry over to the complex real world. Instead we carry the 

logic of comparative advantage to the real world and ask 

how things would have to look to achieve a certain result 

(maximum output and benefi ts). In the end, we should not 

say that the model of comparative advantage tells us 

anything about what will happen when two countries begin 

to trade; instead we should say that the theory tells us some 

things that can happen." 

Yes, I know. Mr. Suranovic is just one economist, perhaps 

not even a good one. But that’s the point. There is no 

precisely defi ned Principle of Comparative Advantage that 

all economists point to; it has been propounded, amended, 

extended, revised, and even adorned. Attempts to refute it 

Subjunctive 

expressions 

would at least be 

honest, as they 

would imply that 

economists were 

unsure of validity 

M URKY ECONOMICS 

can be likened to shooting at shadows. But the principle 

has two features that appear to be universal. 

First, to determine that one country has a comparative 

advantage over another in the production of a specifi c 

product, a comparison of its costs of production in both 

nations is required. Look at what Ricardo writes: 

"England may be so circumstanced, that to produce the 

cloth may require the labour of 100 men for one year; and if 

she attempted to make the wine, it might require the labour 

of 120 men for the same time. England would therefore 

fi nd it her interest to import wine, and to purchase it by the 

exportation of cloth. 

To produce the wine in Portugal, might require only the 

labour of 80 men for one year, and to produce the cloth in 

the same country, might require the labour of 90 men for 

the same time. It would therefore be advantageous for her 

to export wine in exchange for cloth." 

Notice that Ricardo has no idea of how much labor of 

how many men is required to produce anything anywhere. 

Count the modal verbs. Three ‘mights’ and one ‘may’ which 

grammatically should have been another ‘might.’ The two 

paragraphs are couched in the subjunctive 

mood which, in English, implies 

unreality, doubt, and uncertainty. Now 

“how much labor of how many men” is, 

in principle, a simple calculation. It 

merely requires some counting. But even 

today, can anyone say with certainty how 

much labor of how many men is required 

to produce rice in any nation? 

Perhaps all economists should express 

their principles in the subjunctive mood just as Ricardo 

does. Such subjunctive expressions would at least be 

honest, since they would imply that economists were 

uncertain of the validity of their models. But even Ricardo 

isn’t consistent. When he writes, “England may be so 

circumstanced, that to produce the cloth may require the 

labour of 100 men for one year; and if she attempted to 

make the wine, it might require the labour of 120 men for 

the same time,” he should have concluded that England 

might therefore fi nd it her interest to import wine, rather 

than England would therefore fi nd it her interest. But 

“might fi nd it in her interest” is a weaker conclusion than 

“would fi nd it in her interest.” Could free trade be sold to 


83

O PEN WORLD 

people by claiming it might lower prices? 

84 

Someone is sure to point out that the passage can be 

rewritten with conditional sentences that eliminate the 

modal verbs. True. Consider these: 

"If producing cloth in England requires the labour of 100 

men for one year, and if producing wine requires the 

labour of 120 men for the same time, it is in England’s 

interest to import wine and to purchase it by exporting 

cloth. 

If producing wine in Portugal requires only the labour of 

80 men for one year, and producing cloth requires the 

labour of 90 men for the same time, it is in Portugal’s 

interest to import cloth and to purchase it by exporting 

wine." 

The advantage is derived from the increased production 

of cloth when the labor of the 120 men 

spent on producing wine is transferred 

to producing cloth. The argument 

implies nothing about how much the 

imported wine will cost. What lowers 

the price? Applying the law of supply 

and demand, which requires a number 

of assumptions. 

One is that Portugal reciprocates in 

this arrangement and devotes its cloth 

making resources to wine making, and 

another is that the demand for wine stays relatively constant. 

If Portugal chooses not to move its cloth-making 

resources to winemaking, the supply of wine doesn’t 

increase. What if Portugal simply can’t increase its production 

of wine? Wine, after all, is made from grapes which 

don’t grow well everywhere. Then the added English 

demand for Portuguese wine increases the demand while 

the supply remains constant which raises prices. 

Now put a third country into the mix. Suppose Sweden 

fi nds itself in exactly the same position as England. 

Sweden stops making wine to produce cloth. Now the 

demand for Portuguese wine is even greater. There is 

nothing in free trade theory that makes lower prices 

necessary or even certain. 

Subsequently, economists replaced “how much labor of 

how many men “ by “opportunity costs.” But opportunity 

costs are much more diffi cult to compute. Look at how the 

concept of opportunity cost is defi ned: the amount of one 


One of the most 

difficult aspects of 

economic analysis 

is how to interpret 

the conclusions 

of models and 

frameworks 

product that must be given up in order to produce one 

more unit of another product. But how many phone calls 

to an Indian call center must be given up for Indians to 

produce one more pound of hak? And how many pounds 

of hak must be given up by Americans to get one more call 

to an American call center? Is the example facetious? I 

think not. How many American made automobiles must 

be given up to produce one more two-story home? Who 

knows? Does it matter where the automobiles and homes 

are built? Would opportunity cost be the same in California 

and Connecticut or Kerala and Bihar? Would the 

opportunity cost be the same if the workers producing 

automobiles were unionized and those producing houses 

were not or vice versa or both? Can opportunity costs be 

manipulated? Economists avoid these questions merely by 

making more assumptions. 

Opportunity costs are assumed to be 

constant; they never change. No limits 

on production exist. Full employment 

exists in both countries at all times. All 

factors of production are mobile within 

countries but are immobile between 

them. Pricing mechanisms maintain 

perfect competition. Can we ask 

whether the cloth producers in Portugal 

are lazier than the wine producers? No. 

Labor is assumed to be equally productive everywhere. 

All this assuming is very neat, but it’s a sham. Has anyone 

ever seen an analysis of data that shows that the Chinese 

have a comparative advantage over the United States in 

the production of the plethora of products that Americans 

import from China? Why not? If the comparison of how 

much labor of how many men is required (or the opportunity 

costs) can’t be carried out, the principle of comparative 

advantage has no applications and is entirely useless. 

But as useless as it is, economists venerate it. Consider 

this passage: 

"[O]ne of the most diffi cult aspects of economic analysis 

is how to interpret the conclusions of models. Models are, 

by their nature, simplifi cations of the real world and thus 

all economic models contain unrealistic assumptions. 

Therefore, to dismiss the results of economic analysis on 

the basis of unrealistic assumptions means that one must 

dismiss all insights contained within the entire economics

discipline. Surely, this is not practical or realistic. Economic 

models in general and the Ricardian model in particular 

do contain insights that most likely carry over to the more 

complex real world [http://internationalecon.com/Trade/ 

Tch40/T40-0.php]." 

This passage, in its entirety, is a non-sequitur. Even if 

models are simplifi cations of the real world and contain 

unrealistic assumptions, it does not follow that one must 

dismiss all insights contained within them unless there are 

none. After developing the model, a competent model 

builder would then analyze it assumption by assumption, 

asking what happens if this assumption is false, what 

happens if that assumption is false, what happens if the fi rst 

and second assumptions are false, and so on until s/he asks 

what happens when all of the assumptions are false. Only 

then could one see which, if any, insights 

are revealed by the model. Why would 

rejecting all insights contained within 

the entire economics discipline not be 

practical or realistic if there are no valid 

insights? And to conclude that the 

Ricardian model contains insights that 

most likely carry over to the real world is 

pure unjustifi ed opinion. How would 

anyone ever determine its likelihood? 

Building models on assumptions that may or may not be 

true is one thing. Such models may apply to the real world. 

But building models on assumptions that can never be 

true is another. These models are never applicable to the 

real world. 

Economists are a curious bunch. In cuisine, the proof is 

in the pudding. In economics, the proof is in the recipe 

regardless of how rank the pudding tastes. Paraphrasing 

Dani Rodrik, when economists are taken to task for 

ignoring real world complications, they argue that the 

presence of market imperfections does not change the 

model’s logic. He’s right, but they change the model’s 

outcome, and that’s what’s really important. People don’t 

care about theory, and a logical principle, named modus 

tollens, affi rms that if the consequent of a conditional argument 

is false, the antecedent is false. So when economists 

apply a model and the predicted results don’t ensue, the 

only logical conclusion is that the model’s premises are 

surely false. 

In cuisine, proof 

is in the pudding. 

In economics, the 

proof is in the 

recipe regardless 

of how rank the 

pudding tastes 


Second, the principle of comparative advantage relies on 

a generalization so extensive its generalized term has no 

denotation. It is a term without meaning. 

You see, only winos (alcoholics) drink wine! The rest of 

us drink Asti, Beaujolais, Bordeaux, Burgundy, Cabernet 

Sauvignon, Chablis, Champagne, Chardonnay, Chianti, 

Fynbos, Jerez, Kalecik Karası, Luján de Cuyo, Madeira, 

Merlot, Moselle, Pinot Gris, Port, Pouilly Fuisse, Riesling, 

Sake, Sangiovese, Sauternes, Sherry, Tempranillo, Valpolicella, 

Vinhos Verdes and scores of others. Why Ricardo 

chose wine is a mystery. Perhaps he was a wino and really 

didn’t care about fl avor, aroma, dryness, and body. Or 

perhaps he chose wine because the English were and still 

are not very good at making wine. Would the French be 

willing to give up Beaujolais for Port or the Japanese be 

willing to swap Sake for Vinhos Verdes? 

Someone will say it’s just an example. 

But generalize on any product. Automobiles, 

tomatoes, potatoes, chairs, whatever. 

The only products made worldwide 

that are identical are factory produced 

according to precisely defi ned specifi cations 

and sometimes even those vary. 

These products can be made just as 

easily in Chad as in China. There is no 

reason to believe that people in Bongor are any less 

dexterous than people in Beijing. 

Statements like the following are often found in the 

literature: 

"The magic of comparative advantage is that everyone 

has a comparative advantage at producing something. The 

upshot is quite extraordinary: Everyone stands to gain from 

trade. Even those who are disadvantaged at every task still 

have something valuable to offer. Those who have natural 

or learned absolute advantages can do even better for 

themselves by focusing on those skills and buying other 

goods and services from those who produce them at 

comparatively low cost. [http://www.econlib.org/library/ 

Topics/Details/comparativeadvantage.html]" 

Now, just ask, how could anyone know the fi rst sentence's 

claim? Is it simply impossible that someone somewhere 

can’t do anything at all? How can anyone justify a claim 

that such an impossibility exists? And how does everyone 

stand to gain from trade just because they can buy things at 


85

O PEN WORLD 

comparatively (compared to what) low cost? If just one 

person loses his income or his life because of trade policy, 

the statement about everyone is false. The sentence isn’t 

even true if the word ‘gain’ is modifi ed by ‘fi nancial.’ 

So if it cannot be shown with certainty that one nation 

has a comparative advantage over another in the production 

of some product, then no one can be certain that any 

predicted benefi ts from basing trade on a comparative 

advantage will ensue. If free trade can’t be based on 

comparative advantage, it must be based on some other 

kind of real, contrived, assumed, or imagined advantage, 

not comparative advantage. 

Free trade, when reduced to its simplest form, means 

nothing but trade not restricted by protectionist practices. 

But “protectionist practices” is another ill-defi ned, murky 

concept. Consider these scenarios: 

Two countries, Us and Them, each 

produce a product named a domock. Us 

is a highly developed nation that has 

implemented many economic regulations 

to protect its people from injury, 

exploitation, and fraud. Them is an 

underdeveloped nation with no economic 

regulations. Manufacturers in Them 

can export domocks to Us and sell them 

for one curr each. Manufacturers in Us 

can sell domocks for two currs each. So 

what can Us do? 

Leaving aside the possibility that Us might simply allow 

its manufacturers of domocks to go out of business, only 

three unique alternatives exist: Us can impose a tariff of 

one or more currs on each domock imported (a protectionist 

practice), can subsidize its domock-manufacturers so 

they can reduce the price to one curr (another protectionist 

practice), or eliminate the protective regulations that cause 

the price of domocks to be two currs. Free trade advocates 

do not consider this last alternative protectionist, and it is 

the alternative they advocate. 

But why is the third alternative not just as protectionist as 

the fi rst two? All three are done for the same reason and 

produce the same result. How can anyone justify calling 

the fi rst two protectionist and the third not? 

Only one answer to the question exists, and it is trivial. 

Free trade is often defi ned as a trade policy that allows 

86 


If free trade policy 

were implemented 

worldwide and 

all protective 

regulations were 

over, who would 

stand to gain? 

traders to act without having to deal with governmentally 

imposed regulations. Since the fi rst two alternatives 

involve regulations and the third does not, the fi rst two are 

protectionist and the third is not by defi nition alone. But 

logically, a thing is what it is and not another thing. If some 

horticulturalists decide to defi ne orchids as adornments 

and not fl owers, would orchids no longer be fl owers? A 

name does not make something what it is; its attributes do. 

Remember the adage, if it looks like a duck, squawks like a 

duck, and walks like a duck? But if all three alternatives 

are essentially the same, free trade theory collapses into 

utter nonsense. 

In 1913, V. I. Lenin published an article in Pravda titled, 

Who Stands to Gain? Regardless of opinions of Lenin or 

Leninist-Marxism, this question is a useful analytical tool 

when evaluating policy proposals and was stated long 

before Lenin by the Romans (cui 

prodest?). Unfortunately, it is asked far 

too infrequently. If free trade policy 

were implemented worldwide and all 

protective regulations were eliminated, 

who would stand to gain? Merchants certainly. 

But what about the rest of us? 

Well, suppose Them allows its manufacturers 

to employ child labor. Us then 

eliminates it child-labor protections. 

Are the children better off just because 

they can now purchase domocks for one curr each? 

Suppose Them allows its manufacturers to use dangerous 

materials. Us then eliminates its restrictions on the use of 

dangerous materials. Are people better off being injured 

and poisoned just because they can now buy domocks for 

one curr? Suppose Them allows its manufacturers to place 

workers in dangerous circumstances where many are 

maimed and killed. Us then eliminates it regulations on 

unsafe workplaces. Are workers better off being injured 

and killed just because they can now buy domocks for one 

curr? Is anyone even fi nancially better off? So who stands 

to gain? Just merchants? 

To economists, incredibly, merchants are mostly Mr. 

Goodfellows. They don’t lie to and cheat consumers. They 

don’t overcharge. They never market products that don’t 

work or that don’t work as advertised. They don’t market 

products that injure and sometimes kill and hide the fact

that these possibilities were known before the products 

were marketed. They don’t write contracts with hidden fees 

buried in text that can be read only with microscopes or 

that coerce people into repudiating their legal rights. They 

never defraud clients, each other, or governments by 

submitting claims for work never done on governmental 

projects or for governmental programs. They don’t profi teer 

in wartime. They don’t corrupt public offi cials. In fact, 

most are veritable saints, and the few that aren’t, those 

rotten apples, are plucked from the barrel of commerce by 

the invisible hand, because the market is self-regulating. 

But in reality, unregulated business exhibits all the characteristics 

of a criminal enterprise. 

As a logician, if I were asked to prove that the market is 

self-regulating, the only effective proof that I could think of 

would be to list all the untrustworthy fi rms whose dishonest 

actions were restrained by trustworthy 

fi rms and then show that, at best, no or 

just a few untrustworthy fi rms have 

avoided this restraint. But no economist 

has ever developed such a proof, which 

means that either the market isn’t 

self-regulating or that there are so few 

trustworthy fi rms that they lack the 

power to restrain the untrustworthy. 

However, this debate on free trade is 

merely a diversion. The process of 

globalizing trade that has now gone on for several decades 

has nothing to do with comparative advantage or free trade 

theory. No nation has abandoned any industries, transferred 

the resources to industries making products for 

export, and used the exports to pay for the importation of 

the products previously made by the abandoned industries. 

The so-called "developed" nations, whose governments are 

controlled by commercial interests, have merely bought the 

idle labor and resources of "underdeveloped" nations for 

skimpy sums and paid for them with fi at currencies that 

amount to little more than promissory notes. It remains to 

be seen whether the nations holding these promissory notes 

will ever be able to redeem them for value equal to that 

expended on the labor and resources used to manufacture 

their exported products. If not, these nations will fi nd that 

they have been swindled just as the residents of the United 

States, Great Britain, and other nations who have lost their 

The question is 

not trade, but how 

and by whom it 

will be controlled. 

Trojan horses do 

exist and everyone 

is a protectionist 


homes and savings have. The only confi rmed result of 

globalized trade is the greatest transfer of wealth from the 

least wealthy to the most wealthy in recorded history. 

The real issue is independence or dependence. Free 

trade advocates are attempting to convince governments 

worldwide to relinquish their control over their economies. 

It is an attempt by merchants to control all markets. If it 

succeeds, national governments will be irrelevant. 

The real question that nations must answer is whom do 

they want to give control of their economies to? The 

alternatives are national governments, which are at least in 

some cases and in some sense responsible to their citizens, 

or powerful worldwide commercial interests who have to 

answer to no government and no people. Nations that were 

once colonies of Western imperialist countries should 

consider this question carefully. Although the yokes of past 

oppression may have been lifted, the 

interests that propelled imperial conquest 

were commercial and still exist, 

and the agendas have not changed. Only 

the methods of conquest have. 

Trade between nations will not cease 

if free market theory is completely 

debunked. Everyone, as I have argued 

above, is a protectionist; everyone seeks 

to protect something—people their 

lives, merchants their profi ts, consumers 

their protections, laborers their jobs, nations their wealth 

and power. The question is not trade, but how and by whom 

it will be controlled. So I would suggest that the world’s 

governments should beware economists bringing promises 

of prosperity based on utopian theories on behalf of 

merchants. Trojan horses do exist. 

(The views expressed in the article are personal. The author is 

a retired professor of philosophy and logic who blogs on 

social, political, and economic issues. After serving in the U.S. 

Army during the Korean War, he spent 20 years as a university 

professor and another 20 years working as a writer. He has 

published a textbook in formal logic commercially, in academic 

journals and a small number of commercial magazines, 

and has written a number of guest editorials for 

newspapers. His on-line pieces can be found on http://www. 

jkozy.com/ and he can be emailed from that site's homepage.) 


87

G ROWTH ECONOMICS 

88 

The India Story: Served 

Sunny Side Up 


Ketaki Sharma 

Economist, Reliance Equities International 

Pvt Ltd., Mumbai 

A 

periodic visit to the various shopping malls in the 

metros over the past few months reveal a lot about 

the changing consumer mindset and is something 

that sets my economist mind ticking. Footfalls have increased, 

distress discount sales are a thing of the past, business is 

thriving, waiting time outside movie ticket counters has gone 

up and the great Indian pass-time of eating out has undergone 

revival. This, if not a confi rmation, is at least an indicator of 

the great India story that everyone has been talking about. 

As global liquidity returns and risk appetite improves, there 

is bound to be a foreign funds infl ow into the emerging 

markets – especially India and China. Agreed that hitherto 

the emerging markets have been far more volatile than that of 

developed countries but the fact remains that they -almost 

always- outperform the latter. 

Taking a look at Charts 1 and 2, it is 

obvious that the Morgan Stanley Composite 

Index (MSCI) for Emerging markets 

outperforms the index for the world 

markets, more so in the recent past. 

Within this index for emerging markets, 

India clearly outperforms the others. 

It is my belief that India will continue 

to outperform other emerging markets 

and will remain one of the most favored destinations for the 

FII infl ow. What makes me so confi dent? Read further to 

fi nd out! 

As Liquidity is Back with a Bang… 

The Reserve Bank of India cut rates for the fi rst time in 2008 

in October - to fi ght the lack of liquidity in the system post the 

fall of Lehman Brothers. 

Post the Lehman crisis (in September), the Reserve Bank of 

India has been cutting its policy rates. Since October there has 

been a 400 basis point cut in the CRR and similar cuts in the 

Repo and the reverse repo. The big idea was to make money 

so cheap that lenders fi nd it profi table to lend rather than to 

Four and a half 

trillion borrowing 

plan of the state 

will ensure that 

credit remains 

expensive and 

rates may not fall 


S TOCK TAKING 

hold onto cash. Thanks to the monetary loosening, we are now 

seeing a considerable softening of lending rates. Recently SBI 

cut its prime lending rates by 50 bps, while weeks before doing 

so it cut its deposit rates, thus creating incentives for individuals 

to remain more liquid. Another indicator of increasing 

liquidity is the cooling off of call rates (inter bank lending 

rates). Call rates that had peaked to 21% in October, are now 

placed within a more healthy range of 0.75% to 3.5%. 

On the fi scal front, similar measures have been taken. In 

India there have been excise duty cuts and other infrastructure 

expenditure undertaken by the government to ensure 

that domestic demand does not wither away. Here again, 

India is not the only country. China cut its central VAT in 

January while the West has a wide social security net that 

props up demand. 

And Risk Aversion Abates… 

G-Sec yields might have fallen from their peak of 8.4% on 7th September 2008; however they have been more or less stable 

at 6.8% level. Loosening of policy rates has also helped abate 

risk aversion - this is evident from the fall in 10 year G-Sec 

yield. Many might argue that the already 

announced four and a half trillion borrowing 

plan of the government will ensure that 

credit remains expensive and that interest 

rates may not come down any further. 

True, given the borrowing requirements of 

the government, it is unlikely that they will 

fall further. 

India and China are the Most 

Attractive Investment Destinations 

While the world economy contracts, India & China grow at 

fi ve plus level. Both countries combined, India and China 

constitute about 40% of the world’s population. The demographics 

and sheer size of the population ensure strong 

domestic demand. India’s growth story is here to stay. While 

monsoon failure remains a risk to India’s GDP growth, my 

belief is that India and China have so far outperformed the 

rest of the world. And what is the reason behind that strong 

belief? Because what we experience today is a demand side 

constraint. The populous countries of China and India ensure 

domestic demand holds up especially with rising government 

spending to buoy infrastructure and farm activities. In the 

89


Chart 1: Morgan Stanley Composite Index for Emerging Markets Versus the World 

1400 

1200 

1000 

800 

600 

400 

200 

0 

Jan-88 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 

MSCI Emerging Market 

MSCI World Index 

Source: Bloomberg 

Chart 2: Morgan Stanley Composite Index for Emerging Markets Versus India 

900 

800 

700 

600 

500 

400 

300 

200 

100 

0 

Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 

MSCI India 

MSCI EM (Index) 


Chart 3: 10 Year G-Sec Yield Falls, Risk Aversion Abates 

10.00 

9.50 

9.00 

8.50 

8.00 

7.50 

7.00 

6.50 

6.00 

5.50 

Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 

10 year G-Sec 

Jan-09 Feb-09 Mar-09 Apr-09 May-09 


90 


Chart 4: GDP Growth (Year on Year) for January to March 2009 

Table 1: Sensex’ Return on Capital vs. GDP One Year Forward 

Return on Capital (30 Sensex companies) GDP 1 Year Forward 

FY02 16.21 3.7 

FY03 22.22 8.4 

FY04 15.72 8.3 

FY05 25.89 9.3 

FY06 21.02 9.7 

FY07 22.35 9.1 

FY08 20.14 6.7 

Correlation: 62.84% 

Source: Bloomberg and author's calculation 


S TOCK TAKING 

8 

6 

4 

2 

0 

-2 

-4 

-6 

-8 

-10 

-12 China India Indonesia Chile USA UK Thailand Japan 


fi rst quarter, January to March 2009, Chart 4 compares GDP 

growth for a few countries. India and China clearly outperform 

their peers. 

Taking Stock of the Stock Market… 

The Indian stock market is a good indicator of its gross 

domestic product, one year forward. Return on Capital is 

positively correlated with GDP a year forward (see Table 1). In 

simple words, the higher the return on capital in the Stock 

market, the better the growth prospects. Since India and 

China have outperformed the global markets so far, it is highly 

likely that their GDP growth one year forward will outperform 

the rest. 

Conclusion: Sensex, GDP and the Republic of India 

Essentially, the three things that one needs to delve into 

while looking at the India story are the sturdy GDP 

numbers, the ability of the Sensex to indicate the same 

and the very nature of the Indian market which ensures a 

strong domestic demand. As they say in cricket, “Form is 

temporary, class is permanent”. Similarly, while there 

may be hiccups on the way but the Indian market is 

fundamentally an attractive market and has a lot going in 

its favour. 


• Bloomberg 

• Central Statistical Offi ce, for data on Gross Domestic 

Product of India 



91


Is Rising Share of Services 

Inevitable for GDP 

Growth? 

Madhusudan Dutta 

Professor, Sardar Patel Institute of Economics 

and Social Research, Ahmedabad 

The growth of the Indian economy at least over the 

last one and a half decades is generally viewed as led 

by the tertiary (or, service) sector. Many observers, 

while appreciating the rapid growth of services exports in 

recent times, take the soaring share of the tertiary sector in 

gross domestic product (GDP) to be not very healthy; they 

view growth through service expansion to be illusory to a 

great extent as services are ephemeral. The implication seems 

to be that the service-led growth does not refl ect the inherent 

strength of the economy. Vestiges of Smithian ideas of 

productive and unproductive labour may be traced here. 

Adam Smith (1776) considered only material goods to be 

capable of generating economic growth through their use as 

fi xed capital and wage goods. Rendering of services, however 

dignifi ed or important, was considered as unproductive 

labour activity. 

I fi nd it somewhat uncomfortable to direct arguments in 

terms of the service sector as a whole without going adequately 

into the diverse characteristics of the component 

activities lumped together just on the basis of their products 

being intangibles. In fact, the classifi cation of activities on 

the basis of intangibility of product is only convenient and it 

has a historical legacy; but it is not based on any inherent 

strength or weakness of the relevant activities. A major part 

of the service sector activities are related to the production 

92 


W HAT’ S THIS INDIA BUSINESS? 


93


Table 1: Shares in GDP*: Major Sectors 

Relative GDP shares of the major sectors – primary, 

secondary and tertiary – change in the course 

Sector Primary Secondary Tertiary Intermediate 

Service 

Final 

Service 

of development in conformity with change in the 

structure of fi nal demand. The associated change in 

1950-51 57.5 14.7 27.8 11.3 16.5 

the production process involves not only expansion 

1955-56 55.5 16.5 28.1 12.1 16 

in scale but also technical progress that includes 

1960-61 52.9 18.3 28.8 13 15.8 emergence of new products and also change in the 

1965-66 45.1 22.3 32.6 14.9 17.7 structure of production organization. Revolution in 

1970-71 46.3 21.6 32.1 14.7 17.4 computing and telecommunications technology has 

1975-76 44.2 21.7 34 15.7 18.3 given us several new products and it has changed the 

1980-81 39.7 23.7 36.6 17.2 19.4 way work is done making way for greater specializa- 

1985-86 36.3 24.8 38.9 18.1 20.8 tion and, so, splintering of activities. Coming into 

1990-91 32.2 27.2 40.6 18.8 21.8 prominence of business process outsourcing is an 

1995-96 28 28.1 43.9 21.9 22 example of the importance of this trend. Out- 

2000-01 23.7 27.8 48.4 23.8 24.6 

sourced services should be viewed as an integral 

2004-05 20.4 27.3 52.3 26.6 25.7 

part of the production process which they serve, as 

*At factor cost, 1993-94 prices. 

they had used to be until they started to be out- 

Source: Calculations based on various issues of National Accounts Statistics, CSO. 

sourced. But the value-added in such services would 

now be shown in the service sector even though the 

of material goods; so much so that these services used to be, activities form an integral part of tangible or material produc- 

in effect, included in the measure of production used to be tion. There are services like trade and transport which may 

given by the erstwhile socialist countries as Net Material also be viewed as part of material production in the broader 

Product (NMP). 

sense of production as stated above. It will be instructive to 

take an example. 

Classifi cation of Sectors 

and their Dynamics: 

The appellations – primary, secondary and 

Rendering of 

services, however 

Consider companies like the Indian Oil 

Corporation Ltd. It refi nes crude petroleum 

and distributes the products to the 

tertiary – have historical roots. Primary dignified or consumers. The company thus performs 

activities are extractive in nature and these 

were supposed to cater to the most basic 

needs of subsistence. The secondary activities 

are transformative in nature and these 

were viewed to be of the next order of 

important, was 

considered as 

unproductive 

labour activity 

two types of operations: refi ning, belonging 

to the secondary sector and distribution 

of products through trading cum 

transportation activity belonging to the 

tertiary sector. The company reckons its 

importance. Tertiary activities are the 

performance on the basis of the whole 

diverse set of residual activities basically of the nature of gamut of its activities. In order to satisfy the national account- 

services; i.e., they do not result in any tangible product. ing classifi cation the two types of operations (in fact, trans- 

Though left out of the sphere of production by a considerable portation is also separated from trade) are taken into account 

section of opinion for a long time, these services are now very separately. But that cannot blur the integral nature of the two 

much considered as part of a country’s GDP. A modern man basic activities – refi ning and distribution. If the different 

would not consider his car or television set to be more impor- activities were not reported separately the whole value added 

tant than his education or security. That is refl ected in his by the company would be reported in the industry sector 

choice for services exerted through his expenditure. The because the company is known as a refi ner (transforming 

growing share of services in GDP refl ects this choice because crude oil into refi ned oil and related products); that would 

production is not sustainable without demand. 

raise the share of industry in GDP and correspondingly lower 

94 


Table 2: Shares of Sub-sectors of the Tertiary Sector 

the share of services without any consequence for the size of 

the GDP. All the countries of the world do not have equally 

developed national accounting system. Separating different 

types of activities within a company requires a very well 

developed accounting tradition. Surely, this makes the 

sectoral shares of different countries non-comparable to 

some extent. 

In the same way it should not be very diffi cult to see the 

intimate relationship between fi nance and 

the above activities. The more advanced 

does the corporate structure become, the 

more intimately do the companies get 

connected with fi nancial institutions. Thus 

the development of fi nancial institutions 

may be viewed as an adjunct to the 

development of the industrial structure; 

the two developments are synergistic. In 

fact, the greater part of what is shown as 

output in fi nancial institutions is deducted from the output in 

the productive sectors using the services as an intermediate 

input. As such, and to that extent, the growth of fi nancial 

services basically refl ects the growth of other activities that 

use these services as an intermediate input. This is unlike the 

growth of fi nal service like personal, social and community 

services. Determination of value-added in fi nancial services is 

basically a question of distribution of value added between 

cooperating sectors. Indeed, there is much uncertainty 

regarding the proper treatment of value added by different 

fi nancial institutions. 

The financial 

services growth 

reflects the growth 

of other activities 

that use these 

services as an 

intermediate input 


Tertiary 

Shares in the Tertiary Sector 

In GDP THR TSC Communication # Banking & 

Insurance 

DRB Business Service# CSP 

1950-51 27.8 31 12.2 1.4 3.4 19.8 1.5 33.7 

1960-61 28.8 34 13.7 1.7 4.4 16.2 1.3 31.7 

1970-71 32.1 33.9 14.6 2.2 5.2 13.1 0.9 33.2 

1980-81 36.6 33.3 17 2.6 6.3 11.5 1 31.9 

1990-91 40.6 30.9 15.3 2.5 10.3 13.6 1.5 30 

1995-96 43.9 31.8 15.8 3.3 12.7 13.3 3 26.4 

2004-05 52.3 30 20.6 9.1 12.5 11.6 4.3 25.3 

*At factor cost, 1993-94 prices. 

# Communication is a part of TSC and Business Services is a part of DRB. 

Abbreviations – THR: trade, hotels and restaurants; TSC: transport, storage and communications; CSP: community, social and personal services; DRB: Dwellings, real estate and 

business services. 

Source: Calculations based on various issues of National Accounts Statistics, CSO. 

Intermediate and Final Services: 

Considering the inter-linkage among activities as discussed 

above, instead of taking the tertiary sector as a single block it 

should be instructive to divide it into two parts – intermediate 

services and fi nal services. Services that are not directly 

associated with material production are public administrative 

services, education and health, dwellings, 

miscellaneous personal services and a part 

of transport, communications and fi nancial 

services enjoyed as personal consumption. 

These services together with service 

exports constitute fi nal demand for 

services. The rest of the services, accounting 

for a major part of value-added in the 

tertiary sector, are intermediate services 

forming an integral part of the production 

process using them. Secondary sector is the dominant source 

of their demand. 

In fact, as the objective of productive activities is catering 

to fi nal demand a relevant question in understanding the 

sectoral shares is how the composition of fi nal demand has 

changed in the course of development. It is generally 

expected that with rise in per-capita income relative importance 

of services in private and public consumption rises 

(Wagner’s law). But whether intermediate services like 

trade, transport, etc., should grow faster than other activities 


95


Table 3: India’s Exports and Imports ( as % of GDP unless otherwise specifi ed) 

Period 1971-1981 1981- 1991 1991-2005 1996-2005 2000-2005 

Export of Goods and Services 5.29 6.29 11.85 13.2 15.1 

Export of Services 0.85 1.46 3.44 3.59 4.58 

Export of Services as % of Total 15.58 23.27 24.21 26.44 29.9 

Import of Services 0.56 1.02 2.7 2.79 3.36 

Source: Rakshit (2007) 

should depend, among other things, on the evolving sectoral 

structure of production. 

Sectoral Shares in the Indian Economy: 

Table 1 presents the relative shares of the three major sectors 

in GDP. The secondary sector includes mining, manufacturing, 

construction and the utilities electricity, gas and water 

supply. We have divided the tertiary sector into two categories: 

intermediate and fi nal services. We have used inputoutput 

transactions tables for the Indian economy to compute 

intermediate services that include the whole of trade and parts 

of transport, communications, fi nance and 

business services used as intermediate 

input. The rest are fi nal services, which 

include Community, Social and Personal 

services (CSP) as well as parts of other 

services treated as fi nal use. 

It is seen that the share of the tertiary 

sector increased by about 13 percentage 

points in the fi rst four decades after 

1950-51 but it rose further up by about 12 

percentage points in only the next one and 

a half decades. This is a striking development and naturally it 

has caught the attention of observers. The share of the 

secondary sector also rose by roughly the same magnitude as 

that of the tertiary sector in the fi rst four decades but in the 

subsequent period its share remained stagnant. Thus the 

tertiary sector captured the whole of the share lost by agriculture 

(primary sector) in the nineties and thereafter. 

Table -2 presents relative shares of sub-sectors of the 

tertiary sector. THR (trade, hotels and restaurants) constitutes 

the largest sub-sector of the tertiary sector since midfi 

fties. Though CSP (it includes public administration and 

defence as well as education, health and miscellaneous 

services) has remained close to the THR we should keep in 

96 


Intermediate 

services share is 

just above 40% 

of all services in 

1950-51 and it 

increased to 50% 

in 1995-96 

mind that CSP combines really a group of diverse activities. 

THR’s share in the tertiary sector increased during the fi rst 

fi fteen years but then the share gradually declined. Nevertheless, 

as the tertiary sector itself raised its share all through, 

trade’s share in GDP increased, all through from roughly nine 

percent to 15 percent; thus the sub-sector was more than half 

the size of the secondary sector as a whole most of the time. 

Naturally, one will want to know why and how it was so. We 

will take up the question below. 

Transport, storage and communications (TSC) increased its 

share in the tertiary sector very fast during the last ten years, 

but this is entirely explained by the growth 

of communications service, which grew 

particularly fast during the period. The 

other growth story that cannot escape 

attention is (computer related) business 

services. In fact communications and 

business services together explained only 

four percent of the tertiary sector in 

1990-91 but then grew to as much as 13.4 

percent of the sector in 2004-05. This 

meant that communications and business 

services together explain fi ve percentage point (out of 

12-point) rise in the GDP share of the tertiary sector during 

the last fi fteen years. 

Table-1 shows that intermediate services constituted just 

above 40 percent of all services in 1950-51. The share increased 

to around 50 percent in 1995-96 and more or less 

stayed there since then. Thus over the fi rst four and a half 

decades the growth of intermediate service has been faster 

than that of fi nal service. However, if we look at the last one 

decade, intermediate and fi nal services almost maintained 

parity. The fact that the growth of the tertiary sector is 

explained equally by the intermediate (of which industry is the 

main source of demand) and fi nal services implies that

Table 4: Private Final Consumption Expenditure at current prices (Percentage Distribution) 

roughly half of the growth of the service sector is explained 

by the growth of industry at a time when industry generally 

failed to raise its relative share in GDP. This is a fundamental 

point for understanding the growth of relative share of 

the tertiary sector. 

Demand for Intermediate Services: 

A very prominent example of intermediate 

services is distributive trade. Its 

demand is wholly a derived demand, i.e., 

demand arising form demand for commodities 

distributed through traders. 

Also, transport is intimately related to 

trade, so a very large part of the demand 

for transport services is derived demand 

too. Let us take an example. Milk dairy 

movement has led to value addition in the processing of 

milk. In the absence of processing, milk would be considered 

a product of animal husbandry included in the primary 

sector, and it would be distributed largely without the 

intermediation of traders. Milk processing has led to rise in 

value addition not only in food processing industry but also 

created demand for trade and transport of processed milk 

and milk products. The example being a part of everybody’s 

daily experience, one can readily relate the rise in trade and 

transport services to the ‘spread’ of industry. 

At a more sophisticated level we can look at the ongoing 

global integration process. The multi-national companies 

strive at reducing their costs by de-verticalizing their 

Service intensity 

of the secondary 

sector itself 

increased over 

time, as can be 

verified from the 

research data 


YEAR 1960-61 1970-71 1980-81 1990-91 2000-01 2005-06 

1.Food, Beverages & Tobacco 

1.1 Hotels & Restaurants 

2.Clothing & Footwear 

4.Gross Rent,Fuel & Power 

5.Furnitures 

6.Health 

7.Transport & Communications 

8.Recre,Education etc. 

59.5 

0.6 

5.1 

21.9 

2.7 

2.3 

2.6 

2.1 

62.5 

0.6 

4.9 

17.3 

3.1 

2.8 

2.9 

2.5 

58.1 

0.8 

6.3 

15.3 

3.3 

4.4 

4.5 

2.5 

54 

1 

6.2 

13.6 

3.5 

3.8 

9.8 

3.1 

Sub-total (rows 6 through 8) 7 8.2 11.4 16.7 25.1 29.8 

9.Misc. 

Total 

Source: CSO, different years, National Accounts Statistics 

5.3 

100 

4.7 

100 

5.5 

100 

6.1 

100 

47.3 

1.4 

4.6 

11.4 

3 

7.3 

14.2 

3.6 

8.6 

100 

activities – outsourcing certain functions and sub-contracting 

the production of numerous components (think of 

automobiles and electronics goods). Shift from single stage 

to multi-stage production process adds to the ‘depth’ of the 

process. As a result there has been enormous increase in 

trade within industries. Of course, 

vertical integration is known to be a 

means of cutting transactions costs but 

there are limits to such strategies in the 

face of growing competition and specialization; 

and the contrary trend is strongly 

felt in East-Asian markets. The Indian 

economy, one presumes, is not free from 

such effects and these effects should 

affect the intermediate input coeffi cients 

of the relevant sectors. 

What we have talked about trade and transport services is 

roughly valid regarding demand for a large part of fi nancial 

services also. The three broad groups involving these 

services account for roughly three-fourths of value-added in 

the service sector of the Indian economy in recent times 

(Table-2). In order to understand why such services grow so 

fast we just have to understand that the secondary sector 

uses the above services in the highest intensity. So as the 

share of the secondary sector rises the share of these services 

also rises. Furthermore, service intensity of the secondary 

sector itself increased over time. This can be verifi ed 

from the input-output transactions tables for the Indian 

economy (not shown here). 


39.4 

2.3 

5 

11.8 

3.6 

6.5 

19.1 

4.2 

10.3 

100 

97


Structure of Final Demand: 

Given the input-output structure, the composition of the fi nal 

demand vector determines the composition of output and, so, 

the sectoral structure of value added. The fi nal demand vector 

may be viewed as having two parts – one endogenous (determined 

by disposable income) and the other autonomous. 

Income determination requires that, given the autonomous 

fi nal demand, the endogenous fi nal demand must be such that 

the aggregate fi nal demand vector is just equal to the vector of 

net output. To explain the relative share of the tertiary sector 

within this structure we look at the changing composition of 

fi nal demand. 

It is observed from Table-3 that the average of India’s total 

exports in the decade of the 80’s was about 6.3 percent of 

GDP and this fi gure rose to 15.1 in the quinquennium ending 

in 2004-05. Out of this roughly nine percentage point increase, 

the contribution of services was more than three 

percentage points. Since the share of services in total exports 

in the 80’s was less than a quarter of the total, the above 

phenomenon implies, and it is observed form the table, that 

services’ share in total exports increased subsequently. This is 

a very encouraging picture so far as services production is 

concerned and it defi nitely goes some way in explaining the 

rising share of the tertiary sector in GDP particularly in view 

of the fact that services make relatively little use of industrial 

products as intermediate inputs. However, one cannot lose 

sight of the fact that import of services also increased fast 

during the same period. So, the growth of net export of 

services was not as fast. Nevertheless this net export being an 

autonomous component of fi nal demand for services, it 

constituted a new source of stimulation of GDP growth as well 

as a relative growth of the share of the service sector in GDP. 

Now, for the induced part of fi nal demand for services, a 

very important source of change in the relative importance of 

services is rise in per-capita income. When the rise in percapita 

income is accompanied by rise in income inequality the 

change in relative share of services may indeed be sharp. 

Table-4 gives an idea of this change for the Indian economy 

over the period 1960-61 to 2005-06. During this period 

private fi nal consumption expenditure (PFCE) on transport 

and communications, education, health and recreation 

increased from a paltry seven percent to as much as 29.8%. 

We note that PFCE on services as a whole increased from 

17.8% to 40.6% over the last two decades and a half. But this 

98 


impact got a bit softened buy the fall of PFCE as a proportion 

GDP at market prices roughly from about 75% to 65%. Even 

then it is clear that there was a large shift in fi nal demand from 

goods to services. Such shifts in demand from goods to 

services inevitably lead to a substantial increase in sectoral 

share of services. 

Towards a Conclusion: 

Our discussion above shows that in the process of growth of 

the Indian economy the weight of services in private consumption 

expenditure increased markedly. Demand for industrial 

products also increased rapidly for private consumption as 

well as capital formation. This is evidenced by the share of the 

secondary sector in GDP. This resulted in growing ‘spread’ 

and ‘depth’ of industry. The growth of industry led to faster 

growth of demand for intermediate services. Thus, on the 

whole, the service sector has grown rapidly, through demand 

for both fi nal and intermediate services, following the intrinsic 

logic of development. 


• Baumol, W. J. (1967), "Microeconomics of Unbalanced 

Growth: The Anatomy of Urban Crisis", American Economic 

Review, Vol.57, June. 

• Datta, M (2001), The Signifi cance and Growth of the 

Tertiary Sector: Indian Economy – 1950 to 1997, 

Kuznets, S.(1971), Economic Growth of National : Total 

Output and Production Structure, The Belknap Press of 

Harvard University Press, Cambridge, Massachusetts. 

• Rakshit, M. (2007), Services-led Growth: the Indian 

Experience, Money and Finance, III (1), New Delhi. 

• Smith, A. (1776), An Inquiry into the Nature and Causes of 

the Wealth of Nations, Cannan, E. (ed), The Modern 

Library, New York. 

• Wagner, A. (1883), Three Extracts on Public Finance, 

Extracts from Finanzwissenschaft, Part I, Third Edition, 

Leipzig, reprinted in Classics in the Theory of Public 

Finance, Musgrave, R.A. and Peacock, A.T. (eds), 1958, 

Macmillan, London. 

• World Bank (2004), Sustaining India’s Services Revolution, 

Report on the South Asia Region: India. 


the offi cial policy or position of the organisation).


100 1 0 

Modern Theories of 

Growth: A Critique 

THE T HE H IIPM II III PM THI TH TTHINK HI H NK K TANK TAN TANK

Chanadana Ghosh 

Economic Research Unit, Indian 

Statistical Institute (ISI), Kolkata 

Ambar Ghosh 

Economics Department, Jadavpur 

University, Kolkata 

1. Introduction 

The objective of the modern theory of growth is to explain the 

growth in the trend values of aggregate output and employment. 

Its focus is therefore on the long run. It is based on the 

Natural Rate Hypothesis (NRH). The NRH states that in the 

short run a market economy behaves in accordance with the 

Keynesian theory, while the classical theory best describes its 

behaviour in the long run. The NRH in its turn is based on the 

concept of natural rate of unemployment. It 

is defi ned as the rate of unemployment that 

obtains when demand for and supply of 

labour are equal. But, why should there be 

unemployment in such a situation? The 

exponents of the NRH have given two 

major reasons, namely, imperfect information 

and imperfect spatial and occupational 

mobility of labour. Even if there are 

vacancies and an equal number of suitable 

unemployed people, fi rms may not have the information 

regarding the availability of suitable candidates and unemployed 

people may also lack information regarding the availability 

of suitable vacancies and both the parties may have to 

spend some time searching before the vacancies get fi lled up. 

By the time one set of vacancies gets fi lled up, another set of 

vacancies is created and a new group of people enter the labour 

market. This is how unemployment may persist, even when 

demand for and supply of labour are equal. Similarly, concentrations 

of unemployment and vacancies may be in different 

geographical areas and occupations and hence unemployment 

may persist despite matching number of vacancies because of 

imperfect mobility of labour. It is assumed that because of shifts 

In the long run 

we are in the 

world of the 

classical theory, 

where output is 

determined by the 

supply side factors 


A N ELUSIVE QUEST 

in aggregate demand for fi nal goods and services the rate of 

unemployment is above the natural rate in times of recession 

and below it in times of boom so that the trend value of the rate 

of unemployment equals the natural rate in every year. In other 

words, in the long run, the economy is always in the situation of 

full employment. The growth in the trend values of output is 

therefore due to growth in the supplies of labour and capital 

and also due to technological progress that brings about shifts 

in the production function. Accordingly, in the long run we are 

in the world of the classical theory, where output is determined 

by the supply side factors. The NRH invokes the Keynesian 

theory only to explain the deviation of the actual rate of 

unemployment from its trend value in every year (or in every 

short period, which is a year at the maximum). The NRH thus 

neatly compartmentalizes the study of the behaviour of aggregate 

output and employment into two separate fi elds: one 

analyses the trend values of output and unemployment and the 

other focuses on deviations of actual values of aggregate output 

and employment from their respective trend values in different 

short periods. The former constitutes the long run macroeconomics, 

while the latter is the subject of short run macroeconomics. 

The importance of NRH can therefore 

hardly be overestimated in macroeconomics 

today. Accordingly, it is imperative to 

subject it to close scrutiny. The proponents 

of NRH point out that no one has ever 

observed an economy without unemployment. 

However, at the same time they fi nd 

it hard to believe that a market economy 

never achieves full employment. They 

refuse to subscribe to the view that demand defi ciency and 

involuntary unemployment may be, as held by Keynes and also 

by the Keynesians in the hey days of Keynesianism, the natural 

state of affairs in a market economy. Instead, they assume that 

there exists unemployment even in situations of full employment 

and invokes imperfections in information dissemination 

and mobility of labour to explain that. They point out that an 

economy is always in a state of fl ux. Not only does the aggregate 

demand fl uctuate, so also does the composition of aggregate 

demand. The shifts in the composition of aggregate demand 

engender switch in demand from one kind of labour to another 

and also from goods and services produced in one region to 

those produced in another region. Following the innovations of 

101


computers, for example, demand switched to computers from 

typewriters and thereby to computer operators from typists. 

This kind of shifts in demand is referred to as sectoral shifts. 

Since sectoral shifts occur all the time in market economies, it is 

argued, unemployment is inevitable in such economies because 

of imperfections in information dissemination and imperfect 

mobility of labour across occupations and regions, even when 

aggregate demand for and aggregate supply of labour are equal. 

The kind of unemployment that is given rise to by the sectoral 

shifts on account of the imperfections noted above is called 

frictional unemployment. 

The above argument, though seems plausible superfi cially, 

wilts when subjected to close scrutiny. Let us explain. First, 

focus on the case of imperfect information alone and ignore 

imperfect mobility of labour, i.e., assume for the present that 

information is imperfect, but labour is perfectly mobile. Start 

from a situation of full employment. 

Suppose there takes place a change in the 

composition of demand in favour of one 

industry at the expense of another. The 

favoured sector will recruit and expand, 

while the other sector will downsize. It is 

argued that this will lead to unemployment 

as the contracting sector will release labour, 

but the expanding sector will take time to 

recruit because of lack of information 

regarding the availability of suitable unemployed candidates. 

The unemployed workers will also take some time to collect 

information regarding the availability of suitable vacancies. This 

argument does not seem acceptable. Reasons are the following. 

First, in this age of information revolution, there are a large 

number ways of advertising vacancies. There are numerous 

news papers, TV channels, internet and so on. Information can 

be made available and recruitments can be done within a very 

short period of time. Second, fi rms also take time to sack, if they 

think that the change is temporary, as it is costly to train new 

recruits, to make them adapt to the new environment, to learn 

about their skills, sincerity, honesty etc. This phenomenon is 

referred to as labour hoarding and it is quite common. Firms 

downsize only when they think that the shift is a long term one. 

Finally, if sectoral shifts are regular and important, as the 

proponents of NRH emphasize, the workers are always under 

the threat of losing jobs, while fi rms are also under the threat of 

losing profi t because of the delay involved in fi lling up vacan- 

102 


Demand 

deficiency and 

involuntary 

unemployment 

are chronic 

in decentralized 

market economies 

cies. Under these circumstances it is quite natural that institutions 

and practices will emerge to take care of the problem. 

Employment agencies will emerge to place the workers apprehending 

job cuts in fi rms expecting a favourable turn in demand. 

Firms of repute are likely to emerge specializing in 

supplying suitable candidates to fi rms immediately on demand. 

These fi rms will act as an intermediary between workers under 

the threat of losing jobs and workers about to enter the labour 

market on the one hand and the fi rms seeking to expand and 

hire on the other. Hence unemployment given rise to by 

imperfections in the information dissemination system does not 

stand up to close scrutiny. It should be particularly unacceptable 

to those who believe in the effi cacy of the market mechanism. 

Ironically, it is those very people who harp on the imperfections 

in information dissemination. 

Let us now consider the case of imperfect mobility of labour. 

Start from a situation of full employment 

and consider a shift in demand in favour of 

doctors at the expense of engineers, giving 

rise to excess demand for doctors and just 

the opposite for engineers. If wages and 

prices are perfectly fl exible, they will adjust 

and clear markets for both types of labour. 

There will be no unemployment in this case. 

However, if wages and prices are rigid, 

sectors employing doctors will not expand 

because of shortages of doctors, but those employing engineers 

will contract. In this case, the impact of the demand shift is 

similar to that of a contraction in aggregate demand. Engineers 

become involuntarily unemployed – as they are willing to work 

at the going wage rate for the engineers and an increase in 

aggregate demand will reduce their unemployment. Two points 

emerge from the above example. First, sectoral shifts create 

unemployment if and only if wages and prices are rigid. The 

unemployment is therefore involuntary. Second, if sectoral 

shifts are accompanied by price rigidity and give rise to unemployment 

due to imperfect mobility of labour, they will in no 

time snowball into full fl edged recessions. The contracting fi rms 

will cut output, but the fi rms planning expansion will fail to do 

so because of paucity of suitable labour. Aggregate income will 

therefore fall reducing aggregate demand and thereby inducing 

further cut in aggregate output. The contracting fi rms will lose 

and therefore will be in fi nancial diffi culty. Default rate will rise 

putting the lending institutions in trouble. They will ration

credit more severely. It will reduce demand again. These 

contractions will mutually reinforce and cumulate and push the 

economy in a recession. From the above it follows that, if 

unemployment is due to sectoral shifts, there is rigidity in the 

price system. Moreover, if sectoral shifts combine with price 

rigidity and imperfect mobility of labour, they generate strong 

recessionary forces. If one admits that sectoral shifts, price 

rigidities and imperfect mobility of labour are common features 

of market economies, as the proponents of the NRH do, one 

also concedes that a market economy is normally recession 

prone and demand defi ciency and involuntary unemployment 

are rules rather than exceptions. In other words, the implication 

of the assumptions of the proponents of the NRH is that 

demand defi ciency and involuntary unemployment are chronic 

and systemic in decentralized market economies. Sectoral shifts 

that generate unemployment are hardly as innocuous as the 

proponents of the NRH make us believe. 

They have strong destabilizing and contractionary 

impact. Thus, in a market economy 

today, it is sensible to regard the observed 

unemployment as being involuntary - a 

product of wage rigidity and inadequacy of 

aggregate demand. The latter is due to 

various factors including sectoral shifts. 

Even though the mismatch between the 

structure of labour demand and that of 

labour supply has been attributed to 

sectoral shifts in the above discussion, it can occur even without 

any kind of sectoral shifts. It is a general feature of market 

economies. Let us explain. Consumption decisions and decisions 

to invest in physical and human capital in such economies 

are taken by individual economic agents independently of one 

another in an uncoordinated manner. Individual decision 

makers cannot have any idea as to what the total demand would 

be for any particular good or for any particular type of labour or 

what the total supply would be of any particular type of labour. 

The input-output relationships across different sectors of 

production and different types of labour change continuously 

with innovations of new technology, products etc. Individuals 

do not and cannot have information regarding these relationship 

or their changes. Accordingly, structure of labour demand 

that is yielded by the composition of aggregate demand and the 

structure of labour supply that arise out of individuals’ investments 

in different kinds of human capital can match only 

In a market 

economy today, 

it is sensible 

to regard 

the observed 

unemployment as 

being involuntary 



accidentally. The phenomenon of sectoral shifts makes the 

scenario more unpredictable. Moreover, prices and wages are 

also normally rigid because of different kinds of market 

imperfections. Hence, involuntary unemployment and demand 

defi ciency are likely to be chronic and systemic in unplanned 

market economies. 

Let us generalize the above argument. Mismatches in 

demands and supplies of the kind discussed above are by no 

means confi ned to labour markets alone. They apply to physical 

capital also with equal force. Capital too is imperfectly mobile 

across different industries. A steel plant can only produce steel; 

it cannot produce power or any other product. A mismatch 

between the structure of demand for capital services yielded by 

the composition of aggregate demand and the structure of the 

supply of capital services is also quite likely to occur in market 

economies. Thus, even though aggregate demand for capital 

services equals their aggregate supply, there 

may be excess demand for one kind of 

capital service (such as the ones producing 

power or transport) and excess supply of 

some other kind (such as the ones producing 

consumer durables). If prices are rigid, 

as is normally the case, because of oligopolistic 

interdependence in case of private 

goods and administered prices in case of 

public goods, these mismatches will not get 

corrected through movements in prices in 

the short run. Let us illustrate with an example. Suppose in a 

given period, there occurs in an economy excess demand for 

roads, water supply etc and an excess supply of consumer 

durables. Prices of the former are non-existent, as they are 

public goods. Hence they cannot rise to correct the situation. 

Prices of the latter may not fall either because of oligopolistic 

interdependence. Hence the situation will give rise to substantial 

excess capacity in the consumer durables industry saddling 

the investors with heavy losses. We can show the problem in a 

different way also. Since different sectors of production are 

interdependent through input-output relationships, investments 

made in different lines of production in any given period have 

to synchronize to ensure full utilization of capacity for the 

economy as a whole. In the example given above, the capacity 

output of the road and water supply sector is too low to enable 

the rest of the economy to fully utilize its productive capacity. In 

this kind of a situation, serious economic problems will arise 

103


leading to recession. In the sectors having excess supply of 

capital, a substantial part of expensive capacities created will 

remain unutilized and the investors will incur heavy losses. 

They are likely to default on their loan obligations creating 

fi nancial diffi culties for the banks and other lending institutions. 

These institutions’ ability to lend will 

get restricted. They will also be more 

cautious in their lending. This will reduce 

credit supply and consequently aggregate 

demand, which will further aggravate the 

situation pushing the economy into 

recession. The kind of problem specifi ed 

above is and should be systemic in market 

economies since consumption decisions 

and decisions to invest in physical and 

human capital are made by individual 

consumers and investors in an uncoordinated manner and 

prices are rigid for reasons already discussed. This problem is 

referred to as that of coordination failure. It is called disproportionality 

crisis by Marx. This is a, if not the, major factor 

that makes a market economy recession prone. Alternatively, it 

makes demand defi ciency a chronic problem in a market 

economy. In times of high rate of growth or boom, when 

104 


capacities are created at a high rate in different areas of 

production in an uncoordinated manner, the problem of 

coordination failure makes newly created expensive capacities 

idle in different lines of production due to scarcities of certain 

specifi c kinds of labour or shortages of some crucial inputs 

badly hurting investors’ morale, even 

though there may be sizeable excess 

capacity and unemployment on the 

aggregate. This has, as we have already 

pointed out, adverse fi nancial implications, 

which push the fi nancial institutions on the 

back foot aggravating the damage to 

business sentiments. The problem of the 

real sector gets magnifi ed through its 

impact on the fi nancial sector. This process 

is referred to as that of fi nancial accelerator 

– see Bernanke et al.(1998). These mutually reinforcing forces 

push the economy into recession much before the state of full 

employment is reached. Again, in an economy in recession, 

with the increase in the pool of unemployed workers, availability 

of all kinds of workers becomes plentiful; supplies of social 

goods improve due to governments’ efforts at stabilizing the 

economy and with the easing up of fi scal constraints on public 

Table 1 : Y-o-Y Growth rates of India's GDP and Its Components at Constant Prices: 

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 

GDP 4.0 5.2 3.8 8.4 8.3 9.2 9.7 9.2 7.1 

Agriculture1 -0.2 0.8 1.8 10.0 0.0 5.9 3.8 5.1 2.6 

Industry 6.4 2.4 6.8 6.0 8.5 8.0 10.6 7.5 4.2 

Services 5.7 6.9 7.5 8.8 9.9 11.0 11.2 11.1 9.2 

( I ) 2 -3.5 -2.9 17.0 19.9 19.5 19.4 10.9 16.9 9.7 

(I – MC) 3 -3.8 -4.0 15.1 19.5 19.1 16.8 9.3 19.0 

C4 3.2 6,2 2.7 5.8 5.2 8.7 7.1 6.5 6.8 

G5 0.9 2.3 -0.4 2.6 2.6 5.4 6.2 7.0 16.8 

Exports 18.0 1.5 17.8 10.8 32.3 20.2 21.8 4.6 21.5 

ELEM6 23.9 1.1 17.2 10.4 33.4 22.9 25.6 5.1 

Imports 8..2 1.5 17.7 12.6 35.1 27.9 24.4 8.2 

Remittances 5.7 22.3 3.8 20.6 -13.3 12.9 10.0 24.1 

1 Agriculture includes forestry and fi shing 

2 I stands for gross investment 

3 (I-MC) stands for gross investment net of import of capital goods 

4 C denotes private fi nal consumption expenditure 

5 G denotes public fi nal consumption expenditure 

6 ELEM stands for exports net of export related imports 

Source: CSO 

Prices and wages 

are often found 

to be inflexible 

downward, but 

they are not so 

in the upward 

direction in deficits

expenditure. With idle capacities everywhere, supplies of all 

kinds of goods become more abundant too. These improvements 

in supply side factors again begin to boost business 

morale leading to a resurgence in economic activities. The 

point of this whole discourse is that price rigidities and mismatches 

between the structures of aggregate demand and 

those of capital and labour due to coordination failure are an 

integral feature of a market economy. They are systemic and 

generate chronic demand defi ciency and involuntary unemployment. 

They are the main reason why booms turn into 

recession much before the state of full employment is reached. 

Even the current recession in the US ravaging the developed 

world has its roots in massive over-investments in the real 

estate far in excess of genuine demand for housing. The reason, 

again, lay in large scale coordination failure. The increasing 

profi tability of investment in the housing sector led to tremendous 

overinvestment in housing precipitating the crash. 

It thus seems more sensible to regard the observed unemployment 

in a market economy as being involuntary. Apart 

Table 2 : Cross Country Comparisons of Various Economic Indicators 

Country Growth Rate 

GDP 

Canada 

=0.42 

UK 

=0.37 

US 

=0.39 

Japan 

=0.43 

Hong Kong 

=0.37 

Singapore 

=0.49 

South Korea 

=0.30 

Taiwan 

=0.26 

Contribution 

Capital 



from the argument spelt out above, there are other factors that 

tend to make aggregate demand defi cient. People have to save 

to fend for old age, infi rmity etc. Hence consumption demand 

usually falls far short of aggregate output. Investment is highly 

risky and people are generally risk averse. Government expenditure 

is subject to severe budget constraints, given governments’ 

obsession with revenue and fi scal defi cits. For these reasons also 

demand defi ciency may be the norm rather than an exception. 

Even casual empiricism shows that nominal prices are fairly 

rigid and there is no dearth of supplies of goods and services at 

their given prices. If demand defi ciency and involuntary 

unemployment are chronic, it means that in times of recession 

the rate of involuntary unemployment is large and it is small in 

times of boom. Besides the factors noted above, there is 

another reason why a market economy may fail to achieve full 

employment. Usually, there is an asymmetry in the price 

adjustment processes. Prices and wages are often found to be 

infl exible downward, but they are not so in the upward direction 

in the event of shortages. The reason is not far to seek. First 

Contribution 

Labour 

OECD Countries 1960-1995 

TFP Growth 

Rate 

Per Capita 

Growth 

Rate 

0.0369 0.0186 0.0123 0.0057 0.0077 

0.0221 0.0124 0.0017 0.008 0.0175 

0.0318 0.0117 0.0127 0.0076 0.0201 

0.0566 0.0178 0.0125 0.0265 0.0276 

East Asian Countries 1966-1990 

0.073 0.03 0.02 0.023 0.019 

0.087 0.056 0.029 0.002 0.0279 

0.103 0.041 0.045 0.017 -0.047 

0.094 0.032 0.036 0.026 -0.0444 

Source: Estimates of OECD countries are taken from Jorgenson and Yip(2001) 

Estimates of East Asian countries are taken from Young (1995) (QJE,110,August,641-680). 

The last column is the authors’ own calculations. 

105


recession and fi rms have insuffi cient 

demand for their products. A 

s 

1950s 1960s 1970s 1980s 1990s 1991-92 – 

1996-97 

1997-98 – 

2002-03 

2003-04 - 

2006-07 

unilateral cut in wages in such a 

situation and the consequent adverse 

response of the workers may be 

enormously costly to the fi rms. Any 

kind of supply failure in such a 

scenario may lead to a sizeable loss 

in market share and this loss may far 

consider the prices of produced goods and services. Markets of outweigh the gain due to the wage cut. There are also minimum 

these goods are oligopolistic. When there is excess capacity in wage legislations setting fl oors to money wages. In the event of 

the fi rms, no fi rm risks cutting its price unilaterally, as it will labour shortages, however, fi rms can offer higher money wages 

lead to a price war saddling all the fi rms with losses. When all without the adverse consequence noted above. This explains the 

fi rms in an industry engage in competitive price cuts, it has asymmetry in the price adjustment mechanism. This asymmetry 

ruinous implications for them all. But in times of shortages, coupled with the problem of coordination failure may check 

fi rms may unilaterally raise their prices, as there is no risk of output expansion in times of boom much before full employ- 

losing customers to the rivals, since every producer is capacity ment is attained. Let us explain. Capital structure and labour 

constrained. In case of labour, as Keynes pointed out, money structure, as we have already explained, are far from balanced 

wages do not fall in the face of unemployment on account of in market economies, given the lack of coordination among the 

workers’ resistance. Worker unions resist such cuts. Firms may individual decision makers and that of information. Hence, as 

also consider it imprudent to cut wages despite workers’ aggregate demand rises relative to productive capacity, short- 

resistance unilaterally to earn the infamy of being a bad ages of various kinds of goods and labour begin to crop up 

employer. If a fi rm gets singled out as a bad employer, it will not putting upward pressure on prices. This is the standard trade- 

be able to retain or get to recruit the best of the workers and off between infl ation and unemployment that the traditional 

thereby will lose out in competition. Unemployment and Phillips curve captures. Since the government and the central 

recession go hand in hand. In times of unemployment, there is bank do not want the rate of infl ation to rise beyond some 

tolerable levels, they may adopt contractionary 

programmes much before the full 

employment level of output is reached. 

This may also be one of the reasons why a 

market economy never attains full 

employment. In this case, even though 

prices move in the upward direction, it 

cannot do so fully to adjust the pattern of 

demand to that of supply owing to 

government intervention. 

Once we accept that demand defi ciency 

is chronic, a position which seems to 

be much more sensible and logical than 

the NRH, the sharp division between the 

short run and long run analyses in 

macroeconomics dissolves altogether. 

The focus shifts to the year-on-year 

growth rates, which have to be explained 

1 9.7 12.3 17.2 19 23 22.7 24.1 32.7 

y2 Table 3: Saving Ratio and Per Capita Income in India (1950-51 – 2006-07) 

6737 7888 8880 10691 14761 14012 17812 22776 

1 s represents gross domestic savings as percentage of GDP 

2 y represents per capita GNP at factor cost at constant 1993-94 prices. It is measured in Rupees (crore). 

Source: CSO 

Table 4: Average Annual Growth Rate (%) of Gross Domestic Product 

Average Annual Growth PPP per capita Rank 

Rate (%) of GDP GNP ($) 

Country 1990 -2000 2000-2004 2004 2004 

Low Income Countries 4.7 5.5 2258 

Middle Income Countries 3.8 4.7 6644 

High Income Countries 2.7 2 31009 

China 10.6 9.4 5890 108 

Vietnam 

Ireland 

India 

United States 

United Kingdom 

Japan 

7 

7.5 

6 

3.5 

2.7 

1.3 

7.2 

5.1 

6.2 

2.5 

2.3 

0.9 

2700 

32930 

3120 

39820 

31430 

29810 

149 

8 

144 

3 

14 

18 

France 2 1.5 29460 20 

Source: World Development Indicators 2006, The World Bank 

106 


using the short run models only. 

The above observations throw the area of growth wide open. 

It need not necessarily be the exclusive preserve of long run 

macroeconomics that focuses solely on the supply side factors. 

It may be better to study growth by focusing on the year-on-year 

growth using the Keynesian models. The short run Keynesian 

model determines Y or Y . Given Y , it determines a growth 

t t-1 

rate as well. Growth rates in a market economy fl uctuate a great 

deal, but they do so within limits. Growth rates usually follow a 

cyclical pattern. Periods of high growth rates are followed by 

those of low ones and vice versa. Consider, for example, the 

fi gures in Table 1, which shows that India was in recession 

during 2000-01 to 2002-03. However, this phase was followed by 

a period of high growth from 2003-04 to 

2007-08. The growth rate slumped a little 

again in 2008-09. Thus the growth rate 

neither goes on rising steadily over time nor 

does it keep on falling monotonically, even 

though the average or the trend growth rate 

may show a tendency to rise, as is the case in 

India. These fl uctuations in year-on-year 

growth rates are best explained using the 

short-run models. It should be noted in this 

context that in India both demand and 

supply constraints operate at the same time and this makes the 

study of growth much more complicated. Let us elaborate. Even 

casual empiricism shows that in India prices of privately 

provided nonagricultural goods are highly rigid and there is no 

dearth of these goods at these rigid prices. Hence outputs of 

these goods are demand driven. However, there are many 

publicly provided goods in India, which are supplied either free 

of charge or at non-remunerative administered prices, and 

there are marked shortages of these goods. These goods include 

power, potable water, roads, water from major irrigation 

projects etc. Outputs of these goods are capacity constrained. 

Output of the agricultural sector is also given in the short run. 

This is because agriculture is a nature process; production 

requires a pre-specifi ed period of time; and there is no scope 

for adjusting output during the time that elapses between one 

sowing season to the next. To explain growth in India’s GDP in 

a given year, one has to therefore undertake a disaggregated 

study. Growth in the privately provided non-agricultural goods 

has to be explained in terms of growth in their demand, while 

the growth in the publicly provided goods and agricultural 

The neoclassical 

theory of growth 

states that a 

market economy 

in the long run 

eventually attains 

steady state 



output will be determined by the growth in their productive 

capacity due to investments in earlier periods. Note that 

productive capacity in agriculture depends crucially on public 

investment in major irrigation in dry land areas, fl ood control 

facilities in areas prone to fl ooding, inventions of better seeds, 

farming practices etc. The last two in India also depends 

crucially upon public investment in agricultural R&D. Thus 

Keynesian economics does not apply fully to Indian macro 

economy. When GDP is demand driven, its growth can be 

explained in terms of growth in the autonomous components of 

aggregate demand, namely, investment, government consumption 

and export. From the data in Table 1 one can compute the 

growth rates of these components of aggregate demand. But the 

sum of these growth rates, as one can easily 

check, cannot explain fully the growth 

performance of GDP in India during the 

period under consideration – see in this 

context Rakshit( 2009 ). 

We shall now critically assess the major 

theories of long run growth based on the 

NRH. In fact, we shall discuss the pioneering 

work of Solow (1956) and the endogenous 

growth theory that it gave rise to and 

evaluate the results they yield. The model 

Solow(1956) developed is referred to as the Solow model or the 

neoclassical theory of growth. 

2. The Neoclassical Theory of Growth 

The Solow model states that a market economy in the long run 

eventually attains steady state. In the steady state per capita 

growth rates of capital and output are equal to the rate of 

technological progress, which we denote by m. The value of m is 

exogenously given in the model. In the out of steady state 

situations, however, per capita growth rate becomes a function 

not only of m but also of the economy’s saving ratio, the rate of 

depreciation and the rate of growth of population, denoted by s, 

δ and n respectively. Like m, they are all parameters in the 

Solow model. 

Let us now examine whether or how one can apply these 

results of the Solow model to explain the long run growth 

performance of a country. In this context, two alternative 

assumptions are possible. One may assume, for example, that in 

the long run an economy is always in steady state. If this 

assumption is made, per capita growth rate of GDP in the long 

107


run must equal the rate of technological progress. This implies 

that the rate of growth of the trend values of GDP should 

exceed the trend rate of growth of the labour force by the rate 

of technological progress. Surprisingly, none of the major 

empirical studies carried out so far make this assumption. 

Obviously, Solow model cannot explain long run growth 

performance if the above assumption is made. In fact, data 

given in Table 2 do not give any prima facie support to the result 

of the Solow model. It shows that countries with high per capita 

growth may have low total factor productivity (TFP) growth, 

which is a measure of the rate of technological progress, and 

vice versa. Thus UK with a per capita growth of 1.75 percent 

had a TFP growth rate of 0.8 percent, while US with a higher 

per capita growth of 2.01 percent recorded a lower TFP growth 

rate of 0.76 percent. The result becomes all the more startling 

when we fi nd that South Korea and Taiwan with negative per 

capita growth rates of -4.7 percent and -4.4 percent had TFP 

growth rates of 1.7 percent and 2.6 percent respectively. Hong 

Kong, whose per capita growth rate of 1.9 percent was close to 

that of UK registered a substantially higher TFP growth rate of 

2.3 percent. Thus the data do not seem to support the result of 

the Solow model, if we assume that the economies in the long 

run are more or less in steady state all the time, i.e., the trend 

values of the endogenous variables of the Solow model refl ect 

more or less their steady state values always. 

Alternatively, one may assume that the economies even in the 

long run are usually out of steady state. When an economy is 

not in steady state, its growth rate, as follows from the Solow 

model and as we have mentioned above, is determined by the 

parameters of the Solow model. Even though all the empirical 

studies in the mainstream growth theory assume the economies 

to be out of steady state, none of them has tried to verify this 

result. This is surprising in view of the fact that the Solow model 

dominated growth literature for nearly three decades. We have 

dwelt on this issue later in the concluding section. From the 

above it follows that the rate of technological progress is an 

important determinant of the rate of growth of GDP in Solow 

model in both steady state and out of steady state situations. 

Hence we shall discuss below how the rate of technological 

progress is measured in the mainstream growth theory. 

The rate of technological progress is measured on the basis of 

a number of assumptions, which are extremely hard to accept. 

The mainstream macroeconomists assume that there exists an 

aggregate production function that displays constant returns to 

108 


scale and factors of production are paid in accordance with 

their marginal productivities. For simplicity, suppose that the 

aggregate production function is Cobb-Douglas and it is given 

by . Note that the power of each factor gives the 

share of its income in GDP, when the price of each factor equals 

its marginal productivity. Taking logarithm of both sides of the 

Cobb-Douglas production function specifi ed above and 

differentiating them with respect to time, we get 

................................... (1) 

From (1) it follows that the part of the growth in GDP that is 

due to growth in capital and labour is given by . 

The remaining part of the growth in GDP, , 

is due to growth in A, . , which is referred to as Solow residual 

or total factor productivity growth, is usually regarded as a 

measure of technological progress. The above discussion 

suggests a method of measuring . Suppose one wants to 

measure the rate of technological progress in an economy in a 

given decade. One can do so by estimating the average growth 

rates of GDP, capital and labour and the average shares of 

capital and labour during the decade and then by computing 

for the given decade. This method of 

estimating the rate of technological progress is far from satisfactory 

for reasons that we shall explain shortly. (Barro and 

Sala-I-Martin (2004) refers to the above measure of technological 

progress as the primal measure. They have discussed a dual 

measure also. But the latter is based on the same set of assumptions 

as the former.) 

Let us now explain why the above method of measuring the 

rate of technological progress is fl awed. It is so because it 

assumes that the markets are perfectly competitive and factors 

are paid in accordance with their marginal productivities. 

Obviously, almost all the markets in modern developed 

economies today are oligopolistic. In countries like India also, 

this is true except for the markets of agricultural goods, which 

are competitive. Thus, most of the producers earn super 

normal profi t. This means that return on capital far exceeds its 

marginal productivity. 

It is in fact not necessary to resort to marginal productivity 

theory of factor pricing to develop a measure of technological 

progress. The theory is patently false. Mark-up pricing rule in 

oligopolistic industries is regarded as the norm by many writers, 

see, for example Kalecki(1954). Under this rule, price is set by 

applying a fi xed mark-up to the average variable cost of 

production. For the economy as a whole, the average variable

cost consists only of labour cost. If the requirement of labour 

per unit of output is , the average price of goods and services 

under the mark-up pricing rule is given by 

......(2) 

where the average price of goods and services, the fi xed 

average mark-up and the average money wage rate. In (2), 

is historically and exogenously given. It is to be estimated 

from the data on costs and prices. Given the diffi culty of 

estimating demand functions and the complexities thrown on it 

by oligopolistic market structures and the price rigidity that the 

oligopolistic interdependence entails, the application of a 

historically given mark-up to the average variable cost to set up 

the price seems to be eminently sensible and therefore rational. 

From (2) it follows that the share of labour in 

GDP = ...........(3) and share of profi t or 

capital in 

GDP = ...................(4) 

Equations (3) and (4) determine factor shares in terms of the 

average mark-up, . It also suggests a measure of technological 

progress. Since labour is much more variable than capital, 

labour requirement per unit of output may 

be regarded as a technology-determined 

variable. So the rate of decline in l, i.e., the 

rate of increase in the average productivity 

of labour, may be taken to be an index of 

the rate of technological progress. This is 

quite a satisfactory measure of technological 

progress in an economy with an insignifi - 

cant agricultural sector. This is because in 

the non-agricultural sector diminishing 

return to labour is not much pronounced 

and this makes the labour requirement per unit of output more 

or less constant corresponding to any given technology. Since 

there are usually restrictions on hiring and fi ring of labour and 

also on account of the phenomena such as labour hording and 

sectoral shifts, it may be sensible to use the trend values of l for 

measuring the rate of technological progress. 

Finally, it is extremely diffi cult to accept the Solow model as a 

theory of long run growth. In this model, per capita output or 

the rate of growth of per capita output is an endogenous 

variable. However, it is hard to imagine the parameters of the 

Solow model such as s, δ, n etc. as being independent of per 

The Endogenous 

growth theory 

broadened the set 

of determinants 

of the per capita 

growth rate of 

an economy 



capita output especially in the long run. An increase in per 

capita output raises individuals’ capacity to save and thereby 

tends to step up s. It also tends to lower n. It also tends to make 

more resources available to the government per capita, which in 

turn improves per capita supplies of public goods such as 

drainage, protection from natural calamities, public administration, 

defence etc. leading to a fall in δ. Obviously, in this kind of 

a scenario, the Solow model ceases to hold. It has been claimed 

that in the long run the saving function is proportional. However, 

Indian data do not support this. As we fi nd from Table 3, 

saving ratio has increased steadily over time along with per 

capita income. Thus the Solow model breaks down altogether at 

least in the context of the India economy. 

3. Endogenous Growth Theory 

The mainstream growth theory since the mid-eighties tried to 

extend the Solow model by endogenising the rate of technological 

progress. In other words, they tried to formulate theories 

that explain the value of m of the Solow model. Pioneering 

attempts in this regard were made by Lucas(1988) and 

Romer(1986,1990). The growth theory that they developed is 

referred to as the endogenous theory of growth. It is a vast 

literature, which is still growing at a fast 

rate. The endogenous growth theory that 

took off phenomenally from the pioneering 

studies of Lucas and Romer broadened the 

set of determinants of the per capita growth 

rate of a country. It traced the per capita 

growth rate to a whole host of factors such 

as the educational attainment and state of 

health of the people, the share of resources 

devoted to R&D, the rule of law, democracy, 

openness of the economy etc. The 

general problem with the endogenous growth theory is that all 

the different determinants of per capita growth rate that this 

literature identifi es are increasing functions of per capita 

income. Accordingly, they assume highest levels in the developed 

countries, which, however, grow at substantially lower 

rates than many much poorer economies. Table 4 shows that the 

average annual growth rates of GDP during 1990-2000 and 

2000-2004 were the highest in the low income countries, second 

highest in the middle income countries and lowest in the high 

income countries. It also shows that China ranked 108 on the 

basis of per capita income in 2004 recorded highest growth 

109


during the given periods followed by Vietnam ranked 149. The 

third highest growth rate was recorded by Ireland ranked 8th , 

but the fourth highest growth rate was recorded by India ranked 

144th . The richest countries such as the US, UK, Japan and 

France ranked 3rd , 14th . 18th and 20th respectively recorded quite 

modest growth rates. The endogenous growth theory therefore 

prima facie does not stand up to close empirical scrutiny. In 

what follows we shall dwell on the empirical studies that have 

been made on the endogenous growth theory. 

4. Empirical Results and Concluding Remarks 

Empirical studies on the mainstream growth theory, which 

includes the Solow model and the endogenous growth theory, 

focus on three issues in the main, namely, growth accounting, 

explanation of cross-country differences in the long run rates of 

growth and convergence. Growth accounting assumes that 

there are three sources of growth, viz, rate of growth of capital, 

rate of growth of labour and technological progress. It seeks to 

decompose the growth rate of GDP into the contributions of 

these three sources (see, for example, Barro 

and Sala-I-Martin(2004)). We have already 

explained the problems with this kind of 

exercise. The other studies are cross-section 

studies and they seek to explain cross-country 

differences in growth rates. To that end 

they regress long run per capita growth 

rates of different countries on a whole host 

of factors in addition to per capita output as 

explanatory variables such as educational 

attainment, infant mortality rate, life 

expectancy, rule of law, degree of democracy etc. Note that per 

capita income must be an important determinant of all these 

factors. The higher the per capita output, the greater is the 

ability of the people to spend on education, health and less is 

likely to be the incidence of crime. Again, the higher the per 

capita output, the greater is the taxable capacity of the people 

and therefore the larger is the amount of resources at the 

command of the government leading to greater provision of 

public goods such as public administration, health care, 

education, potable water, sanitation etc. per capita. For both 

the reasons, the richer a country the greater is likely to be the 

values of the explanatory variables mentioned above. Accordingly, 

per capita growth rate should be the highest in the richest 

of the nations. Unfortunately, as we have already pointed out – 

110 


If all other 

variables are 

held constant, an 

increase in per 

capita income 

tends to lower the 

per capita growth 

see Table 4 in this context - there is prima facie no evidence to 

that effect. 

These studies also claim that they have found evidences for 

conditional convergence even though not for absolute convergence 

(see Barro and Sala-I-Martin(2004) in this context). In 

other words, they have found that if all other variables are held 

constant, an increase in per capita income tends to lower the 

per capita growth rate and vice versa. The meaning of this result 

is the following. If, for example, in India, per capita income rises 

alone in the long run and all other explanatory variables remain 

unchanged, the long run growth rate in India will tend to fall. 

The mainstream growth theorists regard this result as an 

evidence of conditional convergence. This means that every 

country tends to move towards its respective steady state. As we 

have already pointed out, this kind of exercise hardly makes any 

sense. The notions of conditional convergence follow from the 

Solow model. Since saving rate, rate of growth of population 

and the rate of depreciation are all functions of the per capita 

income in the long run, the model breaks down altogether. In 

fact, tastes and preferences change drastically 

in the long run. They change with 

changes in individuals’ surroundings and 

environment that accompany growth in 

income. Under these conditions, the 

endogenous growth models also cease to 

hold and the steady states that they derive 

become meaningless. This is the basic 

problem of developing a long run theory of 

growth. To quote Keynes, “in the long run 

we are all dead”. 

If we look at the aggregative group-wise raw data, we fi nd 

that, as we pointed out earlier, the long run growth rate varies 

inversely with the degree of development – see Table 4. This is 

in sharp contrast with the predictions of the endogenous growth 

theory. If we focus on more disaggregated country-wise data, 

please refer Table 4, we fi nd that many of the richest of the 

nations persistently grow faster than many of the poorest 

nations, while some poor nations grow at a much faster rate 

than many of the richest nations. Actually, countries with high 

per capita income have many advantages, which the others do 

not have. Governments have larger resources per capita, which 

enables them to supply better and more public goods per capita. 

This implies better infrastructure, better administration, greater 

protection of life and assets and better quality of human capital

leading to higher productivity of capital. People can also spend 

more on education and health contributing to the quality of 

human capital. The rich nations can also afford to engage in 

R&D on a larger scale, given the superior fi nancial might of 

their fi rms and their greater access to quality manpower. All 

these factors create a solid base for high rates of growth from 

the supply side. In other words, all the explanatory variables 

identifi ed by the mainstream growth theory for explaining per 

capita growth rate assume highest values in the richest of the 

nations. Accordingly, if the mainstream growth theory is true, 

per capita growth rate should the highest in the richest of the 

nations. Despite this, some poor economies grow at much faster 

rates than the rich ones – please refer Table 4. Obviously, this 

cannot be explained by the mainstream growth theory, as it 

focuses on the supply side factors alone. Even in the long run, 

demand side factors remain crucially important. Hence, the 

following may be a much more sensible explanation of the 

cross-country differences in the growth performances. Poorer 

countries have much greater urgency to grow fast to remove 

poverty, to catch up with the rich to cope with the international 

competition and even for self defence. This induces many of the 

governments in developing countries to play active roles in 

promoting growth. Moreover, in poor countries most of the 

people have little protection against the elements of nature, 

diseases etc. They hardly have enough to eat. To stay in power 

even in totalitarian regimes on a sustained basis, support of 

these people is crucial. Competition among politicians for 

power therefore brings the development issues in the forefront 

for garnering support. Hence government plays an important 

role in promoting development in these countries. Governments’ 

policies range from direct public investment in different 

sectors to subsidization of saving and investment. This contributes 

to sustaining a high rate of growth in demand for goods 

and services. In the developed countries, since per capita 

income is much higher, the urgency of growth is much less. 

Moreover, most of these countries are against large and 

infl uential governments. They recommend minimization of 

government intervention in economic matters. For these 

reasons governments in these countries do little to directly 

stimulate growth. Growth in consumption is likely to slacken 

with development. The constraint that income puts on consumption 

eases with the increase in per capita income. But 

factors such as the physical capacity to consume, the time 

available for consumption etc. also act as constraints and they 



gain in importance with the rise in per capita income and fall in 

the rate of growth of population. Rate of growth of consumption 

in developed countries accordingly depends crucially upon 

the rate of arrival of new and superior quality consumption 

goods in the market. In richer countries therefore growth in 

consumption demand and, therefore, that in investment are 

largely innovation driven. The growth rates are accordingly low. 

New investment does not add to capacity much. It leads to 

better products and makes a part of the existing productive 

capacity obsolete. For these reasons growth rates in rich 

countries may be low. The mainstream growth theory’s predictions 

go wrong as they focus only on the supply side factors and 

ignore the demand side factors completely. 


• Barro, R.J. and Sala-i-Martin, X.(2004). Economic Growth, 

Prentice Hall, India 

• Bernanke, B, Gartler M and Gilchrist, M. (1998). The 

fi nancial accelerator in a quantitative business cycle framework, 

NBER Working Paper 6455 

• Jorgenson, D.W. and Yip,E.(2001). Whatever happened to 

productivity growth? In E.R.Dean, M.J.Harper and C. 

Hulten, eds., New Development in Productivity Analysis, 

Chicago University Press 

• Kalecki, M.(1954). Theory of Economic Dynamics: An Essay 

on Cyclical and Long-Run Changes in Capitalist Economy, 

Allen & Unwin 

• Lucas,R.E.Jr.(1988). On the mechanics of economic development, 

Journal of Monetary Economics, 22, July 

• Rakshit, M.(2009). India amidst the Global Financial Crisis, 

Economic and Political Weekly, Vol.44, No.13, March28 

– April 03 

• Romer, P,M.(1986). Increasing returns and long run growth, 

Journal of Political Economy, 94, October 

• Endogenous Technological Change, Journal of Political 

Economy, 98, October, Part II 

• Solow, R., M.(1956). A contribution to the theory of economic 

growth, Qurterly Journal of Economics, 70, February 

• Young, A.(1995). The tyranny of numbers: confronting the 

statistical realities of the East Asian growth experience, 

Quarterly Journal of Economics, 110, August. 



111

W ELFARE ECONOMICS 

Employment Guarantee, 

Not Employment Subsidy 

Approach Suits Indian 

Conditions 

112 


Saumitra Mohan 

Additional District Magistrate (General), 

Burdwan, West Bengal 

A 

liberal welfare state tries to ensure equitable 

distribution of the development pie by resorting to 

myriad ways of redistributive allocation of values 

among its citizens. One of such measures include employment 

guarantee schemes for the toiling masses to ensure them 

Illustration : Shantanu Mitra 

R ETHINK AND RESURGE 

work for minimum number of days on pre-decided subsistence 

wages. It is with this objective that the National Rural 

Employment Guarantee Scheme (NREGS) was launched in 

all the districts of this country. This follows on the back of 

various employment generation and food for work programmes 

including Integrated Rural Development Programme 

(IRDP), Community Development Programme 

(CDP) and Swarnajayanti Jawahar Rojgar Yozna (SJRY). 

NREGS is actually predicated on the experiences and 

knowledge gained during implementation of all these 

previous schemes. 


113


Since then, many observers have come up with suggestions 

and proposals for further fi ne-tuning of this fl agship employ- 

ment guarantee programme. This author read with interest an 

article recently which espoused the idea to provide employment 

subsidies to employers instead of providing guaranteed 

jobs through state-run employment generation programmes 

like the NREGS. The underlying assumption of the said 

proposition was the belief that such an approach would create 

jobs more effi ciently and effectively than done by the present 

employment guarantee scheme. 

Nobel Laureate Prof. Edmund Phelps was quoted in the 

said write-up as saying, “Although such programmes have 

been substantial in Europe and the US, the working poor 

remain as marginalized as ever. Indeed, social spending has 

worsened the problem because it reduces work incentives and, 

thus, creates a culture of dependency and alienation from the 

commercial economy, undermining labour 

force participation, employability and 

employee loyalty.” 

Proposing an alternative, Prof. Phelps 

says, “The best remedy is a subsidy for 

low-wage employment, paid to employers 

for every full-time low wage worker they 

hire and calibrated to the employee’s wage 

cost to the fi rm. The higher the wage cost, 

the lower the subsidy, until it has tapered 

off to zero. With such wage subsidies, 

competitive forces would cause employers to hire more 

workers, and the resulting fall in unemployment would cause 

most of the subsidy to be paid out as direct or indirect labour 

compensation. People could benefi t from the subsidy only by 

engaging in productive work.” 

It is believed that the employment generated through this 

alternative scheme that Prof. Phelps proposes, shall be an 

asset for the economy instead of a burden. Prof. Bharat 

Jhunjhunwala of IIM, Bangalore believes that the present 

approach provides for taxes to be imposed mainly on urban 

business enterprises while money is spent in rural areas. The 

urban businesses have to bear the tax burden while the 

benefi ts are reaped by faraway villages. The business sector 

suffers on account of higher wage rates. The availability of 

some employment in the villages acts as a disincentive for 

workers to move from labour-surplus to labour-scarce areas 

because some employment is available locally under the 

114 


Social spending 

has worsened the 

problem because 

it reduces work 

incentives and 

thus creates 

dependency 

Rojgar Guarantee Scheme. The author bemoans the fact that 

the business enterprises do not only have to pay higher taxes, 

but also have to pay higher wages. The author believes that if 

Prof. Phelps’ suggestion is accepted then the taxes paid by 

businesses are recouped by receiving employment subsidies. 

The net outgo on wages shall be reduced due to subsidies 

thus received. 

While the author’s suggestion for subsidy to labour-intensive 

industries does make some sense, but going whole hog for 

Prof. Phelps’ proposed alternative defi nitely does not, more so 

in the Indian context. To begin with the beginning, notwithstanding 

the supposed failure of the employment guarantee 

scheme in the developed countries, they still have not been 

able to replace the same with the ‘employment subsidy’ 

approach as advocated by many including Prof. Phelps. 

This is notwithstanding the fact that such employment 

guarantee schemes have been in force for 

over fi fty years in most of these developed 

countries. Prof. Phelps’ proposal is 

fraught with loopholes and complexities 

and prone to more corruption than one 

thinks. Moreover, it also does not 

promise to increase the job opportunities 

for the jobless as has been proved to 

be practicably possible by the present 

employment guarantee scheme, the 

many implementational hitches and 

glitches notwithstanding. 

First and foremost problem with this approach is the moral 

hazard of passing off the extant employment in a fi rm to claim 

wage subsidies falsely and dishonestly. The employers led by 

petty and comprador bourgeoisie, in stead of creating new 

employment, would try to ingenuously cheat the system for 

claiming the subsidies. After all, we don’t necessarily have a 

data-base of employed manpower of all such fi rms and 

industries. And such a data-base, even if created and maintained, 

may not be completely sacrosanct. Our experience 

tells us as to how such data-base is often tinkered and tampered 

with, often to the advantage of the high and mighty. 

So, any system of working out compensatory subsidies for 

employers by establishing contrived linkages to employment 

generation is going to be very complex and is also likely to 

involve a lot of scope for discretion and subjectivity for the 

bureaucracy than the extant system. There is defi nitely no

need to compensate big businesses for higher taxes levied on 

them as there are already multiple government schemes and 

incentives for performing enterprises and businesses. Moreover, 

even after paying those taxes, they are still left with decent 

profi t margins to go shopping the world over for acquiring 

many of the renowned companies even in times of recession. 

Over the years, our tax and incentives structure have come to 

be comparable with the best in the world. 

The assumed fear that such employment guarantee scheme 

actually encourages mediocrity and dependence on government 

is far from the truth. The present system is an incentivebased 

transparent system where a more productive worker can 

earn more if she/he gives more output and her/his wages shall 

correspondingly be higher compared to others whose output 

is less. The fear that villages unduly gain at the expense of 

towns is unwarranted, to say the least. The fact remains that 

towns are always better endowed in terms 

of basic services and facilities than those 

found in the villages. The employment 

guarantee scheme not only ensures 

assured employment for a household 

throughout the year (considering hundred 

days for each adult member of a family 

including the handicapped), it also 

envisages creation of basic infrastructures 

in the countryside. 

It is believed that the progressive 

creation and availability of such infrastructures and employment 

opportunities in the countryside shall discourage people 

from migrating to the urban areas where basic infrastructures 

and services are already feeling pressure of increasing 

population. It shall also bridge the gap between rural and 

urban areas in terms of socio-economic indicators which are 

quite uneven at the moment. It is believed that wages in the 

urban areas shall go up consequent to reduced emigration and 

reduced availability of workers from the rural area. With less 

workers competing for more works, the real wages in urban 

areas shall go up which would continue to attract a minimal 

number of workers from the countryside as per changing 

demand and supply curve. The increased wages for urban 

workers shall be in keeping with the increased expenses 

required for urban living eventually enabling them to lead a 

better life than has been possible otherwise. 

The apprehension that reduced availability of low wage 

The current 

employment 

guarantee 

approach does 

not reduce labour 

force participation 

and employability 

R ETHINK AND RESURGE 

workers shall either lead to shut-down of enterprises in the 

urban areas or relocation of many of them to the rural areas is 

also unfounded. At a time when we are talking of liberalization 

and globalization, we defi nitely should have no reason to 

think of the industries who shut down as a result of having to 

pay higher wages to the workers, more so when multiple 

government incentives are available. The enterprises need to 

learn to survive the cut-throat competition in the market. 

They always have the option of shaping up or shipping out. 

Moreover, such an apprehension remains far fetched as the 

pool of low wage workers shall still be larger in this unreasonably 

populous country despite local availability of guaranteed 

employment in the villages as there still are many push and 

pull factors which drive people to the urban areas. As such, 

there is no reason to panic. 

Still, if some of them decide to move to low-wage areas 

which are likely to be under-developed, it 

is all the better as that would lead to 

infrastructural and capacity development 

of such areas and further improvement of 

quality of life there which eventually may 

see rise in labour costs in those areas as 

well. The cycle may go on till all parts of 

the country are more or less equitably 

developed. The government can actually 

think of giving incentives for relocation 

or establishment of new industries 

including labour-intensive ones in the backward and underdeveloped 

areas. 

The belief that the current employment guarantee approach 

reduces labour force participation and employability of a 

worker is also not true. The experience from all over the 

country tells us that labour force participation in the economy 

has only increased as a result of operation of such a scheme 

and as a result, per capita income has also gone up. The 

multiplier effect of such a rise has been perceptible in the 

relatively high economic growth rates and other development 

indicators of our economy, recession notwithstanding. 

Besides, an employment guarantee scheme is also immune to 

the negative impacts of a recession. While the government 

shall have more reason to persist with such employment 

guarantee schemes in diffi cult times like recession, the 

employers, fi nding reduced demand and market for their 

products, would shut down overnight rendering all the 


115


workers under their dispensation jobless. 

Again, contrary to the belief, the employability of a worker is 

also not compromised because of in-built incentive structure 

in such employment guarantee schemes as the worker learns to 

be more hard working to earn higher wages by giving better 

output and by being more productive. The various training 

programmes given to people under the said scheme and under 

many other schemes do give the workers a choice to decide for 

themselves as to what do they intend to do. The dovetailing 

and convergence of many such cognate schemes and programmes 

further could yield better results with better value 

allocations among the hoi polloi. The cascading multiplier 

effects and resultant pay offs for the country as a whole is 

bound to be better and greater than commonly understood. 

The supposed acquisition of newer skills under the employment 

subsidy approach is quite problematic and is more at the 

level of assumption than a reality. The belief that the innocent, 

ignorant and gullible workers would get better jobs and acquire 

better skills as per their choice and aptitude moving from one 

industry to another for job-shopping is misplaced and fraught 

with danger. The danger emanates from the feared exploitation 

of workers by these enterprises who are likely to take 

advantage of their helplessness and non-possession of requisite 

skills by paying low wages and forcing them to work in unhygienic 

and undignifi ed working conditions. 

Most of these enterprises are not likely to be enlightened 

enough to do a charity by employing an ignoramus and 

inexperienced worker to teach him/her newer skills to employ 

him/her later. However, the spirit of the proposal here is well 

taken and one does feel that the scope and ambit of such 

employment guarantee scheme needs to be further broadened 

and diversifi ed. It could also be creatively fi ne-tuned to offer 

better wages and better opportunities to the people. But one 

has to give the scheme some time to evolve naturally and be 

more promising and better suited to the requirements of the 

employment-seeking workers. 

After all, the Constitutional Right to Work, as envisaged in 

the fourth chapter of the Indian Constitution detailing 

directive principles of state policy, which took fi ve decades to 

be translated into a reality, is likely to be some more time to be 

better customized to the requirements and needs of the target 

people. The very fact that NREGS, after being launched 

selectively in some districts of the country for guaranteed 

employment in the rural areas throughout the year, has now 

116 


been extended to the entire country, is itself a big achievement 

of sorts. 

The belief that the alternative proposal is corruption proof 

compared to the present one is also not true as already pointed 

out above because of the element of discretion and subjectivity 

inherent therein. The extant scheme because of the transparent 

system of job-card, fi xed responsibility to provide jobs 

within fi fteen days of receipt of an application demanding work 

or to pay unemployment allowance in case of failure of the 

same and the provision of social audit is much better placed to 

do the needful. The provision of job cards, public hanging of 

Muster Roll, public notice of details of an on-going works and 

Muster Rolls and a participatory social and fi nancial audit of 

all the aspects of the schemes ensure better transparency and 

accountability than any other scheme. The Right to Information 

plugs the loopholes and fi lls the gaps, if any left anywhere. 

Yes, one does feel that there is lot of scope for further 

improvement of the scheme. One is sure that as more feedback 

from the fi eld is received and fed into the system to further 

fi ne-tune it, the extant scheme shall respond better to the tasks 

and objectives it is supposed to realize. To give some credit to 

Prof. Phelps, his proposal can be tried on an experimental 

basis in selected areas as a pilot project rather than completely 

replacing the extant scheme. After all, it is too early to pronounce 

a judgement on the success and failure of the same. 

And in any case, an ingenuous and creative mix of the two 

conceptions rather than an exclusive reliance on any of the one 

can always be a better idea. One hopes that NREGS would 

evolve with time in keeping with the objective of realizing and 

ensuring growth with equity and justice. 

Also, with the failure of the invincible capitalist system of 

economic development as represented by the Washington 

Consensus, it is all the more accepted and acknowledged that 

we can no longer depend on market forces for taking up social 

responsibilities. Rolling back the state completely is no longer 

an option. The state has to be there as a regulator and disciplining 

force with minimal responsibilities of maintaining law 

and order, dispensing justice and building an equitable society. 

So, the ‘employment subsidy’ approach, as dependent on 

private enterprises, is just not acceptable in preference to the 

employment guarantee approach. 


the offi cial policy or position of the organisation.)


Governance and 

Employment Generation 

in Rural Areas: 

A Case Study of NREGS in 

Selected Districts of West 

Bengal 

Byasdeb Dasgupta 

Head, Department of Economics, 

University of Kalyani, West Bengal 

Bipul De 

Lecturer, Sonamukhi College, 

Bankura, West Bengal 

NREGS and its Financing 

The National Rural Employment Guarantee Act (NREGA) 

was passed unanimously in the Lok Sabha on 23rd August 

2005. It guarantees 100 days of unskilled work at the minimum 

wage to each household which can not eradicate poverty 

but it can reduce severe distress if implemented effectively. It 

came into force in 200 districts on 2nd February 2006 and was 

then extended to an additional 130 districts in the fi nancial 

year 2007-08 (113 districts were notifi ed w.e.f. 1st April 2007 

and 17 districts in Uttar Pradesh w.e.f. 15th May 2007). The 

118 


Act has been universalized w.e.f. 1st April 2008 and now 

covers the entire country. The individuals needing unskilled 

work for survival must be aware of the NREGS, the eligibility 

requirements for work, the procedure for registration, getting 

a job card, wage rates etc. 

The NREGS makes a provision for compensation and treatment 

in case of injury and some on-site facilities like safe 

drinking water, care for small children, periods of rest and a 

fi rst aid box. It bans contractors and restricts the use of labour 

displacing machines. It requires that the wage component 

should be at least 60 percent of the expenditure in any project. 

It tries to create much needed rural assets through watershed 

development, water conservation and harvesting methods, 

irrigation works, forestry, land development, fl ood control, 

construction of roads etc. [CSE, 2008; PACS, 2006] 

These investments can lead to improvements in agricultural 

productivity, water security and creation of livelihood opportunities. 

But NREGA provides the guarantee at the level of 

the household and not that of the individual. Therefore the 

rights of women get subsumed under those of the household 

(though the act requires that at least one third of the benefi ciaries 

should be women). 

The Central government will bear the following costs: 

• The entire cost of wages for unskilled manual workers,

• 75 percent of the cost of material and wages for skilled and 

semi skilled workers, 

• Administrative expenses as may be determined by the 

central government. These will include the salary and 

allowances of Programme Offi cers and their support staff 

and work site facilities, 

• Administrative expenses of the central Employee Guarantee 

Council. 

The State government will bear the following costs: 

• 25 percent of the cost of material and wages for skilled and 

semi skilled workers, 

• Unemployment allowance payable in case the State 

government cannot provide wage employment within 15 

days of application. This allowance acts as a penalty every 

time the State is unable to provide work. 

• Administrative expenses of the State Employee Guarantee 

Council. 

[Source: NREGA Operational Guidelines 2008] 

The important aspect of NREGS is that it recognizes the 


R ECAST AND RESTRUCTURE 

role of the Panchayats as the principal agents of implementation 

and empowers citizens to play an active role in the 

implementation of the scheme through Gram Sabhas, Social 

Audit, use of Right to Information Act (RTI), participatory 

planning and other activities. 

Objective of the Study 

After three years of implementation it is the time to judge the 

effi cacy of the scheme in terms of several aspects like jobs 

demanded and provided, household participation rate based 

on the employment demanded, gender wise proportion of 

person days of employment generated, caste wise proportion 

of the total person days of employment generated, estimates 

of the proportion of work completed to total works taken up 

and the proportion of total funds spent under NREGA. 

Status of NREGA Implementation in Major 

Districts of W.B. 

National Rural Employment Guarantee Act was passed by 


119


Table 1: Employment Generated during the Year 2008-2009 up to the Month of March 2009 

120 

[1] 

Districts 


[2] 

Employment Demanded 

by HH 

(in lakhs) 

[3] 

Employment Provided 

to HH 

(in lakhs) 

[4] 

Person Days of 


(in lakhs) 

[5] 


as a Percent 

of Employment 

Demanded 

(3/2) 

[6] 

Average Person 

Days Generated 

Per HH 

(4/3) 

24 Pgs North 1.16955 1.13678 12.37190 0.97198068 10.8832844 

24 Pgs South 0.77470 0.77325 9.35412 0.99812831 12.0971484 

Bankura 1.22834 1.19917 19.03979 0.9762525 15.8774736 

Birbhum 2.86099 2.81015 23.57875 0.98222993 8.39056634 

Burdwan 4.50177 4.43213 54.57808 0.98453053 12.3141875 

Coochbeher 0.10738 0.09331 0.70197 0.86897001 7.52298789 

Darjeeling 0.20470 0.18648 2.44036 0.9109917 13.0864436 

Dinajpur (D) 0.19137 0.18686 2.63722 0.97643309 14.1133469 

Dinajpur (U) 0.01130 0.00997 0.08887 0.88230088 8.91374122 

Hooghly 1.20038 1.17597 13.41062 0.97966477 11.4038794 

Howrah 0.04979 0.04872 0.35850 0.97850974 7.35837438 

Jalpaiguri 1.19202 1.10526 9.72354 0.92721599 8.79751371 

Maldah 0.06983 0.06938 0.86309 0.99355578 12.4400404 

Murshidabad 0.70559 0.69541 6.16522 0.98557236 8.86559008 

Nadia 0.97162 0.96052 7.I5836 0.98857578 7.45258818 

Paschim Midnapur 1.73470 1.66179 20.21487 0.95796968 12.1645154 

Purba Midnapur 1.38219 1.34035 15.90327 0.9697292 11.8650129 

Purulia 0.10389 0.10076 1.22481 0.96987198 12.1557166 

TOTAL 18.46011 17.98626 199.81334 

Source: www.nrega.nic.in (Till March 2009) 

Note: bold letter represents the fi rst phase districts 

Parliament in 2005. It became operational in West Bengal 

from February 2006. In the fi rst phase NREGA was 

implemented in 10 districts (South 24 Parganas, Bankura, 

Birbhum, Dakhhin and Uttar Dinajpur, Jalpaiguri, Maldah, 

Murshidabad, Paschim Midnapur, Purulia) followed by 

another seven districts (North 24 parganas, Burdwan, 

Coochbihar, Darjelling, Hooghly, Puaba Midnapur, Nadia) 

from 1st April 2007 and one more district from 1st April 

2008 (at Howrah). 

1. Jobs Demanded and Provided 

The NREGS has primarily been evaluated in terms of jobs 

demanded and provided. The performance as shown in 

Table 2, has not been uniform across the districts. 

Offi cial record shows that till May 2009, out of 1.84 

million people demanding jobs 1.79 million were provided 

with jobs which generated almost 200 million person days 

and around 10.87 person days per family which is far away 

from the envisaged 100 days. Bankura is showing the maximum 

average person days of employment i.e. 15 and at 

least seven districts are showing less than 10 average 

person days of employment. 

The record also shows that demand for employment was 

almost met (at 99%) in South 24 Parganas and Maldah.

Table 2: NREGS Participation Rate 

[1] 

Districts 

[2] 

No of Rural HH in NREGS 

(in lakhs) 

Only in two districts like Uttar Dinajpur and Coochbihar 

the demand for employment was met at less than 90%. 

2. Participation Rate 

An attempt can be made to estimate the 

NREGS household participation rate 

based on employment demanded by 

rural households in 18 districts as a 

proportion of the total number of rural 

households in districts in which the 

NREGS was being implemented. Table 

2 shows the results. The household 

participation rates are highest in Burdwan 

(60 percent) followed by Birbhum 

(48.44 percent) and lowest in Uttar 

Dinajpur (0.22 percent). The participation ratets in seven 

districts are less than 10%. 

These two parameters ‘participation rate’ and ‘jobs 

demanded and provided’ raise the questions regarding a 

[3] 

Employment Demanded by 

HH (in lakhs) 


[4] 

Participation Rate 

(3/2) * 100 

24 Pgs North 542954 116955 21.5404988 

24 Pgs South 602185 77470 12.8648173 

Bankura 454901 122834 27.0023588 

Birbhum 590605 286099 48.4416827 

Burdwan 750130 450177 60.0131977 

Coochbeher 325971 10738 3.29415807 

Darjeeling 71171 20470 28.7617147 

Dinajpur Dakshin 234678 19137 8.15457776 

Dinajpur Uttar 411711 1130 0.27446437 

Hooghly 453041 120038 26.4960566 

Howrah 147944 4979 3.36546261 

Jalpaiguri 574648 119202 20.7434812 

Maldah 381065 6983 1.83249577 

Murshidabad 865466 70559 8.15271773 

Nadia 579487 97162 16.766898 

Paschim Midnapur 699991 173470 24.7817472 

Purba Midnapur 547776 138219 25.2327594 

Purulia 362458 10389 2.86626313 

The NREGS 

generated fewer 

than the one-third 

female person 

days stipulated 

by the Act in 11 

districts out of 19 

potential correlation between governance in a state and 

the need for employment generation through such 

schemes. 

3. Gender Aspect of NREGS 

The NREGS is designed primarily 

along the lines on Maharashtra EGS 

(MEGS). Women were the major 

benefi ciaries of the MEGS as the 

scheme guaranteed work for all those 

who demand it. Table 3 shows that 

NREGS generated fewer than the 

one-third female person days stipulated 

by the Act in 11 districts out of 19. The 

proportion of person days of work 

generated for women was satisfactory in Darjeeling (48.9 

percent) followed by Jalpaiguri (40.19 percent). Districts 

like Bankura (35.57 percent), Burdwan (34.84 percent), 

Uttar Dinajpur (36.71 percent), Purulia (37.04), Purba 


121


Table 3: Gender Wise Proportion of Person Days of 

Employment Generated (in percentage) 

Midnapur (32.35) can manage the target. Women have 

been active participants in few districts where Self Help 

Groups have been made the implementing 

agencies for developing land 

of BPL/SC/ST households under 

NREGA which has increased not only 

their self confi dence but has enhanced 

their status. 

4. Caste Aspect of NREGS 

Table 4 shows the caste wise proportion 

of the total person days generated 

under NREGA. The proportion of 

person days of employment availed by SC/ST benefi ciaries 

is more than 30 percent in 11 districts with the proportion 

being more than 50 percent in three districts out 

of 18. The proportion is highest in Bankura (55.39 

122 

[1] 

Districts 


[2] 

Women 

[3] 

Men 

24 Pgs North 5.72 94.28 

24 Pgs South 9.77 90.23 

Bankura 35.57 64.43 

Birbhum 24.7 75.3 

Burdwan 34.84 65.16 

Coochbeher 20.76 79.24 

Darjeeling 48.9 51.1 

Dinajpur Dakshin 26.44 73.56 

Dinajpur Uttar 36.71 63.29 

Hooghly 26.41 73.59 

Howrah 8.69 91.31 

Jalpaiguri 40.19 59.81 

Maldah 20.43 79.57 

Murshidabad 10.59 89.41 

Nadia 13.99 86.01 

Paschim Midnapur 25.52 74.48 

Purba Midnapur 32.35 67.65 

Purulia 37.04 62.96 


Note: Bold letter represents the fi rst phase districts 

[1] 

Districts 

Land, especially 

non-irrigable 

land was a basic 

requirement to 

provision jobs 

under the NREG 

scheme 

Table 4: Caste Wise Proportion of Person Days of 

Employment Generation (in percentage) 

[2] 

SC 

[3] 

ST 

percent) followed by Darjeeling (55.38 percent) and 

Hooghly (51.86 percent). 

[4] 

Others 

24 Pgs North 24.38 5.87 69.75 

24 Pgs South 43.63 3.16 53.21 

Bankura 55.39 19.78 24.83 

Birbhum 44.3 11.32 44.38 

Burdwan 47.84 17.52 34.64 

Coochbeher 48.45 3.32 48.23 

Darjeeling 55.38 21.11 23.52 

Dinajpur Dakshin 27.09 18.72 54.19 

Dinajpur Uttar 45.29 8.95 45.76 

Hooghly 51.86 10.57 37.56 

Howrah 39.46 0.08 60,45 

Jalpaiguri 43.06 31.1 25.84 

Maldah 30.47 12.05 57.48 

Murshidabad 14.7 4.78 80.52 

Nadia 27.25 3.7 69.05 

Paschim Midnapur 27.25 3.7 69.05 

Purba Midnapur 29.88 23.73 46.4 

Purulia 19.98 0.89 79.13 

Purulia 27.41 30.92 41.68 


Note: Bold letter represents the fi rst phase districts 

5. Proportion of Works Completed to 

Works Taken Up 

Estimates of the proportion of works 

completed to total works taken up under 

NREGA are shown in Table 5. Offi cial 

data shows that nine districts lead with 

fi gures of more than 50 percent—Uttar 

Dinajpur (87.63 percent), Jalpaiguri 

(69.76 percent), Murshidabad (68.26 

percent), Darjelling (65 percent), Purba 

Midnapur (64.29 percent), Burdwan (64.27 percent), 

Birbhum (55.89 percent), South 24 Parganas (55.65 percent), 

Bankura (52.42 percent). For the rest of the districts 

the proportion of works completed to total works taken up

Table 5: NREGS—Proportion of Works Completed to Works Taken Up 

[1] 

Districts 

is between 29 percent to 47 percent. 

6. Proportion of Total Funds Spent 

Data shows in Table 6 that the proportion 

of total funds spent is highest in 

Dakkhin Dinajpur (93 percent) followed 

by Purba Midnapur (86 percent) 

and lowest in Nadia (32 percent). The 

state average is 71 percent of total fund 

was spent till March 2009. There are 

nine districts above the state average 

out of 18. 

[2] 

Total Works Taken Up 

Concluding Observations 

Despite the fact that all the 18 districts in the state have 

been covered under the National Rural Employment 

Guarantee Scheme (NREGS) and more than 88 lakh job 

cards have been distributed so far in the state, West Bengal 

[3] 

Works Completed 


[4] 

Proportion Of Works Completed 

(In percentage) 

24 Pgs North 6652 2817 42.348166 

24 Pgs South 3980 2215 55.6532663 

Bankura 7473 3940 52.7231366 

Birbhum 10022 5601 55.8870485 

Burdwan 18312 11770 64.2747925 

Coochbeher 2765 1317 47.6311031 

Darjeeling 498 324 65.060241 

Dinajpur Dakshin 695 317 45.6115108 

Dinajpur Uttar 1415 1240 87.6325088 

Hooghly 3893 1510 38.7875674 

Howrah 637 185 29.0423862 

Jalpaiguri 6108 4261 69.7609692 

Maldah 1649 593 35.9611886 

Murshidabad 2814 1921 68.2658138 

Nadia 1934 994 51.39607 

Paschim Midnapur 1649 593 35.9611886 

Purba Midnapur 13865 8915 64.2985936 

Purulia 5848 1864 31.874145 

Total 99778 54125 54.2454248 

West Bengal 

seems to lag 

behind other 

states in terms of 

average number 

of days provided 

with job per family 

clearly seems to lag behind other states in terms of actual 

job provision or the average number of days provided with 

job per family. Of the total 88 lakh job card holders in the 

state around 21 lakh have been provided 

with employment cumulatively till date. 

One of the major reason for this 

lacunae or shortfall was paucity of 

funds as also lack of demand for jobs, 

this being an entirely demand driven 

scheme unlike previous employment 

schemes. The state even faced a severe 

crunch of funds in the last two years, 

which primarily meets the wage needs, 

said the source. 

The main reasons were unequal and illogical distribution 

of funds, besides frequent case of siphoning of funds or 

money laundering which caused some districts like Birbhum, 

Purulia, Jhargram, with good scope for the scheme 


123


Table 6: NREGS—Expenditures 

Districts Total Fund (in crores) Expenditure (in crores) Proportion of Total Fund 

Spent 

24 Pgs North 86.23 63.16 0.73246 

24 Pgs South 39.80 29.46 0.740201 

Bankura 94.39 80.65 0.854434 

Birbhum 131.89 85.45 0.647888 

Burdwan 147.90 148.12 1.001487 

Coochbeher 59.21 60.20 1.01672 

Darjeeling 10.67 5.56 0.521087 

Dinajpur Dakshin 17.70 16.48 0.931073 

Dinajpur Uttar 31.10 16.57 0.532797 

Hooghly 52.12 33.57 0.644091 

Howrah 10.32 5.51 0.533915 

Jalpaiguri 126.73 71.77 0.566322 

Maldah 71.74 23.46 0.327014 

Murshidabad 93.68 51.60 0.550811 

Nadia 71.74 23.46 0.327014 

Paschim Midnapur 123.84 106.01 0.856024 

Purba Midnapur 59.11 50.88 0.860768 

Purulia 59.27 42.87 0.7233 

Total 1287.44 914.78 0.710542 

falling short of funds and some districts sitting on extra 

cash. This was primarily because the funds from the 

Centre would go directly to the district offi ces in the hands 

of the district program coordinator who looked after the 

disbursal of funds. The State P&RD department had no 

say on the disbursal inspite of knowing which districts 

required it. 

Districts like Purulia, Bankura, Birbhum, Jhargram, 

part of West Medinipur, had huge potential as far as the 

scheme was concerned because of availability of land which 

suited the types of job provided under the scheme. Infact, 

Bankura ranked highest in terms of average number of 

days provided with jobs per family last year, which was 

around 41 days compared to the state's average of 25 days 

per family. 

Land, especially non-irrigable land was a basic requirement 

to provide jobs under this scheme. The jobs provided 

under this scheme in the state at a minimal wage of Rs 75 

per day were mainly water conservation jobs, land levelling, 

124 


road construction, drought proofi ng, plantation of trees, 

mostly non-agricultural-based jobs, with a huge requirement 

for non-irrigated land. Rajasthan and Madhya 

Pradesh rank high in the implementation of this scheme 

due to land availability. 


• Krishnaraj, M., D. Pandey and A. Kanchi (2004), “Does 

NREGS Require Restructuring for Poverty Alleviation 

and Gender Equality”, Economic and Political Weekly, 

39 (17): 1741-47; 24th April. 

• Menon, S (2008), “Right to Information Act and NRE- 

GA: Refl ection on Rajasthan”, MPRA Paper No:7351 

• Siddharta and Anish Vanik (2008), “CAG Report on 

NREGA: Fact and Fiction”, Economic and Political 

Weekly, 43(25): 39-47; 21st-27th June 


refl ect the offi cial policy or position of the organisation).


NRDWP – A Paradigm 

Shift in Rural Drinking 

Water Supply 

126 


Benny George 

Consultant (M&E), 

Department of Drinking Water 

Supply, Government of India, 

New Delhi 

Government of India has been striving to 

provide drinking water security in the rural areas 

since independence. Incorporating the wisdom 

accrued over decades through the implementation 

of water supply programmes, Government 

of India has launched a new programme – 

NRDWP – on 1st April 2009. Though it comes 

with a whiff of fresh thinking and bold measures 

to safeguard the interests of the weaker sections 

of the society, a great deal of its success hinges 

on its effective implementation. 

Introduction 

Availability of drinking water in right quality 

and quantity is one of the prerequisites for a 

healthy life. Human Development Report – 

2006 states that delivering clean water, removing 

wastewater and providing sanitation are 

three of the most basic foundations for human 

progress. United Nations Committee on 

Economic, Social and Cultural Rights declared 

that “The human right to water entitles everyone 

to suffi cient, safe, acceptable, physically 

accessible and affordable water for personal

and domestic use” (UNDP 2006). 

Government of India has been striving to achieve the goal of 

providing safe drinking water to the people of India. Till the 

end of the 10th Five Year Plan, almost Rs. 70,000 Crore had 

been invested by Central and State Governments in providing 

drinking water in the rural areas (Table 1). Eleventh Plan 

Central outlay for the rural water supply sector stands at Rs. 

39,490 crore. 

Despite making huge investments for ensuring drinking 

water security in rural areas, we still have some more distance 

to cover. As per UNICEF and WHO (2008), only 86 percent 

rural population in India had access to ‘improved’ water supply 

in 2006. 

2. ARWSP 

To accelerate the pace of coverage of problem villages, the 

Government of India introduced the Accelerated Rural Water 

Supply Programme (ARWSP) in 1972–73 to assist States and 

UTs with 100% grants-in-aid to implement drinking water 

supply schemes in such villages. 

2.1 Components: 

To ensure that all aspects of rural water 

supply are adequately addressed, ARWSP 

was broken into different components. 

Those components, funds earmarked for 

them, interventions to be made and the 

funding pattern are given in Table 2. 

2.2 Coverage Norms: 

1. 40 lpcd of drinking water for human beings 

2. 30 lpcd of additional water for cattle in 

areas under the DDP 

3. One hand pump or stand post for every 250 persons, and 

4. Availability of water source within a distance of 1.6 Km in 

plains and 100 m elevation in hilly areas. 

3. National Rural Drinking Water Programme 

(NRDWP) 

India has come a long way in providing drinking water to its 

rural population. However, life has changed so much since the 

early days of ARWSP. Then the core strategy was aimed at 

building physical infrastructure and institutional mechanisms 

to supply water which was abundant in nature. 

In the Eleventh 

Five-Year Plan, 

Central outlay for 

the rural water 

supply sector 

stands at Rs. 

39,490 crores 


W ATER WISDOM 

Water is no more an abundant resource. India with 2.4% of 

the world's total area has 16% of the world's population; but 

has only four percent of the total available fresh water. Currently, 

the total water use (including ground water) is 634 

BCM, of which 83% is for irrigation. The demand for water is 

projected to grow to 813 BCM by 2010, 1093 BCM by 2025 and 

1447 BCM by 2050, against utilisable quantum of 1123 BCM 

(Planning Commission 2007a). 

The rapid extraction of ground water has led to its over 

exploitation in the country. In 15% of the Blocks, annual 

extraction of ground water exceeds annual recharge and in 

four percent of Blocks it is more than 90% of recharge (Planning 

Commission 2007b). Such a scenario does not augur well 

for drinking water supply as about 80% of rural drinking water 

supply programmes are ground water based1 . 

Another issue of major concern is global warming and its 

fallout on drinking water security. Using the General Circulation 

Models, weather experts have predicted that global 

warming will intensify the hydrologic cycle; more intense 

rainfall will occur in fewer spells; fl oods and droughts both will 

become more intense; the fl oods will be more frequent; the 

rainfall will shift towards winter; and there 

may be a signifi cant reduction in the mass 

of glaciers, resulting in increased fl ows in 

the initial few decades but substantially 

reduced fl ows thereafter (Ibid). 

‘Slipped back’ habitations have been a 

scourge of rural water supply programmes 

in India2 . Magnitude of this problem can 

be gauged from the fact that, of the 

6,03,639 habitations to be covered under 

the Bharat Nirman Programme, 3,31,604 

habitations (54.93 percent) were slipped back (http://ddws.gov. 

in/popups/BNPcummulative.pdf, accessed on 10th March, 2009). 

In the wake of increasing water stress and aging physical 

infrastructure, slipping back is likely to pose major challenges. 

Against this backdrop, NRDWP has been launched in the 

country on 1st April, 2009 as a game changer, which heralds a 

paradigm shift to move away from single source coverage of 

habitations to universal access to safe drinking water on a 

sustained manner for all rural people (NRDWP, Framework for 

Implementation 2008-2012 is available at http://www.ddws.gov. 

in/popups/FinalRWSGuideLines.pdf, accessed on 16th March, 

2009). The Programme seeks to provide every individual 

127


Table 1: Plan-wise Expenditure Incurred on Providing Rural Drinking Water 

PERIOD ARWSP STATE SHARE 

Allocation Release Exp. Reported Provision Exp. Reported 

1st Plan (1951-56) 

N.A 3.00 

2 Not applicable as ARWSP 

was introduced 

from 1972-73 

nd Plan (1956-61) 

3 

28.00 30.00 

rd Plan (1961-66) 67.00 48.00 

Annual Plans (1966-69) N.A N.A 

4th Plan (1969-74) N.A 34.10 34.10 131.00 208.00 

5th Plan (1974-79) 98.2 157.17 157.17 481.00 348.00 

Annual Plan 1979-80 N.A 58.20 58.58 N.A N.A 

6th Plan (1980-85) 1056.52 895.38 880.55 1407.66 1530.17 

7th Plan (1985-90) 1922.35 1905.64 1931.21 2525.41 2471.53 

Annual Plan 1990-91 423 410.54 391.58 646.33 595.85 

Annual Plan 1991-92 758 644.49 505.68 744.49 692.54 

8th Plan (1992-97) 4230 4139.74 3739.16 5458.63 5084.44 

9th Plan (1997-02) 8563.95 8454.57 8032.85 12268.01 10773.11 

10th Plan(2002-07) 16195.01 16254.43 12486.37 17892.80 15102.42 

Source: Department of Drinking Water Supply, Government of India. 

residing in rural areas with adequate water for drinking, 

cooking and other basic needs on a sustainable basis by 

reviving traditional systems and promoting conjunctive use of 

surface water, ground water and rain water. 

3.1 NRDWP Components 

NRDWP retains all the components and the coverage norms 

of ARWSP. Yet, there are radical changes in funds earmarked 

and funding patterns. For instance, under ARWSP, around 68 

percent funds were earmarked for coverage of habitations. 

Refl ecting the fast changing ground realities and priorities, 

NRDWP earmarks only 38 percent of the funds for the 

purpose. However, only fi ve percent of the funds allocated for 

ARWSP (coverage) (which in turn was around 68 percent of 

the total allocation made for ARWSP) was earmarked for 

sustainability. So, the actual allocation for the sustainability 

component was just around 3.4 percent of the total funds under 

ARWSP. In a major departure, NRDWP earmarks 20 percent 

of the total funds for this component, which refl ects the high 

priority accorded by the Government of India to check 

slippages. Apart from that, under ARWSP, funding pattern of 

the sustainability component was 50:50 between the Central 

and the State Governments. Under NRDWP, it is fully funded 

128 


by the Government of India. 

Components of NRDWP, funds earmarked for them, 

interventions to be made and the funding pattern are given in 

Table 3. 

3.2 Criteria for Allocation of Funds 

Criteria for allocation of funds to the States under ARWSP 

and NRDWP are featured in Table 4. Under ARWSP, 15 

percent weightage was given to NC / PC habitations, which has 

been widely regarded as a reward for inaction on the part of 

the State Governments. Moreover, it allegedly goaded States to 

over-report the incidence of slippage. Putting a fi rm lid on the 

scope for such perverted incentives, NRDWP does not factor 

in the number of NC / PC habitations while allocating funds to 

the States. However, in order to incentivize community 

ownership and management of water supply systems, NRDWP 

gives 10 percent wieghtage to States where assets are transferred 

to Panchayati Raj Institutions. 

3.3 Innovative Steps 

Government of India needs to be complimented for a few more 

ground-breaking steps, besides the ones discussed already, 

initiated under the NRDWP. The most signifi cant ones are

Table 2: ARWSP Components 

listed below. 

1. Recognition of the Demand for Basic Drinking Water Needs as 

a Fundamental Right: NRDWP Framework for Implementation 

2008-12 categorically states that water is a socio-economic 

good and the demand for basic drinking water needs is a 

fundamental right (Page 25). It goes on to add that drinking 

water supply cannot be left to market forces as it does not 

recognize the importance of providing livelihoods supply to 

all, nor does it ascribe an appropriate value to health of the 

people. It further states that the commodifi cation of water will 

shift the focus to profi ts to be made from a scarce resource 

rather than human rights to water for livelihood (Page 9). 

2. Drinking Water Security at the Household Level: Hitherto, 

coverage had been measured in terms of habitations and 

population (which was arrived at by multiplying the habitations 

covered with corresponding population). The NRDWP 

Framework for Implementation 2008-12 states that installation 

of a water supply system in a habitation does not confer 

the ‘Fully Covered’ status on it unless every house hold in the 

habitation has been fully covered with potable water in 

suffi cient quantity (Page 11). Moreover, NRDWP provides for 

appointing village level workers – Jal Surakshaks – to 

generate data on coverage at household level (page 62). That 

the Government is serious about the whole exercise is 

refl ected in its making provisions for paying a regular salary 

to Jal Surakshaks. 

3. Creation of Technical Agencies: To breathe innovation and 


W ATER WISDOM 

Component Funds Earmarked Purpose Funding Pattern 

Natural Calamity 5% 

For restoration of water supply 100% GoI funding 

suffered on account of any kind of 

natural calamity 

DDP Areas 5% For drinking water supply in DDP 

blocks / areas 

100% GoI funding 

Support Activities / Programme 2% For various support activities relating 

to rural water supply 

100% GoI funding 

Sub-Mission on Water Quality Up to 20% For addressing quality problems in 

the affected habitations 

75:25 GoI and State 

Normal Rest of the funds 

Source: Ministry of Rural Development 2008. 

-Up to 15% for operation and 

maintenance, and 

- Remaining amount for coverage 

- 50:50 GoI and State 

Up to 5% of total funds 

for sustainability 

fresh thinking into planning and implementation of rural 

drinking water supply programmes, NRDWP provides for 

engaging State Technical Agencies and National Experts 

Groups for preparation of projects, technical scrutiny and 

evaluation of rural water supply schemes. 

3.4 Areas of Concern 

1. Implementation Mechanism at the State Level: 

Brisco and Malik (2006) observe that staffi ng levels of water 

supply agencies in India are 10 times international norms, and 

most public funds are spent feeding the administrative 

machinery, not maintaining the stock of infrastructure or 

providing services. Though the NRDWP intends to restructure 

State Rural Water Supply Implementing Agencies 

(NRDWP Framework for Implementation 2008-12, Section 

12.5, page 28), it remains to be seen as to how effective this 

exercise would be. In this context, it may be worth recalling 

the words of Prof. Wangari Maathai, 2004 Nobel Peace Prize 

winner, that water crisis is a crisis of governance: man-made, 

with ignorance, greed and corruption at its core (Transparency 

International 2008). 

Multiplicity of agencies at the State level is likely to do more 

harm than good. Besides introducing Technical Agencies at 

the State level, yet another agency – Water and Sanitation 

Support Organisation (WSSO) – has been created at the State 

level. WSSO will have a tough time fi guring out its boundaries 

as the space is already crowded with a host of other players 

129


Table 3: NRDWP Components 

Component Funds Earmarked Purpose Funding Pattern 

Coverage 38% Coverage of habitations 50:50 GoI and State µ 

Water Quality 20% For addressing quality problems 50:50 GoI and State µ 

Sustainability 20% To achieve drinking water security through ensuring 

sustainability of sources and systems 

100% GoI 

O&M 10% For the O&M of water supply systems 50:50 GoI and State µ 

DDP Areas 5% For providing drinking water in DDP areas 100% GoI 

Natural Calamity 5% For restoration of water supply suffered on account 

of natural calamity 

100% GoI 

Support 2% For activities relating to IEC, HRD, Computerization 

(MIS), water quality monitoring, R&D, 

CCDUs, etc. 

100% GoI 

µ 90:10 for N-E States and J&K 

Source: National Rural Drinking Water Programme, Framework for Implementation 2008-2012 

such as SWSM, SWSC and CCDU, besides having SLSSC and 

PHED / nodal agency for the implementation of water supply 

programmes at the State level. 

2. Absence of Effective Planning: 

Importance of planning in ensuring drinking water security at 

the household level cannot be over-emphasised in a country 

with so much diversity in terms of agro climatic conditions and 

hydro geological parameters. On the one hand, we grapple 

with the seemingly insurmountable problems of slippages and 

water quality. On the other, there are clear signs of over-provisioning 

by schemes in many parts of States such as Uttar 

Pradesh and Tamil Nadu (World Bank 2008). 

Oft repeated reasons for slippages are sources going dry, 

poor O&M and systems outliving its utility. Of these, the fi rst 

two could be addressed to some extent with proper planning. 

For instance, a large piped water supply scheme based on 

ground water is doomed to failure if it is set up in a place with 

already depleted ground water resources. Similarly, it goes 

without saying that a water supply system which is high on 

O&M is ill-suited for a village with poor willingness and / or 

capacity to pay. 

Signifi cant wastage of resources arises from over-provisioning 

by some schemes, defunct schemes, and the existence of 

multiple schemes. In Uttar Pradesh more than half of the hand 

pumps are shared by 10 or less households (as against a norm 

130 


of 50) and in 10 percent cases, a hand pump is shared by four 

households or less. Such over-provisioning of services exists in 

other states as well (with the exception of Karnataka) and is 

particularly noticed in the case of Tamil Nadu (Ibid). There is 

an urgent need to address this issue. 

Though the Framework for Implementation talks about 

preparing Village Action Plans (VAPs) and District Water 

Security Plans based on VAPs (Page 33), it appears that it is a 

statement of intent, not a pre-requisite for funding. Enduring 

drinking water security can be achieved only if context specifi c 

systems are put in place based on parameters such as source of 

water (surface vs ground), type (hand pump vs piped water 

supply [single village scheme vs multi-village scheme]), interand 

intra-village confl icts (caste and political), affordability 

(willingness and ability to pay), etc. Absence of comprehensive 

planning is a recipe for over provisioning and further slippages. 

3. Over Dependence on Civil Society Organisations: 

NRDWP envisages the civil society organizations to play a 

prominent role in planning, community mobilisation, implementation 

and operation and maintenance of water supply 

programmes. Even as I appreciate the critical role that such 

organizations can play in bringing about drinking water 

security in our villages, I strongly believe that we need to be 

mindful of their limitations as well. The civil society argument 

has now been around for about 25 years. The problems of the

Table 4: Criteria for Fund Allocation under ARWSP and NRDWP 

S. No Criteria Weightage (in %) 

ARWSP NRDWP 

1 Rural population 40 60 

2 Not Covered / Partially Covered villages 15 0 

3 Quality affected villages 10 0 

4 Rural population managing rural drinking 

water supply schemes 

0 10 

5 States under DPAP, HADP and special category 

Hill States in terms of rural areas 

35 30 

Total 100 100 

Source: Ministry of Rural Development 2008 and NRDWP Framework for Implementation 2008-2012 

world remain as intractable, even as the numbers of agents who 

seek to negotiate the ills of the human condition have expanded 

exponentially. In popular imagination, the State still seems 

to occupy a central position. And it is clear that there are 

certain problems that only the State can resolve, and should be 

resolving (Chandhoke 2009). 

To put things in perspective, the forgoing contention may be 

juxtaposed with some observations made by the CAG recently. 

It observes that over Rs. 51,000 Crore allocated for the fl agship 

anti-poverty and development schemes in 2007-08 was transferred 

to the bank accounts of NGOs, autonomous bodies and 

district authorities. However, the Government has told the 

CAG that it was not aware of the actual expenditure by those 

organizations. The CAG goes on to say that as the money is 

kept outside government accounts, it is beyond the purview of 

any checks and balances of the Government of India (Anonymous 

2009). So, it may be a better idea to pay more attention to 

reviving the government machinery than placing too much 

hope on civil society organizations to redeem the situation, 

only to be disillusioned, yet again, with the passage of time. 

4. Conclusions 

Considerable amount of resources have gone into the 

provision of drinking water in the rural areas of India and 

the outcome is encouraging. To address the changing 

realities of life, Government of India has launched a new 

programme, incorporating the wisdom accrued over 

decades through the implementation of water supply 

programmes. Though it comes with a whiff of fresh thinking 

and bold measures to safeguard the interests of the weaker 


W ATER WISDOM 

sections of the society, a great deal of its 

success depends on its effective implementation. 

We should not forget that a programme 

is as good as its implementation. 

Endnotes 

1 Page 46, NRDWP Framework for Implementation 

2008-12. 

2 Slipped back refers to the situation wherein a 

Fully Covered habitation slips back in to the 

status of either Partially Covered or Not 

Covered, owing to either decline in supply 

level or water quality problems or both. 


• Anonymous (2009): “Central Government may be Overstating 

Spending on Aam Aadmi”, Times of India, 23rd February 2009, New Delhi. 

• Brisco, John and R.P.S. Malik (2006): India’s Water 

Economy – Bracing for a Turbulent Future, World Bank, 

New Delhi. 

• Chandhoke, Neera (2009): “Putting civil Society in Its 

Place”, Economic and Political Weekly, 44(7), PP 12-16. 

• Ministry of Rural Development (2008): Annual Report 

2007-08, Government of India, New Delhi. 

• Planning Commission (2007a): Ground Water Management 

and Ownership – Report of the Expert Group, New 

Delhi. 

• Planning Commission (2007b): Report of the Steering 

Committee on Water Resources for Eleventh Five Year 

Plan (2007-2012), New Delhi. 

• Transparency International (2008): Global Corruption 

Report 2008 - Corruption in the Water Sector, Cambridge 

University Press, Cambridge, UK. 

• UNDP (2006): Human Development Report 2006 - Beyond 

scarcity: Power, Poverty and the Global Water Crisis, 

New York. 

• UNICEF and WHO (2008): Progress on Drinking Water 

and Sanitation, New York. 

• World Bank (2008): Review of Effectiveness of Rural 

Water Supply Schemes in India, New Delhi. 


the offi cial policy or position of the organisation). 

131

L AW AND ECONOMICS 

Uma Sankaran 

132 

Review of Economic 

Development and 

Legal System: An 

International Perspective 

“Criminal law, while it has major non-economic functions, 

also services to deter theft and some forms of economic fraud. 

Civil law has economic aspects centrally in its concerns. 

Contract law can be said to be mainly for the governance of 

economic activity; laws of tort and liability pertain to contracts 

as well as not-contractual relationships, both mainly in the 

economic sphere” – Dixit A.K. (2004) 

Introduction 

Economic development is one of the main objectives of all 

economies in the modern world. Achieving this objective 

depends on the macro economic factors like investment, 

exchange rate, infl ation, etc. In addition to that, economic 

development is also affected by micro economic institutions 

like property rights, contract enforcement etc. These are 

institutional environment which facilitates micro economic 

decisions. Kohling (2000) assumed indirect correlation 

between economic activities and legal system i.e., the 

judiciary itself has no impact on productive factors, but 

through individual decision-making, it can infl uence economic 

relevant decisions. In short, these micro economic 

institutions are mainly related to the country’s legal system1 . 

Role played by the institutions for achieving economic 

development is growing steadily. Among the institutions, 

judicial system plays an important role in the economic 

Research Scholar, Centre for Development 

Studies (CDS), Trivandrum 



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Colonial Origins of Comparative Development: An 

Empirical Investigation”, The American Economic 

Review, Vol. 91, No. 5, Dec., pp. 1369-1401 

Banerjee A and Iyer L History (2005), “Institutions, and 

Economic Performance: The Legacy of Colonial Land 

Tenure Systems in India” The American Economic 

Review, Vol. 95, No. 4, Sep., pp. 1190-1213 

Barro J., Robert (1991), “Economic Growth in a Cross 

Section of Countries”, The Quarterly Journal of Economics, 

May, Vol. 106, No. 2, pp. 407-443 

Chemin, Matthieu (2004), “Does the Quality of the 

Judiciary Shape Economic Activity? Evidence from 

India”, Department of Economics, LSE, October. 

- (2007), “Does Judicial Quality Shape Economic Activity? 

Evidence from a Judicial Reform in India”, Cahier de 

recherche/Working Paper 07-25, September 

Cross, B., Frank (2002) “Law and Economic Growth”, 

Texas Law Review, 80 (7), June, 1737-75, (Ed.) Hans- 

Bernd Shafer and Angara V. Raja, “Law and Economic 

Development”. 

Davis E., Kevin and Trebilcock J., Michael (2001), “Legal 

Reforms and Development”, Third World Quarterly, 

22(1), 21-36, (Ed.) Hans-Bernd Shafer and Angara V. 

Raja, “Law and Economic Development”. 

Demsetz Harold (1967), “Toward a Theory of Property 

Rights”, American Economic Review, 57 (2), May, 

347-59, (Ed.) Posner A., Richard and Parisi Fransesco, 

“Economic Foundations of Private Law”. 

Douglass C. North (1991), “Institutions”, The Journal of 

Economic Perspectives, Winter, Vol. 5, No. 1, pp. 97-112 

- (1996), “Institutions, Institutional Change and Economic 

Performance”, Cambridge University Press. 

Feld P., Lars and Vogit, Stefan (2003), “Economic 

Growth and Judicial Independence: Cross Country 

Evidence using a new set of Indicators”, CESifo Working 

Paper No. 906, April. 

Ginsburg Tom (2000), “Review: Does Law Matter for 

Economic Development? Evidence from East Asia”, Law 

& Society Review, Vol. 34, No. 3., pp. 829-856. 

Klerman, Daniel, “Legal Infrastructure, Judicial Independence, 

and Economic Development” 

Kohling, K.C., Wolfgang (2000), “The Economic Conse- 

L AW GROWTH NEXUS 

quences of a Weak Judiciary”, Centre for Development 

Research, University of Bonn, Germany, November. 

Maria Dakolias (2003), “The Role of the Judiciary for 

Economic and Social Development”, November 14th , 

2003 Speech to the EU Judiciaries Representatives The 

Hague, The Netherlands 

Pinheiro, Armando Castelar (1996), “Judicial System 

Performance and Economic Development” October. 

Pistor, Katharina and Philip A., Wellons (1999), “The 

role of law and legal institutions in Asian economic 

development : 1960-1995”, Asian Development Bank, 

Executive Summary. 

Posner A., Richard (1998), “Creating a Legal Framework 

for Economic Development”, World Bank Research 

Observer, 13(1), February, 1-11, (Ed.) Hans-Bernd 

Shafer and Angara V. Raja, “Law and Economic Development”. 

Rabiyath, Siddik (2007), “Litigation, Disposal Effi ciency 

and Pendency: A Comparative Analysis of Kerala and 

Andhra Pradesh”, M.Phil., dissertation, University of 

Hyderabad. 

Santhakumar V. (2003), “Citizens’ actions for protecting 

the environment in developing countries: an economic 

analysis of the outcome with empirical cases from India”, 

Environment and Development Economics 8: 505-528, 

Cambridge University Press. 

Scully W., Gerald (1988), “The Institutional Framework 

and Economic Development” The Journal of Political 

Economy, Jun., Vol. 96, No. 3, pp. 652-662 

Visaria, Sujata (2006), “Legal Reform and Loan Repayment: 

The Microeconomic Impact of Debt Recovery 

Tribunals in India”, April. 

World Bank (2002), World Development Indicators. 

Xavier, Francis Rathinam (2007), “Law, Institutions and 

Finance: Time Series Evidence from India”, German 

Working Papers in Law and Economics, Paper 4. 


refl ect the offi cial policy or position of the organisation. The 

earlier version of this paper was presented in Centre for 

Development Studies. Here the author acknowledges Dr. 

Shanthakumar, Dr. Sunil Mani, and other participants who are 

all given valuable comments to the author and a special thanks 

goes to Alice Sebastian and Krishna Reddy Chittedi.) 


141

performance and development of market economies 

[Pinheiro - 1996, World Bank - 2002]. It does so in many ways: 

the judiciary is the mechanism whereby disputes on the 

allocation of rights mainly property rights, disputes between 

private parties, private and public parties are decided 

according to norms and rules of the society. Consequently, 

institutions help to reduce uncertainty by providing a 

structure to everyday life [North - 1996]. Posner (1998) 

mentioned that legal machinery in its ideal form consists of 

competent, ethical, and well-paid professional judges, 

lawyers, police or other functionaries who administer rules 

that are well designed for promotion. It is necessary because 

effi cient legal system depends on the effi cacy of the institu- 


tions which is implementing the rule of the law. 

Kohling (2000) argues that a country’s government can 

infl uence the economy negatively through a weak administration. 

Inappropriate mechanisms that lack checks and 

balances create corrupt government. Therefore judiciary is 

the appropriate body to exercise control over such a corrupt 

administration. Thus, an unbiased judiciary is essential for 

economic development. Hence law is not only considered as 

a dispute resolution system but also considered as an 

important instrument of economic development. 

Economic theory supports the idea of judicial independence 

and high quality courts facilitate economic growth [Feld 

and Vogit - 2003]. Effi cient, independent, and impartial 

courts enforce contracts and protect property. This encourages 

investment which is essential for economic development. 

It is therefore important to study the economic 

implications of the legal system in the context of developing 

countries. In those countries, law enforcement is poor 

because the general institutional structure is weak. 

This paper has a dual objective. First, to review the 

theoretical arguments that helps to understand how effi cient 

judicial system helps to attain economic growth. Second, to 

review literature which explain the relationship between 

judicial system and economic performance. Special attention 

is given to studies with empirical content related to India. 

What is Well-Functioning Judicial System? 

Before going into the analysis of the theoretical and empirical 

literature, which explains the relationship between legal 

system and economic development, it is necessary to understand 

the well-functioning judicial system and the ways it can 

affect economic development. 

A well-functioning judicial system should have the following 

properties such as low cost access, transparency, fairness, 

predictability, and timely outcomes which help to promote 

business and commercial activities through protecting 

property rights of the individuals [Maria Dakolias (2003), 

Pinheiro (1996)]. 

Kohling (2000) identifi ed three preconditions for institutions 

to be effi cient: (i) the respective institutions are well 

defi ned; (ii) all necessary information is verifi able; and (iii) 

the absence of cost for transferring or securing of property 

rights. According to him ineffi ciencies usually emerge due to 

information asymmetries or incomplete information as not 


133


all contingencies can be foreseen, and therefore the respective 

solutions cannot be included a priori in contracts. 

What Ways Legal System 

Can Promote Economic Growth? 

Piheiro (1996) mentioned that in the supply side growth, 

well-functioning judiciaries can promote growth through 

the following channels: Technological progress, investment, 

and effi ciency. 

Technological Progress 

Well-functioning legal system may 

stimulate growth by protecting intellectual 

property rights and in this way 

fostering technological progress and 

absorption. It can encourage domestic 

fi rms to invest in Research and Development 

(R&D). This leads to wider diffusion 

of knowledge, including not only 

spillovers, but also the transmission of sound managing, 

marketing and fi nancing practices. 

Investment 

By stimulating a more rapid accumulation of factors of 

production, well-functioning judicial system can encourage 

investment in both physical and human capital 

through secure property rights. Particularly private agents 

will only make long-term and highly specialized investments 

if they are secure that the contract activities will be 

properly enforced. 

Effi ciency 

Dysfunctional judicial system can limit growth by stimulating 

ineffi cient use of resources and technology through high 

risk and large transaction cost. And it can reduce economy’s 

effi ciency by consumption of scarce resources. 

Cross (2002), quoted Lon Fuller stressed point that 

property and contract rights are vital to growth, a legal 

system must restrain the “rigidities of property and contracts” 

so that the society can “direct its resources toward 

their most effective use.” Therefore the effi ciency of the 

judiciary is important not only for themselves, but also for all 

other institutions for promoting long-term investment and 

contracts. As the judiciary enforces and monitors all other 

134 


Institutions are 

humanly devised 

constraints (formal 

and informal) that 

structure political, 

economic, and 

social interactions 

institutions, a weak judiciary can affect the performance of 

all other institutions. 

Theoretical Background of 

Legal Institutions and Development: 

This section theoretically analyses the importance of legal 

institutions for reducing uncertainty and transaction cost 

which encourages economic activities in the economy. 

Institutions are humanly devised 

constraints that structure political, 

economic, and social interaction. They 

consist of both informal constraints (sanctions, 

taboos, customs, traditions, and 

codes of conduct), and formal rules 

(constitutions, laws, property rights). 

These institutions provide the incentive 

structure of an economy; as that structure 

evolves, it shapes the direction of economic 

change towards growth, stagnation, 

or decline [North – 1991]. 

‘New Institutional Economists’ argued that economic 

development requires many kinds of investment such as 

physical capital, human capital etc. Investment will occur if 

investors can be confi dent that they will attain their profi ts. 

Investment will undermine if the government or a private 

party expropriates the investment or profi t [North - 1996]. If 

no mechanisms such as governmental or non-governmental 

exist to prevent theft, then any person can wait for others to 

create property or produce output and then steal it; this 

usually makes less effort to creating property or the product 

oneself [Dixit – 2004]. 

Ginsburg (2000) quoted North view of “How effectively 

agreements are enforced is the single most important 

determinant of economic performance”. Feld and Vogit 

(2003), summarizes the institutions importance to reduce 

uncertainty and how it helps to improve the investment 

which is essential for growth. 

Among the many functions of government, the reduction of 

uncertainty is of paramount importance. But the law will 

only reduce uncertainty if the citizens can expect the letter of 

the law to be followed by government representatives. An 

independent judiciary could thus also be interpreted as a 

device to turn promises – e.g. to respect property rights and 

abstain from expropriation – into credible commitments...

citizens will develop a longer time horizon which will lead to 

more investment in physical capital but also to a higher 

degree of specialization... 

In the marketplace transaction can be concluded as two 

bundles of property rights are exchanged. A bundle of rights 

often connects with a physical commodity or services, but 

that value of the rights determines the value of what is 

exchanged [Demsetz -1967]. Market economy can not have 

effi cient exchanges in the presence of high transaction costs 

and externalities [Rabiyath – 2007]. Transaction costs are 

higher when law is uncertain [Scully – 1988]. In the small 

economy i.e. closed economy transaction costs are low; 

because of the face to face transactions. But when the economy 

or market begins to grow transaction costs will sharply 

increase due to complex production system. In this complex 

system production costs are high through specialization and 

division of labour. This requires safeguard of property rights 

across national boundaries so that capital markets (as well as 

other kinds of exchange) can take place with credible 

commitment on the part of the players. Therefore it demands 

the effective institutions which can reduce transaction 

costs through reducing the asymmetric information. 

Obviously transaction costs are a critical determinant of 

economic performance. Ultimately, institution's effective 

enforcement determines the cost of transactions. In other 

words, effective institutions can raise the 

benefi ts of cooperative solutions or the 

costs of defection [North – 1991]. 

Non-Legal Rules 

or Informal Rules 

While institutional economists consider 

the effective value of legal institutions 

and property rights, non-institutional 

economists are argued that the actual 

need for such institutions may be exaggerated. Judicial 

independence and good courts are not necessary for investment, 

there are other mechanisms which can enforce 

contracts and protect property. Contracts can be enforced by 

reputation, without recourse to the courts. When parties 

deal with each other repeatedly contracts may be respected 

because people fear of their good reputation. Similarly, the 

government can protect property through policies against 

expropriation disputes [Klerman]. In other words, individu- 

The shortage of 

empirical research 

is a problem 

that affects the 

entire field of 

institutional 

economics 


als can voluntarily organise their transactions 2 , without legal 

institutions i.e., they may substitute co-operation for law, in 

that manner can reap their profi ts. These informal substitutes, 

includes arbitration and reputation, for the legal 

enforcement and protection of property and contract rights 

[Posner - 1998]. 

However such kind of an informal framework may limit 

transactions within one family members or ethnicity [Cross 

- 2002]. Small number of players fi nds it worthwhile to 

cooperate when they play repeatedly and when they possess 

complete information about the other player’s past performance. 

But cooperation is diffi cult to sustain when the game is 

not repeated, when information on the other players is 

lacking and when there are large numbers of players [North 

– 1991]. As a consequence, shortage of new fi rms and people 

with new ideas and entrepreneurship, and an inability to 

enter into long-term contracts can prevent the adoption and 

development of complex technologies. In addition that 

institutions need not and generally has not prohibited the 

norms and private arrangements such as arbitration agreements, 

but considerably expands the scope of contracting 

choices [Cross – 2002]. 

In short, there are two schools of thought: one belongs to 

institutional economics which is giving importance for 

formal institutions and another school which is for informal 

institutions. It is therefore not clear from 

a theoretical standpoint how much 

institutions are important for economic 

development. This lacuna needs to be 

fi lled with empirical evidence which 

shows the relationship between legal 

system and economic development. 

Review of Literature: 

International Perspective 

Institutions are so ingrained with social, economic, legal, and 

political life that it is diffi cult to isolate the impact of one 

institution such as legal, on economic performance. Therefore 

the shortage of empirical research is a problem that 

affects the entire fi eld of institutional economics. In spite of 

that, the following empirical literature tries to provide the 

relationship between judicial system and economic development. 

There is renewed interest among economists in the 

question of what are the fundamental factors for the large 


135


difference in income per capita across countries? Though 

there are multiple answers for this question, differences in 

institutional framework and property rights have received 

considerable attention in recent years. One of the important 

studies in this context was by Scully (1988). The study 

tried to explain the impact of the choice of institutional 

framework on effi ciency and growth of economies. The 

study used linear multiple regression analysis and the 

model incorporated economic variables (viz. real per capita 

gross domestic product and capital-labour ratio) and 

institutional variables (viz. political, civil, and economic 

liberty) for 115 market economies for the period 1960 to 

1980. The study found that politically open societies, which 

subscribe to the rule of law, to private property, and to the 

market allocation of resources, grow at three times the rate 

and are two and one-half times as effi cient as societies in 

which these freedoms are circumscribed. 

However, most of the countries are facing political 

instability rather than liberty. Therefore, Barro (1991) 

studied the impact of political instability on economic 

growth for 98 countries in the period 1960-1985. The study 

used regression technique for analyzing the impact of 

revolutions and coups, and per million population of 

political assassinations on per capita growth. The study 

showed that both these variables are negatively affecting 

investment and economic growth via 

adversely infl uence the property rights. 

The limitation of this study is that, it 

doesn’t explain how these variables are 

adversely affecting property rights, 

because political assassination may 

happen for several purposes. 

While institutional framework is 

considered as an important instrument 

for explaining differences in income 

between countries there is a little doubt 

about that whether history has any role in determining the 

shape of present-day institutions and the economic performance 

of the countries? In this context an interesting study 

was conducted by Acemoglu et al. (2001). It argued that 

differences in colonial experience could be a source of 

differences in institutions. The study analyzed the European 

colonization; Europeans adopted different strategies 

associated with institutions. In places where they faced high 

136 


Differences in 

historical property 

rights institutions 

lead to continued 

differences in 

many economic 

outcomes 

mortality rates or where they could not settle safely, they 

created extractive states or did not protect private property 

rights. The study used regression method and model includes 

economic outcome (per capita GDP) and institutional 

variable (protection against expropriation) for a sample of 

64 countries. The study found that early institutions persisted 

to the present; therefore settler mortality rates do not 

have direct effect on income today other than through their 

infl uence on institutions. However, this study analyzed 

whether the settlement of institutions during the colonization 

have any impact on present day institutions, it is important 

to study whether any specifi c historical institution 

followed during the colonization period have impact on 

present day economic performance. 

Banerjee and Iyer (2005) attempted to compare the 

present-day economic performance of different districts of 

India, which were placed under different land revenue 

system by British colonial rulers. The study showed that 

differences in historical property rights institutions lead to 

continued differences in economic outcomes, i.e., areas in 

which property rights of land were historically given to 

landlords have signifi cantly lower agricultural investments 

and productivity in the post-independence period than areas 

in which given to the cultivators. 

While property rights or choice of institutions are considered 

as important for economic growth, 

the qualities of these institutions are also 

equally important. In this aspect an 

interesting study done by Feld and Vogit 

(2000) analyzed the relationship between 

economic growth and judicial independence 

(JI). The study introduced two 

indicators of JI such as de jure and de 

facto. Whereas de iure JI can be derived 

from the legal documents, de facto JI is 

the independence enjoyed by judges and 

justices does not suffi ce to write in legal documents. The 

study used econometric model which incorporated economic 

variables (viz. real GDP per capita, private and public 

investment etc.) and JI variables such as accessibility of the 

court, appointment procedure of judges, constitutional 

specifi cation of the court’s procedures, tenure of judges and 

their salaries etc. for de jure and length of the members of 

the high court, court’s budget etc. for de facto for a sample

of 57 countries between 1980 and 1998. This study found 

that de jure JI does not have any impact on economic growth 

and de facto JI positively infl uences economic growth. The 

limitation of this study is associated with the collected data 

for de facto. This study defi nes JI as judges can expect their 

decisions to be implemented regardless of other government 

branches upon whom implementation depends. For analyzing 

de facto this study collected data through questionnaire 

(via e-mail). If respondents answered 

socially desired answer for this question3 then the results may be questionable. 

Economists have also analyzed the 

importance of law for economic growth in 

context of liberalization or market 

orientation, because in recent years most 

of the countries liberalized their economies 

for integrating with the rest of the 

world. So it is important to study, in the 

open market regime, how legal system is 

important for economic growth. In this aspect an important 

study conducted by Pistor and Wellons (1999) analyzed the 

relationship between law and economic development 

experience with Asia. The study covered six East Asian 

economies for the years of 1960-1995. The study found that 

by mid 1980s all economies moved from state-led economic 

policy to market-oriented solutions, law became important. 

Therefore, it concluded that law mattered for economic 

development in the period after the policy shift. An important 

question regarding this study conclusion is that, if law is 

important for economic development after the policy shift 

means, before that whether law does not matter for economic 

growth or is this study accepting the non-institutionalist 

view? This study doesn’t answer these questions. 

Apart from property rights and law effi ciency one 

important aspect which is missed in the theoretical argument 

is how weak legality, which arises from the violation 

of laws, can affect investment and economic growth. An 

interesting study in this perspective done by Daniele and 

Marani (2008) analyzed the impact of organized crime on 

Foreign Direct Investment (FDI) in Italy. The study found 

that in Italy compared to northern part, southern part 

attracts very less FDI. Italy is rooted presence of organized 

criminal organizations (viz. camorra, mafi a, sacra corona 

unita etc.) So the study hypothesized that the presence of 

Presence of 

crime constitutes 

a competitive 

disadvantage, 

limiting the area’s 

potential for 

attracting FDI 


crime constitutes a competitive disadvantage which limits 

the degree of an area’s attractiveness for potential foreign 

investors. After controlling the relevant economic variables, 

this study found that the extortion of money and the 

number of accused persons, which are proxies for organized 

crimes negatively affects FDI infl ows. But the limitation 

associated with this study is that, it doesn’t address the 

impact of organized crime on domestic investment. If 

domestic investment itself is affected by 

these types of crimes, then there is no 

point to expect foreign investment. 

One of the main criticisms of crosscountry 

empirical study is that, cross 

country regression are based on unrealistic 

assumptions such as equal growth path 

and equal weighting of countries and also 

suffer omitted variable bias and sample 

selection bias [Barro - 1991]. And to 

control for a range of factors that infl uences 

economic performance cannot be as convincingly 

controlled for in cross country data [Chemin – 2007]. 

Therefore, it is necessary to study the country specifi c 

empirical studies which explain the relationship between 

legal system and economic growth. 

The Indian Case: 

India seems to be an interesting testing ground to analyze 

the relationship between legal system and economic development; 

it is one of the developing countries that witnessed 

dramatic deregulations in various sectors during the 1990s. 

These efforts need a complementary reform in legal sector 

also. Postner (1998) suggests that legal reform is an important 

process for poor countries, but the focus of such reforms 

should be on creating substantive and procedurally effi cient 

rules of contract and property than on creating a fi rst-class 

judiciary. The Indian judiciary operates at three levels: a 

unique Supreme Court at the federal level; High Courts in 

each state; and, at lower levels, district judges for civil cases 

and session judges for criminal cases. India operates under a 

common law system which implies that the actions of High 

Court judges set precedents for the functioning of subordinate 

courts in Indian state4 . Judicial effi ciency and speed in 

India seems to be the greatest problem with courts in India, 

dominating all other problems such as fairness, predictability 


137


and access to the judiciary [Chemin – 2004]. Pendency in 

India has been growing four percent in High Courts and 3.6 

percent in the Subordinate Courts in the period 1999-2005 

as against a mere of 1.29 percent in US Courts for the period 

1990-1998. Average duration for disposal in India is 5-10 

years where as it is only one year in US [Rabiyath – 2007]. In 

a study of citizens’ action against environment damage 

Santhakumar (2003) mentioned that delay in court decisions 

will create social loss via more pollution if 

citizens’ action is against existing fi rms or 

affect production if it is against new fi rms. 

For reducing pendency in Indian 

courts, which is one of the notable 

problems, several measures have been 

introduced in the last decade like Lok 

Adalat5 , Debt Recovery Tribunals 

(DRT) 6 , and Code of Civil Procedure of 

1908 Amendment Act7 of 2002 etc. It is 

therefore important to study how these 

legal reforms or procedural laws helps to increase the quality 

of judiciary and to improve economic development of the 

country. Though there are different dimensions of the 

empirical literature available in the case of cross-country 

analysis, country specifi c literature are limited particularly 

related to India. In the next section we attempt to review the 

available empirical literature on India. 

In this section we review the empirical studies which have 

attempted to examine the impact of pending cases on 

economic growth and effects of legal reforms, which is speed 

up the disposals of cases, on economic growth in India. 

Regarding pending cases, the fi rst question raised in our 

mind is that whether pending cases affects economic growth 

or not. One of the important studies in this context done by 

Kohling (2000) examined the economic consequences of a 

weak judiciary on the economic growth using data on 25 

Indian states and union territories for the period 1971 to 

1996. The study used cross-regional time-series regression 

and the model includes economic variables such as per 

capita income, agricultural production, private sector 

development, capital formation, poverty rates, etc. and 

judicial variables such as speed of the judiciary or average 

years of backlogs in the High Court (viz. ratio of pending 

cases at the beginning of the year to cases decided within 

that year) and predictability of the High Court rate (viz. 

138 


Pendency has 

been growing 

at 4% in High 

Courts and 3.6% 

in the Subordinate 

Courts in the 

period 1999-2005 

ratio of allowed appeals from High Court to Supreme 

Court). The study concluded that a weak judiciary has a 

negative effect on economic development which leads to 

lower per capita income, higher poverty rates, lower private 

economic activity, poorer public infrastructure, higher crime 

rates, and industrial riots. Here it should be noted that the 

weakness of this study is that, it identifi ed predictability 

through allowed appeals from High Courts to Supreme 

Court, in India appeals to the Supreme 

Court is only for matter of law not for 

matter of fact and this study is concerned 

weakness of the High Courts only. This 

kind of studies mainly suffer from the 

limitation that it doesn’t make any 

distinction between economically relevant 

cases and others. It may thus be 

over estimating the pendency in Indian 

High Courts. 

Chemin (2004) analyzed how the case 

pendency rate in state courts in India affects the contracting 

behaviour of 170,000 small non-agricultural informal fi rms 

from the 55th round of the National Sample Survey of 2000. 

The study used Probit regression technique and after 

controlling the state-level (through state domestic product, 

literacy rates, state expenditure etc.), fi rm-level variables 

(through indebtedness, fi nancial sources, labour productivity 

etc.), sector-specifi c effects, and panchayats and rural 

planning commissions information, the study found that the 

slow judiciary, which is measured by ratio of pending cases at 

time period ‘t’ to the pending cases at ‘t-1’ plus cases fi led, 

implies more breaches of contract, discourages fi rms from 

undertaking specialized investment, impedes the access of 

fi rms to formal fi nancial institutions, and favours ineffi cient 

family-owned fi rms. 

However, for reducing pendency Indian courts introduced 

various legal reforms to speed up the disposal of 

cases. Thus it is interesting to study whether these legal 

reforms really helps to increase the speed of the disposal of 

cases and if it is so, how it helps to improve the economic 

growth. One of the important studies in the context was by 

Visaria (2006). The study analysed the Recovery of Debts 

due to Banks and Financial Act, 1993 (Debt Recovery 

Tribunal Act), a judicial reform which aimed at accelerating 

banks' recovery of Non-Performing Assets (NPAs) through

speed up the legal process. The study used difference-indifferences 

strategy based on two sources of variation (the 

monetary threshold for claims to be eligible for these 

tribunals and the staggered introduction of tribunals across 

Indian states) and showed that the establishment of 

tribunals reduces delinquency in loan repayment by 

between three and 11 percent. Furthermore, new loans 

sanctioned after DRT establishment are charged interest 

rates that are lower by 1.4-2 percentage points. 

Chemin (2007) investigates the impact of judicial reform, 

enacted in 2002 Amendment Act to the Civil procedure 

Code of 1908 in order to make litigation more effi cient, on 

fi rms contracting behaviour and economic performance of 

5,20,000 small informal non-agricultural fi rms from 2000 and 

2002 rounds of National Sample Survey. The study used the 

spatial variation in the implementation of judicial reform 

and found that this reform decreased the number of cases 

pending per judge in lower courts. For analyzing fi rms 

behaviour the study used regression technique and after 

controlling state and sector specifi c effects, the study found 

that a speedier judiciary leads to decrease in the breaches of 

contract, encouraged investment, facilitated access to 

fi nance, and expanded rental markets. The drawback of this 

study is that it controlled alternative dispute resolution 

system such as fast-track courts and Lok Adalats, but in rural 

areas people still depends on panchayats 

for solving their disputes. This study does 

not control this alternative informal 

dispute solution system and fi rm specifi c 

effects. Nevertheless, this study explains 

judicial reform positively infl uencing 

economic behaviour of fi rms. 

Xavier (2007) analysed the long run 

relationship between fi nance and growth 

through the determinants of fi nancial 

sector growth such as legal and institutional 

developments and fi nancial regulation in India. 

During 1990’s India introduced various legal reform, 

Securitization and Reconstruction of Financial Assets and 

Enforcement of Security Interests Act (SRFAESI Act), Debt 

Recovery Tribunals Act etc. It is expected that these innovations 

in the procedural law would facilitate fi nancial sector 

development. The study analyzed these effects in the VAR 

system, incorporated following variables such as per capita 

Though pendency 

is the potential 

problem in Indian 

courts, there are 

other problems 

like corruption 

and instability 


GDP and Legal Development (procedural law and regulatory 

reforms as they matter for the speed and the quality of 

redress), Financial Regulation (statutory liquidity ratio and 

other interest rate controls) and Index of Institutional 

Development (a ratio of broad money net of currency in 

circulation to broad money) indicies. This study identifi ed 

that a single co-integrating vector in all of the specifi cations 

indicating that there is a long run relationship among the 

variables considered. The result shows that legal, institutional 

developments positively affect fi nancial sector with 

considerable feedback and economic growth with less 

feedback and fi nancial regulation has a negative impact on 

fi nancial sector growth. The interesting aspect in this study is 

that the studies which we reviewed above showed one way 

relationship i.e., improvement of the judicial quality leads to 

increased economic activities, but this study is expressing 

two way relationship which is development of fi nancial 

sector demands the legal development. 

From the above studies we can understand that law and 

governing institutions are clearly relevant for economic 

growth. 

Scope for Further Research: 

In the case of cross country studies it deals with different 

aspects of legal system such as political or property rights, 

policies, judicial independence etc., but 

in the case of empirical studies from 

India directly or indirectly deals with 

quality of judiciary which is delay in court 

decision or backlog of pendency in 

Indian courts and how it affects the 

economic growth. Some studies deals 

with judicial reforms which are also 

related to pendency cases in Indian court, 

how the judicial reform helps to increase 

the speed of the judiciary, and how it 

helps to promote the economic growth of the country. With 

these one dimension studies it is diffi cult to articulate, for 

practical purposes what laws and implementing organizations 

are most effective at enhancing economic growth and 

what actions preventing such growth. Though pendency is 

the potential problem in Indian courts, there are other 

problems such as legal corruption, political instability, legal 

process (much procedures to approach courts will increase 


139


transaction costs), implementation of law, implementation 

institutions etc. But empirical studies from India do not 

address these issues. 

Another important issue is that legal institutions do not 

play a wholly autonomous role in development; their 

effectiveness depends on the effectiveness of a number of 

other institutions. Therefore it is important to study legal 

systems as well as other institutions such as Government 

upon which the effi ciency of judicial system depend simultaneously. 

In India sector specifi c studies are also limited for e.g. 

Kohling (2000) render specifi c look at the agriculture sector 

and he found that in India thirty percent of the civil claims 

related to land ownership, rent, and other related issues. 

Therefore increasing the quality of the judiciary facilitates a 

higher agricultural production and reduces the long-term 

poverty rates through long-term investments. Though some 

of the studies which we reviewed show the fi nancial sector 

development and growth, these deals with the banking 

sector reforms only. In recent years India’s services sector is 

experiencing faster growth than other sectors. These 

studies do not talk about how legal reform helps services 

sector, except fi nancial sector, to achieve this growth as 

most of the services sectors are in informal sectors. It is 

important to study how legal system or reform relates 

services sector growth particularly in the informal sector. 

In other words, these studies use the variables which are 

representing the characteristics of legal institutions and 

they do not concentrate much on which type of institutions 

play the most important roles in development. Though 

legal institutions are important for economic growth, it is 

only part of the legal system. These studies do not address 

the issue of relationship between legal system and economic 

development. Therefore, in that context additional 

researches are required to explore the relationship between 

law and economic development. 

Summary and Conclusion 

In theory, according to New Institutional Economists, 

institutions particularly legal or formal institutions are 

important for achieving property rights which encourages 

investment that is essential for economic growth, because 

investment will occur only if investors are confi dent that 

they can reap their profi ts. 

140 


At the same time non-institutional economists who are 

arguing that the importance of legal institutions are 

exaggerated, individuals themselves can organize institutions 

and in that manner they can attain their profi ts and 

contracts can be enforced through reputation. But this is 

possible only in the closed or primitive society. When 

society expands or it becomes complex market economies it 

needs proper institutions which enforce private property 

rights and contracts. Therefore, it is important to understand 

the relationship between legal system and economic 

development with the help of empirical studies. 

This paper reviews the Cross-country and Indian empirical 

studies which are exploring the relationship between 

legal system and economic development. India is one of the 

developing countries facing the potential problem of large 

backlogs in its courts. In order to solve that Indian courts 

introduced some legal reforms to speed up the disposal of 

cases. These are expected to improve economic development 

via supporting the liberalization of the economy. 

Therefore, India is the interesting ground to test the 

relationship between legal system and economic growth. 

Though in India not much empirical studies available in 

different dimensions, the studies which we reviewed 

illustrate the importance of the quality of the judiciary on 

economic development. Therefore, with the help of 

literatures this study concluded that there is a direct 

relationship between legal system and economic development 

in India. 

Endnotes 

1 I will use the words judicial system and legal system 

interchangeably in what follows 

2 The best example is diamond business. 

3 “In how many cases has one of the other government 

branches remained inactive when its action was necessary 

for a decision to become effective?” 

4 Chemin - 2004 

5 Lok Adalat is dispute resolution mechanism which 

follows the methods of conciliation and mediation are 

employed to settle cases before goes into the court. 

6 Banks and fi nancial institutions can recover their nonperforming 

loans through DRT quickly. 

7 It encourages out-of-court dispute settlement such as 

arbitration, conciliation, mediation etc.


142 

Free Trade and Free 

Markets: A General Law 

Perspectives 


Rabin Majumder 

Advocate & Attorney, 

NuDelhiLawFora, Law Firm, New Delhi 

A. Introduction 

Commodity exchange or bartering to hunters’ fl esh trade 

for produce to even fresh fruits producers’ practice for 

vegetable to mediums such as stone, metal, and later coins 

and paper money to trading papers of shares, bills, promissory 

notes, and all kinds of future instrument to high-end 

technology into a paperless society for trading the intangibles 

have been in the transitions with some yet not-sostrong 

legal regimes in India, until recently. The oldest 

development is revocation of the slavery 

law leaning towards humane treatment 

of every such activity to improve standard 

of living and promote freedom to 

allow human dignity which became the 

mantra of legal systems globally affecting 

that of India. 

Free markets myths, even the self 

regulated free Laissez-faire (welfare) 

market in vogue in mid-19th century, 

simply did not fair well, not even marketforces-would-balance 

off any bad elements-through competitive 

market mechanism theory. Even Adam Smith, the 

most famous proponent of British laissez-faire ideology, did 

not believe free market in its strict sense. However, government 

activity in public utility works was engaged in regulation 

of foreign commerce to safeguard few selected home 

industries resulting in creation of free trade zones of 

NAFTA, AFTA, APEC, APEC plus Three and plus Five, 

EU, through EEZ to STPI to SEZ etc. which have never 

been freed by excluding non members to the markets. This is 

also evident in the Free Trade Agreement (FTA) signed 

between India with many other trading nations. The evolu- 

A free-trade 

policy does not 

necessarily imply 

that the state 

abandons all 

policy and 

legal controls 


F LAT WORLD 

tion and effect of WTO to regulate trades with greater 

restriction to free trade is something which needs detail 

discussion. On the private front, concept of Anti-trust, 

insider-trade, unfair trade practice, corruption, smuggle, 

that suggest rampage of non-free trade practices and so as 

the legal provisions and its applications. The ambit of laws 

immensely enlarged with traditionally domestic focused 

legal systems to transnational reach. 

In Indian context, much hyped "free"-ship in "free markets" 

and “free trade" is, in effect, a manipulated freedom of 

the high and mighty which calculatedly prevents equality 

which otherwise essentially hits by basic features of the 

Constitution of India besides other substantive laws prevailing 

from time to time. As some sections rightly observed, 

trade is not the same as democracy since ability to access to 

markets (read “free markets” through “free trade”), do not 

obviously presume free and fair elections. In short, inequality 

looms large by way of camoufl aged-tyranny backed by 

legal sanction affecting 'aam aadmi' of India. Law here 

seems rendered ineffective. 

The wide spread acquisition of lands by the “land-sharks” 

backed by the Governments and inappropriate 

applications of prevailing land 

acquisition laws is an glaring example of 

doing away with democratic legal 

process through policy shifts which can 

not be challenged in any court of law and 

such illegality and inequality is often 

overlooked by way a “suitable” compensation 

packages often sanctioned by the 

Courts rendering the theory of fair 

practices meaningless. 

Legal regimes are ones although engulf the system yet 

policy overshadows the substantive legal provisions making 

the legal environment further weak. Secondly, foreign 

trade policy envisages that a trade policy cannot be fully 

comprehensive in all its details which would naturally 

require modifi cation from time to time based upon the 

inevitable changing dynamics of international trade. For 

example. by way of partnership with business and industry 

as in PPP models. 

B. Hypocrisy of Free Trade 

It has been observed that ever since the beginning of 

143


economic liberalization in 1991, a plethora of new industrialization 

policies have been unveiled and the government is 

continuing to do so. Having laid the policy framework that 

allows private control over community resources – water, 

biodiversity, forests, seeds, other markets and resources – 

successive governments have laid the foundations of an 

“exit policy” for farmers. Be that as it may, some general 

and area specifi c laws have been put in place to shape the 

legal environment clearer and effective to deal with 

changed scenario internationally at national level, in order 

to “free” trade. 

Big Brother WTO 

Gradually, the heat at the grassroots began to sweep into the 

political system. Primarily because of this heat generated 

within the country, India’s stand at the WTO has hardened 

over the years wherein India’s negotiators have so far kept 

national interests in mind. Opposition to the WTO has also 

galvanised newer protests, i.e., against 

SEZs, land acquisitions and FDI in food, 

retail, etc. Sensing troubles, within the 

country, the Indian government has had 

to bring in a new rehabilitation policy for 

those so displaced. 

The continuing WTO deadlock has 

given India the impetus to re-orient trade 

policies from multilateral to bilateral 

agreements. India began exploring the 

possibility of entering into comprehensive 

economic partnership agreements (EPAs) with, inter alia, 

including the ASEAN members. And that India is also 

seeking trans-continental FTAs. A bilateral trade agreement 

with the EU is on the roll. India is also gearing up to 

start preferential trade agreements with BRIC countries and 

the Southern African Customs Union. It may be noted that 

specifi c commitments pertaining to national laws so as to 

make strong, transparent disciplines on government procurement 

procedures, rules of origin and effective enforcement 

of domestic labor and environmental laws are being 

put in place. 

C. Myths Generally 

Every system of laws has obvious strength for which it is 

brought forth and also has its corresponding inherent lacuna 

144 


By allowing 

private control 

over community 

resources, 

governments 

infact laid an 'exit 

policy' for farmers 

and pitfalls and so also has its own myths. Proponents of 

free-ship of trade and commerce in free market concept are 

like a coin having two sides i.e. one way they are neo-liberal 

and on the other, orthodox. Some Western economists 

provide cogent arguments as to why developing nations 

should go against such ‘manufactured’ wisdom and plump 

for development models that best suit their goals. 

Ironically, for countries like India, related trade laws are 

focused and tailor-made keeping in mind what so called 

“Good Samaritans” and their dictat desire us to do, no 

wonder what their action is, people in India follow through 

what is preached before it and that becomes new beginning 

for India which is in essence skipping industrialization and 

increase in domestic laws problems and also evolution and 

benefi t of only service sector (which according to some is a 

dangerous game, having direct effect on core economy 

concept for which India is known to the world.) And new law 

takes over overnight without any other or further discussion 

with “universal” applicability. 

A structured economic concept suited 

for a particular system is made “universally” 

applicable with modulated legal 

provisions to give required shape. WTO 

dispute settlement mechanism is one of 

those kinds, to name a few. And often it 

has been seen that India adapt such legal 

culture which was until recently unknown. 

Competition laws are of that 

kind. People at power elevate people on 

roads to understand that new laws are the ones which can 

not be ignored and has to be assimilated with like latter’s 

bread-n-butter. 

Probably, India has mastery over injecting the new legal 

concept every now and then it is asked to. A copy-paste 

culture is in vogue in legislative process of making of new 

laws. The laws relating to intellectual property rights; 

foreign direct investments, rules and regulations have been 

so framed that the benefi t only those other india as a nation. 

It is frightening to note if countries like India violate these 

rules to protect its sovereignty and food security, etc., the 

nation is threatened with trade sanctions and economic 

isolation. But if the propounder of such scheme makes an 

exception, it is economically so justifi ed (and legally too). 

Its new kind of international legal tools whereby exploita-

tion worldwide is sanctioned and is made tenable. In one 

such occasion concerning American Rice, Inc., a U.S. 

District Court leisurely legitimatized bribery by a U.S 

company to a foreign offi cial to reduce the company's tax 

burden or customs duties etc. in abroad, thereby paving the 

way for future legal protection of those in the Western 

countries to seek legal protection for their wrong doings 

elsewhere whereby the accused could have been tried and 

convicted if found guilty in domestic legal systems. This is a 

clear case of ousting the jurisdiction of Indian sovereignty 

over choice and application of its own laws. 

Corporate Good Governance, happily celebrated by 

economies like India, seems only to be the hallmark India 

alone. Thus India has made free inroads for market economy 

assimilating again the those laws alien to domestic 

demands and legal status. 

The problems India faces today is legislative efforts are 

also market-driven now-a-days and people specifi c. Mere 

adoption of such international laws as 

municipal laws is strategically dangerous 

especially in technology driven laws. 

D. Market Economy in India & Laws 

Induction of market-driven economy 

(read free market) in India raised a few 

eyebrows amongst academics having dual 

interests in economy and law. The 

‘roll-back’ by the State would affect social 

security provisions otherwise guaranteed 

by the Constitution of India which in turn entails inequality 

and thus, have dangerous elements of altering basic structure 

theory of the Constitution. This would essentially also 

weaken the community-feeling and the extended family 

concept which is core bondage of India’s family institutions 

and thus may cause a massive law and order problems. 

On the other hand, some opine that free market economy 

in India must not be viewed so negatively which needs 

to live and sustain on the strengths of Indian socio-cultural-political 

values. It may be noted that role of the State is 

quite crucial in India in comparison with respect to 

market liberalization. 

India is a fast-growing economy with a dynamic and 

robust fi nancial system. Being a democracy ensures a stable 

policy environment and its independent institutions guaran- 

In fact, a market 

economy is based 

upon private 

property rights 

and this inturn is 

secured by the 

rule of law 


F LAT WORLD 

tee the rule of law. India is a free-market democracy with a 

legal and regulatory framework that rewards free enterprise, 

entrepreneurship and risk taking. India is a free-market 

democracy with a robust, well-developed legal and administrative 

system. The Indian legal system has been derived 

originally from that of the UK and is considered at par with 

that of any developed economy. Accounting standards in 

India are similar to those followed internationally. 

E. Conclusion 

It is often said that the ‘Rules of the Game’ helps facilitate 

the economic process, in which the rule and law and 

property rights are components. Economically, the most 

important feature of the rules of the game is clearly defi ned 

property rights and a rule of law that recognizes them. 

Legally speaking, it creates bundle of rights to enjoy and 

litigate. Property rights are essential features of the free 

market economy because they encourage market coordination 

and create comparative advantage. 

In fact, a market economy is based upon 

private property rights – rights associated 

to specifi c individuals in the form of 

legal ownership. 

This is secured by the rule of law, which 

encourages wealth, and prevents the 

subjection of people to the tyranny and 

exploitation of others. However, free 

trade assumes a state of perfect competition 

to achieve comparative advantage, 

the policy permits trading partners mutual gains from trade 

of goods and services. 

A free-trade policy does not necessarily imply that the 

government abandons all policy and legal control, but rather 

that it refrains from actions specifi cally designed to hinder 

international trade which might arise from tariff barriers, 

currency restrictions, and import quotas, etc. The extent to 

which free trade benefi ts economic development amidst any 

kinds of legal systems in place is unknown which may be 

examined from time to time by domestic legal tools prevailing 

at the given time. 


refl ect the offi cial policy or position of the organisation. The 

author can be contacted at nudelhilawfora@gmail.com) 

145

E NVRIONMENTAL ECONOMICS 

146 


G. Bhalachandran 


S ILENT SPRING 

Mitigating Environmental 

Crisis: Can India 

Show the Way? 

Department of Economics, Sri Sathya Sai 

University, Prasanthinilayam 

Suresh Chandra Babu 

Senior Fellow and Program Leader, 

International Food Policy Research Institute 

(IFPRI), Washington D.C. 

Introduction 

Several aggregate economic and non-economic forces positively 

contribute to the development process of an economy which 

aims at the promotion of socio-economic welfare of its citizens. 

Generally, development means uninhibited economic growth1 . 

One can argue that such a development is acceptable only if it is 

achieved through ethical means. In other words, the concept of 

development is value-centric, inclusive of human costs and 

sacrifi ces, accountable, transparent and subject to critical 

examination2 . To put it simply, development bereft of human 

values3 is not only unsustainable but also positively dangerous. 

The process of economic development involves enormous 

quantity of production, distribution, and consumption of goods 

and services. The process of production, in turn, depends on 

the availability and the use of factors of production. It means, 

there will be a continuous derived demand for natural resources, 

consists of renewable and non-renewable gifts of nature, 

human capital and man-made capital. Population and its 

characteristics set the magnitudes and quality of consumption 

of society. The manner in which the factors of production is 

used, decides the contours of economic development. Since the 

dawn of industrial revolution, advanced countries preferred the 

path of unlimited growth. As early as in 1960s, the cost-benefi t 

analysis of such growth process revealed that the cost of 

economic growth in terms of environmental damage was quite 

alarming4 . The environmental concern for development 

process was fi rst revealed by R.Carson, in her Silent Spring5 . She 

warned the advanced countries that their growth-path had 

resulted in large depletion of natural resources and caused 

chemical contamination of the world environment, resulting in 

an ecological imbalance. 

Many critics condemned the unlimited growth strategy and 

poised for the limits to growth. Barry Commoner, a biologist by 

profession, proved with empirical evidence that the present 

course of environmental degradation had challenged the 

ecological system and would destroy the Earth’s capacity to 

support her living beings6 . A mathematical model developed by 

Dennis Meadows and his team, predicted a catastrophic 

collapse of the world ecological and economic system under a 

wrong footing of unlimited growth strategy. This Limits to 

Growth Strategy derived its fi ndings on fi ve major parameters, 

viz., population, natural resources, food availability per capita, 

industrial output per capita and environmental pollution. This 

model showed the mode of development from 1960 to the 

projected year of 2100 AD and revealed that the over exploitation 

of resources would end up in a halt of the currently pursued 

aggressive path of development. Many great thinkers of 

different fi elds concurred with the contention of this model, 

since it has proved once again in 2004 that their propositions are 

prophetic with thirty years of additional data and world computer 

models7 .The critics8 of this model were optimistic to point 

out that 

a) there are many natural resources which would not disappear 

forever 

147


b) this model never thought of the concepts of reuse and 

148 

recycling and 

c) the alternative approach of cleaner technology, more fuel 

effi ciency, lesser use of raw materials with improved technol- 

ogy and lesser waste production were not thought of. 

The Sustainable Development Hypothesis 9 , on the other 

hand, conceived and suggested by the team led by Gro Bruntland 

of Norway as an alternative development strategy, clearly 

underlined the nature of relationship between economic 

development and environment. It directed the world community 

to follow that pattern of development which takes care of 

the welfare of the present generation with an assurance to the 

future generation, a life that is at least as comfortable as that of 

the present generation. This approach has made many people in 

economically developed countries to raise questions like; what 

good is great material wealth if it comes at the cost of largescale 

disruptions of the eco-systems by 

which we are nourished? Recent developments 

in climate change debate are an 

example. Sporadic efforts have been made 

by the international bodies to step up 

awareness about sustainable development. 

Unfortunately, the response is disheartening. 

What is required currently is an 

awareness in the world community, that 

man’s life is interdependent on the life of 

every other on the planet and the quest for 

sustainable development is the most urgent need of the hour. 

History, Economics and Environment 

History reminds one not only of the glory of the past but also 

offers valuable inputs from the experience of the forefathers 

one can obtain to handle many of tough issues of today. Even to 

understand the full gravity of the environmental problems, the 

historical perspective of the study of a problem is useful. For the 

sake of experiment, when one turns the pages of history, right 

from the dawn of the Mohenjdaro-Harappa civilization up until 

the industrial revolution in the eighteenth century, one can’t 

fi nd any record of environmental degradation10 . Pollution of the 

present magnitude had never been experienced on the planet 

till then. One of the main causes was that population was small; 

on account of this, wants were limited; the level of production 

and consumption was low; and the pollutants generated were 

cleaned by nature in the routine processes. In other words, 


What good is 

material wealth 

if it comes at the 

cost of disruptions 

of the eco-systems 

by which we are 

nourished? 

man’s ability to pollute was well within the nature’s capacity to 

clean up. Hence, pollution was not a threat to the world 

community and the planet earth. 

Great civilizations in Greece, Rome, Mesopotamia, China 

and India revealed refi nements in handling issues of different 

nature and each one’s culture saw to it that there was no trace of 

environmental degradation. Indian Culture, which is the sole 

living ancient culture of the world as of today, has hardly 

referred about environmental degradation in the past in any of 

its vast literature available at present. There are records of 

natural disasters and catastrophes in it; but the environmental 

degradation caused by human civilization was unknown in 

ancient India. 

As indicated earlier, industrial revolution had changed the 

mind-set of the capitalistic countries. Amazing scientifi c 

discoveries of the western world have had deep impact on 

human life and nature in general11 . Their up 

by the bootstraps approach aroused the 

productive forces and paved the way for 

mass production. This is diagonally opposite 

of Gandhian dictum: Production by the 

masses. At present, even in India, the 

traditional approach to industrial production 

by the artisans and through guild 

system was given a go-bye and large-scale 

production by machines; employing 

thousands of workers and using large 

quantities of inputs and capital with a view to catering the 

demands of far-off markets were encouraged. Naturally, levels 

of pollution had to rise up. This happened to be beyond the 

nature’s capacity of ‘cleaning-up-process’. The net result is the 

unabating environmental pollution at present. Another corollary 

factor to this is the rise in the growth of world population in 

general and the improvement in the life-expectancy years of the 

population of industrialized countries in particular. As a result, 

the rise in demand for goods and services has become phenomenal 

and the derived demand for inputs from nature is also 

increased manifolds. The interplay of the demand-supply forces 

of these has added fuel to fi re. 

Finally, even the very existence of the species on the planet 

earth has been put on stake. At present, the easiest option 

available to contain this problem is to refer to the wisdom which 

the ancient culture of human civilization could offer to mend 

our ways and means and correct our paths of development.

What Can Indian Culture Teach Us? 

The unlimited growth model of industrialized countries emphasizes 

rapid growth keeping in view of higher standard of living. 

But this has led to the irresponsible and continuous exploitation 

of natural resources and environment beyond the threshold of 

resilience of the eco-system. 

Indian culture views the eco-system in its entirety which is 

represented by the fi ve hydrological constituents12 . The development 

strategy of a country or world at large can’t disturb the 

equilibrium in the hydro-dynamic integrated system. But, the 

western paradigm for development has not cared for it. As a 

result, this has accentuated various dormant and active geomorphic 

processes on the earth and caused imbalance in the 

natural eco-system. The Indian culture does not allow the 

squandering of natural wealth of any kind. It also emphasizes 

that the development path ensures the needs of the present 

generation without compromising the ability 

of the future generation to meet their own 

needs. Moreover, it stands for policies, which 

enables future generations to have as much 

wealth / benefi ts as the present generation 

receives. In other words the present generation 

is not entitled to be over exploitive and 

generate debts for the future generation. 

This is what the ancients in India called 

Dharma13 and it implies fairness to future. 

The concept of sustainable development 

fl oated by the report entitled, Our Common Future echoes the 

same message that was conceived and made as the way of life of 

people in ancient India. 

Another interesting fact one can observe from the ancient 

Indian literature is that their society was encouraged to use 

more of renewable resources than of non-renewable resources14 . 

The reason one could infer is that the price mechanism works 

well with regard to man made goods where as the same principle 

does not work when nature / environment has to be priced. It is 

because that environment is beyond a price. Hence the ancients 

in India assigned a pride place of worship to nature. They 

trained the society to judiciously use one’s own conscience to 

trade off between ecology and economic development. Another 

added advantage was that they had perfect understanding of the 

difference between the private and social cost of resource 

exploitation15 . Hence, they took utmost care to preserve the 

natural resources to the possible extent, which in their opinion 



was a means to the end. This paved the way for equitable 

distribution by preventing the over exploitation by any section of 

society. In a nutshell, the ancients in India made it clear to every 

one in society that Sustainable Development (Dharma) was 

holistic as well as universal and the approach to it should never 

be a piecemeal. This is the cue for the modern society around 

the world to emulate, follow and adapt for its benefi t in the 

present as well as future. 

Operationalizing Indian Thoughts for 

Environmental Protection 

In the beginning, people around the globe had seen protection 

of environment was essential for the human survival and 

development. The other living creatures including plants, 

animal species and natural resources in the world were valued 

for their ‘utility value’ to the human survival, development and 

satisfaction. But the truth is that every 

living being and life forms have some 

inherent value in themselves and there is 

an interconnectedness among all of them 

for the welfare of the planet Earth itself. 

This concept promotes the notion of 

environmental ethics. 

People in (so called) modern civilized 

society are of the opinion that human 

beings are the most intelligent of all living 

species and they are empowered to 

manipulate and exploit the natural world in any manner they 

deem fi t. Moreover, they feel that those species which have a 

use value for their survival and comfort need their protection 

and patronage16 . But this is a disastrously wrong perception 

and practice. 

Here comes the ancient wisdom of India as a handy tool to 

have the right attitude towards the life and environment around. 

The ancients in India practiced and preached integrated human 

and environmental ethics, which directed the human beings to 

hold the responsibility for the stewardship of protection of all 

living species17 . This notion of interconnectedness is the way and 

means for getting the globe out of the morass of misconception 

and mismanagement of the world environment. This ethical 

principle has to reach every citizen of the world in right perspective 

and each one has to practice it for the benefi t of global 

welfare. It is possible only when the spirit of universal love holds 

the key of every thought, word and deed of people of all 

Indian culture 

views the ecosystem 

in its 

entirety which is 

represented by the 

five hydrological 

constituents 

149


countries without any exception. If humanity as a whole indicates 

this ethics, then the concept of sustainable development (as 

conceived and practiced in ancient India) can become a reality, 

even today. For this purpose a strong political will, forward 

looking socio-politico-economic institutions and people with 

universal value system are the prerequisites. 

It is worth recollecting here the vision of Mahatma Gandhi – a 

reformed India – which is based on sound environmental 

management principles of the ancient India. All these principles 

are now considered the integral part of sustainable, long – term 

development. As a part of his experiment with truth, Gandhiji 

had designed a suitable life-style for himself, when these concepts 

were not part of general thinking, with a view to revealing 

to the rest of the world that the injunctions of Indian culture 

were not only idealistic but also practical. He fi rmly believed that 

the world could support people’s needs but not to their greed. 

The world now is at the cross roads because 

it is fi nding diffi cult to yield to the demand 

and pressure of industrially advanced 

economies on one side and could not feed 

the poverty-ridden population of less-developed 

countries on the other side. Foreseeing 

this, Gandhiji wanted that every citizen in 

India to practice a sustainable life-style that 

cares for the earth and promotes the quality 

of human life simultaneously. 

Mahatma Gandhi’s famous concept of 

Trusteeship can be well extended to drive home that humans are 

the trustees of nature, species and environment around them. 

Indian culture asserts that human beings are just one small cog in 

the wheel of life on earth. In other words, each living being, a 

plant or animal, has a right to life as a part of the earth’s community. 

This message has to reach every nook and corner of this 

country through the process of Environmental education at all 

levels of learning. The direction of the Hon’ble Supreme Court of 

India made this mandatory and the University Grants Commission 

has taken it religiously and steps are being taken to make it 

action oriented18 . At the societal level, two basic values have to be 

inculcated by governments, corporations, media, institutions and 

people in their life-style. One, valuing the nature as a mother. 

This principle has been upheld by all the scriptures of this 

venerable Land19 . This has been forgotten now. This value 

kindles the conservation-awareness in man. Second, appreciating 

the beauty of Nature. If one’s heart is given to nature, this value 

150 


Modern society 

has to evolve 

a scientific 

and utilitarian 

approach in 

exploring nature 

without damage 

puts man in rightful role as the custodian of nature and not its 

exploiter. Moreover it elevates his spirit and fi nds himself one 

with it20 . For this, the elders of civic society have a major role to 

play in inspiring their children and young generations. 

Ahimsa or Non-violence towards life, living beings and nature, 

is a cardinal principle and basic philosophy for which India 

stands for, even today. This was a way of life in ancient India; but 

reiterated for the benefi t of society by Mahavira, the Buddha, 

and recently by Mahatma Gandhi and Bhagawan Sri Sathya Sai 

Baba. Many modern thinkers in the west have begun to see the 

intrinsic value in Indian culture and support it as the basic for 

human development. The discussion here emphasizes that 

modern society has to evolve a scientifi c as well as utilitarian 

approach in exploring nature without causing any damage to it. 

One has to be aware here that any harm done unto nature will be 

retaliated by it with immeasurable force21 . 

In India, the time has come to consolidate 

the values which lead to an effective process 

of decision making and right action for the 

weal of humanity. The Indian constitution 

emphasizes this process succinctly22 . This 

expects that every individual in the society 

must become environmental–sensitive and 

pro–environmental actions have to move 

from the domain of individuals to that of a 

community and later to society at large. For 

this purpose, a force of pro-environmental 

lobbying can be constituted to infl uence governments to enforce 

laws that can bind every citizen for the pro-environmental 

outcomes that include not only material resources but also many 

valuable services. 

It is not out of context to stress here that it is obligatory on the 

part of the present generation to do its best to protect many of 

our ancient structures of archaeological importance including 

temples. These were constructed by the ancients of this land, not 

only to speak of their glory, architectural ability, their engineering 

marvel and their refi ned evolution of the spirit but also to 

support the future generation as the priceless environmental 

assets. They protect the people in times of calamity, but most 

often, they prevent environmental damages to a large extent. 23 

Conclusions 

Humans are a miniscule part of nature’s complex web of life. 

Nature upholds the value of unity in diversity. Man, who is



endowed with a sixth sense, has to become the trustee of the immemorial in India, has no equivalent in any other tongue. 

earth’s magnifi cent life-forms, not its destroyer. Indian 

But, it encompasses and synthesizes all the healthy, profound 

culture is unique for being idealistic and practical in several principles and practices, the concept of Sustainable Develop- 

respects. It has many striking values and tips for the modern ment stands for. 

society to become pro-environmental and trim its ways and 14 See, Arjun Das, Economic Philosophy of Ancient India, 

means for sustainable development. Hence, this paper 

Agam Kala Prakashan, 1986, pp. 29-31. 

stresses that let Indian society lead the rest of humanity 

15 See, Kautilya’s Arthashastra, Book II, Ch. 12 

towards pro-environmental-actions and thus paves the way 16 For eg. People living in advanced countries look at a cow as a 

for pollution -free planet. 

source of milk or meat. 

17 Each one lives for the other and all collectively for the welfare 


of mankind – This is the conscious prayer of every son of the 

1 Jeremy Seabrook, The Meaning of Sustainability, in Chan- soil in ancient India, quoted in all sacred texts. See, V. 

dreyee Das and Dipankar Ghosh(ed), Eye on Development, Sivarama Sharma (ed) Srimad Valmiki Ramayana, Chowka- 

Sampark, 2006, p.207. 

hamba Vidya Bhavan, 1982, 3ed., p.5. 

2 See, Des Gasper, The Ethics of Development, Vistaar, 2004, 18 Arun Nigavekar, Forward, in Ercach Bharucha, Text Book of 

pp 14-16 

Environmental Studies, University Press, 2005,p. VII 

3 According to Bhagawan Sri Sathya Sai Baba, the universally 19 See, Laxmi Mall Singhvi, Environmental Wisdom in Ancient 

acceptable human values are Truth, Righteousness, Peace, India, www.ecomall.com, site visited on March 20, 2009. 

Love and Non-Violence. See, Bhagawan Sri Sathya Sai Baba, 20 King Pari, a legendary philanthropist of Tamil Sangam era 

Thought for The Day, Sri Sathya Sai Book Trust, 1993 p.K.2.S. (300 BC to 300 AD), once happened to travel with his 

4 A.K.Ghosh, Sustainable Development: Is it achievable, in daughters, Angavai and Sangavai, in his chariot, through a for- 

C.D. Ghosh, op.cit, p.76. 

est. There, they stumbled upon a huge jasmine creeper spread 

5 See for more details, R .Carson, The Silent Spring, Houghton across the road, since someone had cut off its prop-tree. The 

Miffl in, 1962. 

King’s benevolent heart melted. He asked his daughters to 

6 See, Barry Commoner, The Closing Circle, Alfred A. Knopf, unchain the horses from the chariot and he himself led the 

New York, 1972. 

chariot to leave it for the creeper to use it as its prop. He could 

7 See, (a) Dennis Meadows et.al, A Report for the Club of do such an act since he saw himself in the jasmine creeper. 

Romes: Project on the Predicament of Mankind, Universe This is the highest stage of the evolution of a man. That is why; 

Books, New York, 1972. (b) Donella Meadows et.al., Limits to Pari’s name is synonymous with philanthropy in Tamil land. 

Growth: The 30-year Update, Chelsea Green Publishing co., See, Kapilar, Purananooru, verse 201, Varthamanan Pathip- 

U.S.A., 2004. 

pagam, Part-II Chennai, 1999, p.5. 

8 See, William Nordhaus, ‘World Dynamics: Measurement 

21 There is a scientifi c base to prove that in all natural calamities 

without data’, Economic Journal,83;pp.1156-83,1973. 

the humanity suffers, there is a human element at work. See, 

9 See, G .Bruntland, Our Common future-A climate for change, John D Carmack, Is God responsible for the Good or Bad, 

Oxford, 1987. 

www.helium.com, site visited on March 27 

10 Gautam Gupta, Environment, Ecology and Economy, in R.N. 

Bhattacharya, Environmental Economics: An Indian Perspective, 

Oxford, 2001, p. 17. 

11 B.M. Sanyal, Sustainable Development: Certain Critical 

Observations, in Chandraya Das and Dipankar Ghosh (ed), 

op.cit., p.89. 

12 They are soil/earth; water; wind; ether/atmosphere and fi re/ 

energy 

13 The concept of dharma which has been in vogue from time 

th , 2009. 

22 See, Article 48 A and Article 51 A(g), indiacode.nic.in 

23 When tsunami stuck the eastern coast of Tamilnadu, on 

December 26th , 2004, none of the temples on the eastern coast 

including the Rameswaram temple located in an island was 

affected. See, Chennai and Tamilnadu, in www.google.com , 

site visited on March 27th , 2009. 



151

E NERGY ECONOMICS 

Wind Energy in India - 

Reforms to the Rescue 

Introduction 

During the last twenty years, very few oil and gas discoveries have 

happened and proven reserves are falling. In order to reduce their 

dependency on oil, many countries are trying to increase energy 

generation from renewable energy sources. However generating 

power using renewable energy sources is costly and government 

subsidies and incentives are critical for the viability of renewable 

energy projects. In this article we will fi rst discuss why wind energy 

has witnessed higher growth as compared to other renewable 

energy sources. Then we will discuss the incentives provided by 

India and various state governments. In the end we will discuss 

where regulatory changes and reforms are needed in India in 

order to attract investors and to enhance the transparency. 

Wind Power is Gaining Popularity 

Wind power is generated by converting wind energy into a 

152 


useful form of energy, such as electricity, 

using wind turbines. Oil prices were 

highly volatile during the last fi ve years 

and we witnessed oil prices reaching 

USD 147 per barrel and then falling to 

nearly USD 30 per barrel, all in a span 

of one year. During the oil shock of 

1970s, economies realized the importance 

of alternate source of energy and 

started investing in renewable sources 

of energy like solar energy, wind energy, 

hydro-power etc. However generating 

energy from renewable sources was 

costlier in early years and real thrust for 

installing renewable energy sources 

really started in 1990s. Amongst all the 

sources, wind power registered the highest 

amount of growth (Table 1) and 

investment owing to low investment 

costs and high IRR. 

At the end of 2008, worldwide installed capacity of windpowered 

generators was 121.2 gigawatts (GW) (Chart 1). In 

2008, wind power produced about 1.5% of worldwide electricity 

usage; and is growing rapidly, having doubled in the three 

years between 2005 and 2008. Several countries have achieved 

relatively high levels of wind power penetration, such as 19% 

of stationary electricity production in Denmark, 11% in Spain 

and Portugal, and seven percent in Germany and the Republic 

of Ireland in 2008. As of May 2009, eighty countries around 

the world were using wind power on a commercial basis. 

Growth Drivers For Wind Energy 

1. Cost competitive – Cost per KWH of wind generation 

decreased from US$ 0.38 in early 80s to present US$ 

0.03-0.06, at excellent wind sites

Ritesh Agarwal 

Analyst, 

ASK Group, Mumbai 

Shiva Agarwal 

Indian School of Business, Hyderabad 

2. Environmental awareness / government initiatives 

a. Kyoto protocol – CO2 emission to reduce by 5.2% of 

1990s levels, by 2012 

b. Renewable energy targets – EU – 20% by 2020, India 

– 10% by 2012, China – 10% by 2020 

3. Energy Security – High volatility in oil / gas prices and 

depleting oil / gas reserves 

4. Increasing electricity demand 

Table 1: Comparison of Various Renewable Energy Sources 

Technology Increase in Energy 

Production, 

1997-2001 

(percent per year) 

Biomass Energy 

Electricity 

Heat 

Ethanol 

Bio-diesel 

Source: World Energy Assessment Report 2004, Update 

~ 2.5 

~ 2 

~ 2 

~ 1 


C HARGING AHEAD 

a. Global electricity consumption expected to double 

between 2002 & 2030 

b. Wind Energy’s contribution expected to increase from 

0.2% in 2002 to three percent in 2030 

Wind Energy in India 

India currently accounts for nearly eight percent of total 

global wind energy installed capacity. The installed capacity 

was only 200 MW in 2000 which increased to nearly 9600 

MW by 2008. Although India registered impressive growth 

in installed capacity, it lagged countries like China which 

gave greater emphasis on energy security. India was fourth 

globally by installed capacity in 2007 and lost its fourth 

place to China in 2008 which nearly doubled its installed 

capacity (Table 2). 

Incentives and Subsidies 

Provided by Indian Government 

Indian government and various state governments pro- 

Turn Key 

Investment 

Costs (2001 US$ 

per Kilowatt) 

500-6000 

170-1000 

Current Energy Cost Potential Future 

Energy Cost 

3-12 ¢/kWh 

1-6 ¢/kWh 

(8-25 $/GJ 

15-25 $/GJ) 

4-10 ¢/kWh 

1-5 ¢/kWh 

(6-10 $/GJ 

10-15 $/GJ) 

Wind Electricity ~ 30 850-1700 4-8 ¢/kWh 3-10 ¢/kWh 

Solar Photovoltaic Electricity ~ 30 5000-18000 25-160 ¢/kWh 5 or 6-25 ¢/kWh 

Solar Thermal Electricity ~ 2 2500-6000 12-34 ¢/kWh 4-20 ¢/kWh 

Low-temperature Solar Heat 

Hydro Energy 

~ 10 300-1700 2-25 ¢/kWh 2-10 ¢/kWh 

Large 

~ 2 

1000-3500 2-10 ¢/kWh 2-10 ¢/kWh 

Small 

Geothermal Energy 

~ 3 

700-8000 2-12 ¢/kWh 2-10 ¢/kWh 

Electricity 

~ 3 

800-3000 2-10 ¢/kWh 1 or 2-8 ¢/kWh 

Heat 

Marine Energy 

~ 10 

200-2000 0.5-5 ¢/kWh 0.5-5 ¢.kWh 

Tidal 

0 

1700-2500 8-15 ¢/kWh 8-15 ¢/kWh 

Wave 

- 

2000-5000 10-30 ¢/kWh 5-10 ¢/kWh 

Tidal Stream/Current 

- 

2000-5000 10-25 ¢/kWh 4-10 ¢/kWh 

OTEC 

- 

8000-20000 15-40 ¢/kWh 7-20 ¢/kWh 

153


Chart 1: Wind Energy Installed Capacity 

200.00 

180.00 

160.00 

140.00 

120.00 

100.00 

80.00 

60.00 

40.00 

20.00 

Source: World Wind Energy Report 2008, WWEA 

vide lucrative benefi ts to investors looking to invest in 

wind energy and wind turbine generators (WTG). Following 

are some of the benefi ts provided by Indian government 

– 

1. 80% Income Tax Accelerated Depreciation : 

80% depreciation can be claimed in the fi rst year of 

installation itself, if the project is commissioned on or 

before 30th September in a fi nancial year; and 40% 

depreciation in case the project is commissioned on or 

after 1st October in a fi nancial year. The catalyst saves 

income tax outfl ow in current business in a year. (Section 

32 – Depreciation: Income Tax Act, 1961) 

An investor, investing in WTG post September, can claim 

depreciation as follows – 

40%: 2009-2010 

48%: 2010-2011 

10%--2011-2012 

2% --2012-2013 

2. Tax Holiday under Section 80 I (A): 

According to income tax act Section 80 I(A), a wind energy 

154 

0 

7.480 

1997 

World Total Installed Capacity (MW) 

9.667 

1998 

13.700 

1999 

18.039 

2000 

24.322 

2001 


31.181 

2002 

39.295 

2003 

47.693 

2004 

59.024 

2005 

74.151 

2006 

93.927 

2007 

121.188 

*Prediction 

project attracts a 100% income tax holiday 

for the income generated from the project 

for 10 consecutive years among fi rst 15 years 

of operation. 

3. Equity / Loan Ratio: 

The project involves approx. 30% Equity and 

70% Loan Funding. Various PSUS and 

private banks provide funding for wind 

power projects. 

Incentives and Benefi ts Provided by 

State Governments 

Table 3 describes the incentives and benefi ts 

given by various state governments . 

Limitations 

1. Wind machines must be located where 

strong, dependable winds are available most 

of the time 

2. Winds do not blow strongly enough to 

produce power all the time, therefore energy from wind 

machines is considered "intermittent," that is, it comes and 

goes. Therefore, electricity from wind machines must have 

a back-up supply from another source 

3. As wind power is "intermittent," utility companies can use it 

for only part of their total energy needs 

4. Wind towers and turbine blades are subject to damage from 

high winds and lighting. Rotating parts, which are located 

high off the ground can be diffi cult and expensive to repair 

5. Electricity produced by wind power sometimes fl uctuates in 

voltage and power factor, which can cause diffi culties in 

linking its power to a utility system 

2008 

152.000 

2009* 

190.000 

2010* 

Pain Points in Investing in Wind Energy in India 

Before discussing the pain points and needed regulatory 

reforms in India, we need to understand that the entire sector 

is driven by private players and government’s role is limited 

to providing subsidies and incentives. There is an autonomous 

body called “Center for Wind Energy Technology” 

under Ministry of New and Renewable Energy (MNRE). 

However C-WET is not a regulatory body like SEBI but it is 

more like a standardization and certifi cation body. C-WET’s 

responsibilities include setting the minimum quality stand-

Table 2: Global Wind Energy Installed Capacity 

Position 

2008 

Country Total Capacity 

Installed End 

2008 

Added Capacity 

2008 

ards of equipments, and approving the wind farm sites etc. 

In essence, the investor willing to invest in a wind turbine 

generator has to rely entirely on private players after the 

project is commissioned. Table 4 is a sample summary sheet 

provided by a leading wind power player 

to a potential investor. A cursory look at 

the Table 4 reveals that the only signifi - 

cant parameter known with certainty to 

the investor is tariff rate. Rest all the 

signifi cant factors are not in control of an 

investor and the investor has to depend on 

the company / lending bank. We will now 

discuss the problems associated with all 

the parameters / factors and will discuss 

how regulatory reforms can improve the 

investment environment in India. Please note that the 

parameters will directly impact the investment results if 

parameters are changed. 

Price / WTG 

This is the total initial investment (including debt and equity) 

needed to commission a WTG. The cost comprises equipment 

costs, land leasing, erection and commissioning 

charges, processing fees, basic infrastructure setting up etc. 

Growth 

Rate 

2008 

Position 

2007 

Total 

Capacity 

Installed 

End 2007 



Total 

Capacity 

Installed 

End 2006 

Total 

Capacity 

Installed 

End 

2005 

[MW] [MW] % [MW] [MW] [MW] 

1 USA 25170.0 8531.2 49.7 2 16818.8 11603.0 9149.0 

2 Germany 23902.8 1655.4 7.4 1 22247.4 20622.0 18427.5 

3 Spain 16740.3 1595.2 10.5 3 15145.1 11630.0 10027.9 

4 China 12210.0 6298.0 106.5 5 5912.0 2599.0 1266.0 

5 India 9587.0 1737.0 22.1 4 7850.0 6270.0 4430.0 

6 Italy 3736.0 1009.9 37.0 7 2726.1 2123.4 1718.3 

7 France 3404.0 949.0 38.7 8 2455.0 1567.0 757.2 

8 United Kingdom 3287.9 898.9 37.6 9 2389.0 1962.9 1353.0 

9 Denmark 3160.0 35.0 1.1 6 3125.0 3136.0 3128.0 

10 Portugal 2862.0 732.0 34.4 10 2130.0 1716.0 1022.0 

Source: World Wind Energy Report 2008, WWEA 

The C-WET is 

not a regulatory 

body like SEBI. 

It is more like a 

standardization 

and certification 

agency 

This price is quoted by the manufacturer as a whole and this 

is “negotiated” with the investor. Although C-WET certifi es 

the minimum quality standard, it does not specify the 

maximum charges for the equipment. If government sets a 

maximum price for a particular size of 

WTG then the investors get a reliable estimate 

of the initial costs.Manufacturers 

may argue that depending on the technology 

and quality, more power may be 

generated. The pricing may include 

clauses that excess power generation than 

the set benchmark may entitle the manufacturer 

to share revenue. However this 

leads to another problem of getting the 

benchmark for average power generation. 

Generation (KWH) 

At present, manufacturers quote this fi gure primarily 

depending on their own estimates and calculations. However 

government agencies need to estimate the wind speed 

and generation for a particular location so that investors 

have a realistic estimate of the potential power generation. 

This expected potential will also help in setting the price for 

the equipments. 

155


Table 3: State Wise Description of Various Parameters 

Description Gujarat Karnataka Madhya P. Maharashtra Rajasthan Tamil Nadu 

Tariff Rate 

Sale to Board 

Rs. 3.37 Rs. 3.40 Rs. 4.03 - 3.36 Rs. 3.50 Rs. 4.28 Rs. 2.90 

Escalation 

Nil Nil Reduction of 15p/yr for 13 yr Nil Nil 

on Tariff 

17p/yr up to 

3.36 and constant 

after that 

PPA Period 20 years 10 years 20 years 13 years 20 years 20 years 

Penalty on Rs. 0.10 / Rs. 0.40 / Rs. 0.27 / Rs. 0.25 / Nil Rs. 1.00 / KVARH 

Reactive 

Power Drawn 

KVARH KVARH KVARH KVARH 

Third Party 

Sale 

Permitted Permitted Permitted Permitted Permitted Permitted 

Wheeling 

Charges 

4% 5% 2% 20-30% 10% 5% 

Banking Surplus genera- Permitted in Not permitted Permitted in Permitted Permitted in same 

tion is purchased same fi nancial 

same fi nancial in same cal- fi nancial year 

by GUVNL@ 

Rs. 3.37 

year 

year endar year 

Banking 

Charges 

Nil 2% Not applicable Nil Nil 5% 

Source: Ministry of New and Renewable Energy (MNRE), New Delhi 

Interest Rates 

There is no set policy according to which loan is provided to 

the investors. At present, various PSU and private banks give 

loans against the WTG according to their own perceived risks 

and understanding. Moreover the loan is 

usually not fi xed but fl oating which only 

enhances the uncertainty in net cash 

infl ows for the investor. It is understandable 

that risks vary from state to state 

amongst different wind farm locations but 

risks for a particular wind farms is same 

for all the WTG installed in the wind 

farm. In a gist, the risks that all the WTG 

installed at a location are same (discounting 

technical problems as of now). 

At present, some banks offer loans at PLR + some risk 

premium and this PLR varies from bank to bank. Moreover 

PLR also changes according to economic conditions and 

banks’ policies. According to us, government needs to 

incentivize the banks to rationalize the interest rates. We 

propose that a range of risk premium for a state should be 

156 


The Government 

needs to 

incentivize 

the banks to 

rationalize the 

interest rates on 

high priority basis 

worked out depending on the past experiences in wind power 

generation and future expected cash fl ows from the location. 

Plant Load Factor 

The quoted plant load factor is usually 

21-25% in India. However global experience 

shows that this high load factor is not 

possible for all the time. This factor varies 

according to environment which is not in 

investor’s / manufacturer’s control. 

Plant load factor is calculated as the 

ratio of (actual amount of power produced 

over time) and (Power that would have 

produced if turbine operated at maximum 

output 100% of the time). While calculating 

this ratio, we need to account for time when wind speed is 

less than optimum speed; scheduled / unscheduled maintenance; 

production losses; dirty or corrosive blades, grid line 

theft etc. After accounting for the entire factors, realized load 

factor is typically less than 25%. 

An investor cannot calculate the load factor owing to the

Table 4: Summary Sheet For Investing in A Wind 

Turbine Generator (WTG) 

Sr. No. Parameter 600 kW WTG 

1 Size of the Project(MW) 0.6 

2 No. of WTGs (600 kW each) 1 

3 Price of the Project (Rs. Lacs) 421 

4 Price / WTG (Rs. Lacs) 421 

5 Generation (KWH) 16 

6 Losses 7% 

7 O & M (Rs. Lacs per year) 7 

8 Escalation 7.50% 

9 Free O & M (yr.) 1 

10 Tariff (Rs. / unit) 3.48 

11 Tariff Escalation (Rs. / unit) 0.02 

12 Tariff Escalation (Rs. / unit) 0.01 

13 Interest Rate 13.00% 

14 Loan Term (yr.) 7 

15 Moratorium (yr.) 1 

16 Plant load factor (PLF) 24.70% 

Sr. No. INVESTMENT - RESULTS 

1 Payback 1.08 

2 Cumulative Infl ow/ MW 673.65 

3 I R R (20 Yr.) 21% 

Bold indicates most signifi cant factors for the investor 

Source : A leading Indian wind energy company 

limited data at his disposal and his own capability to estimate 

the power generation. An investor faces loss when the wind is 

less than the estimated wind and also faces loss if there is high 

velocity and power transmission is limited by the grid capacity. 

There is a need to formalize a policy according to which the 

manufacturer should quote the realized load factor from the 

farm instead of only estimated load factor. This may be 

diffi cult if a new farm is developed, however manufacturers 

can be asked to give quotes for various possible scenarios. 

Transparency and Disclosures 

Although this factor is not mentioned in the table above, we 

believe that this is one of the most important factors to instill 

confi dence in investors. Some cues to enhance the transparency 

can be borrowed from SEBI. According to SEBI regulations, 

mutual fund houses have disclose their stock holdings, 



stock churning, various charges and performance etc to the 

investors on a periodic basis. 

We propose that the corresponding fi gures for load factor, 

power generation, down time etc should be disclosed to all the 

investors in a wind farm. 

Payment Collection 

The power purchase agreement (PPA) is signed between the 

investor and the state electricity board. The State Electricity 

Board (SEB) is supposed to pay the investor within 45 days. 

However collecting the money from the SEB is problematic 

and time consuming. Maharashtra SEB has introduced Real 

Time Gross Settlement (RTGS) payment system so that 

timely payment can be done. Extending RTGS to all the states 

can certainly lessen the woes of the investors. 

Conclusion 

India has set itself ambitious targets in renewable energy 

generation and government has indeed provided a host of 

subsidies and benefi ts. Wind energy is relatively cheap and 

various states have extended lucrative benefi ts to the 

investors. However a lot of work has to be done in order to 

standardize the investment process; government needs to 

instill transparency so that more investors may diversify 

their portfolio taking exposure to renewable energy sources 

like wind energy. 


• World Wind Energy Association (February 2009). 

"World Wind Energy Report 2008". Report. http://www. 

wwindea.org/home/images/stories/ 

worldwindenergyreport2008_s.pdf. Retrieved 24th August, 2009 

• Wind Power: Capacity Factor, Intermittency, and what 

happens when the wind doesn’t blow? Retrieved 24th August, 2009 

• MNRE Website http://mnes.nic.in/ 

• C-WET website http://www.cwet.tn.nic.in/ 

• Global wind energy council (GWEC) statistics 

• European wind energy association (EWEA) statistics 

• Various investor interviews 



157

M ICRO MACRO 

Mismatch between 

Entrepreneurial Intention 

and Environment - 

A Survey in Burdwan 

District of West Bengal 

158 


Soumyendra K. Datta 

Professor, Department of Economics, 

Burdwan University, Burdwan 

Rimu Chaudhuri 

Research Student, Department of Economics, 

Burdwan University, Burdwan 

Introduction 

The spate of events in recent years in the wave of globalization 

and liberalization have brought forth severe uncertainties 

in the industrial sphere. Unpredictable shift in demand 

pattern and corresponding need to adjust production 

capacity, fl exibility in labour market and rapid changes in 

technology - all have posed great problem to a smooth 

development of the large scale sector. The large scale 

sector run mostly on the method of 

mass production, produce customized 

product, use lumpy capital and capital 

intensive technology. Besides this, the 

recent events have unquestionably led to 

shrinking employment opportunities 

and changes in job orientation. Added to 

this has been a lack of co-ordination in 

skill formation and job prospects. The 

relative lack of adaptability of large 

sector to a rapidly changing circumstances and inability to 

absorb a rising labour force has in recent times brought 

into prominence the adjustive and complementary role of 

small sector in the development of the country. Accordingly 

the aspect of self- employment through fl ourishing of 

entrepreneurial development in small scale sector has 

acquired great importance in recent period and requires 

incisive analysis. 

Key to Entrepreneurship 

However, the concept of entrepreneurship is too complex 

to be explained by a single set of factors. Combining the 

defi nition of Schumpeter(1934), Korzner(1985), Bygrave & 

The concept of 

entrepreneurship 

is too complex to 

be explained 

by a single 

set of factors or 

other variables 

E NTREPRENEURIAL ETHOS 

Hofer(1991) - an entrepreneur is defi ned as one who 

perceives a profi t opportunity and undertakes an organization 

to initiate newer product and technology to achieve 

the objective with some degree of risk. 

These three factors like initiative to launch something 

new, drive to attain certain objective and fulfi l certain 

unsatisfi ed need and taking of risk are supposed to be the 

three main corner stones, based on which entrepreneurship 

can be said to blossom. The blossoming of the 

process of entrepreneurship is usually supposed to be 

conditioned by the demographic, psychological factors and 

the mental make up to accept challenges, attain a specifi c 

goal, motivational attitude to create new ventures etc. 

These are refl ected in the intention of a person to achieve 

something new. 

Small Industries- 

Congenial to Flourishing Entrepreneurship 

In order for the small sector to help incite the quality of 

entrepreneurial attainment, it is necessary that aforesaid 

quality be present in the individual seeking employment in 

the small scale sector. Now there are 

many people in our country who seek 

some subsistence or just above subsistence 

type of employment in the small 

informal sector involving petty trade or 

services. Usually they do not create 

organization and hardly have any 

substantial money to take any drive to 

launch on a profi table venture. However 

in the small industrial set up, be it 

formal or informal, there is often enough scope for a 

fl ourishing of entrepreneurial spirit. 

It is usually assumed that the small scale sector can 

quickly respond to changes in demand pattern adjustive to 

fl exible use of labour and capital and can relatively easily 

develop along the sub-contracting mode of production. 

Multi-skilled worker and multi-purpose capital is said to be 

the corner stone in the development of small sector. 

However innovative development in the small scale sector 

presupposes adequate skill formation in the relevant 

labour group, aptitude and orientation to take risk and 

mental and psychological upbringing to face the challenges 

in uncertain market prospect. Aptitude and orientation to 


159

M ICRO MACRO 

Table 1: State Wise Origin of the Entrepreneurs 

Statewise origin No of entrepreneurs 

Marwari & Gujrati 40 

Bihari 6 

Punjabi 3 

Bengalee 11 

Source: Compiled from data based on personal interview with the entrepreneurs 

Table 2: Motivational Background 

Family Friends VRS No Job Risk -loving 

Non-Bengalee 47 - - - 2 

Bengalee 4 - 1 5 1 


Table 3: Academic Background 

Academic Qualifi cation No of Entrepreneurs 

Engineer 2 

Non-technical graduate 40 

Under Graduate 14 

Non-Matric 4 


Table 4: Technological Inclination of the 

Entrepreneur 

Technology in Use No. of Entrepreneurs 

New technology used 33 

Old technology used 27 

R and D NIL 

Source:Compiled from data based on personal interview with the entrepreneurs 

Table 5: Technical Aspects of the Surveyed Entrepreneurs 

Level of Investment No of entrepreneurs Years of existence of 

the enterprise 

160 


take risk as manifest in the attribute of entrepreneurial 

intention is often shaped and governed by a combination of 

external factors clubbed as entrepreneurial environment. It 

encompasses a host of overall economic, cultural, social 

and political dimension that promote or even sometimes 

discourage entrepreneurial propensity of an individual. 

Entrepreneurial Environment : A Driving Force 

Gnyawali and Foget grouped the entrepreneurial environment 

into fi ve dimensions- government policies and 

producers(import/export restrictions, entry barrier, etc); 

socio-economic conditions (public attitude towards 

entrepreneurship, presence of experienced entrepreneurs, 

etc); entrepreneurial and business skill (entrepreneurial 

training programmes, availability of information etc); 

fi nancial support to business (venture capital, low cost 

loans, etc); and non-fi nancial support to business (counseling 

and support services, entrepreneurial networks, etc). 

The authors review the existing literature on environment 

for entrepreneurship and list the empirical evidence for the 

factors that they consider infl uential in promoting entrepreneurial 

activity. Thus entrepreneurial environment 

mediate the relationship between entrepreneurial intention 

and entrepreneurial resourcefulness. However, there is 

often observed to exist a mismatch between entrepreneurial 

intention and entrepreneurial environment that dampen 

the spirit of entrepreneurial resourcefulness. 

Quintessence of Entrepreneurial Resourcefulness 

Entrepreneurial resourcefulness mean the ability to 

identify opportunities in the environment and regulate and 

direct behaviour to successfully cope with the task of 

creating and managing an organisation to pursue the 

opportunity. Following the concept of Kanungo and Misra, 

Labour skill Single as 

well as multiple 

Types of product 

Rs10.5 – 25.5 lakh 9 40 years Both type Multiple 

Source: Compiled from data based on personal interview with the entrepreneurs

Table 6: Results of the GET Test 

entrepreneurial resourcefulness can be said to comprise 

three generic competencies – cognitive, affective and 

action oriented. Cognitive competency refers to the 

effective management of thought processes, beliefs and 

expectations. Six components of cognitive competence are 

identifi ed which contribute to entrepreneurial resourcefulness. 

These are – ability to analyse and make sense of large 

volumes of information, ability to take risk, innovativeness, 

ability to perceive and make sense of equivocal realities, 

tolerance for equivocality and uncertainty, high effort- outcome 

expectancy. 

Affective competence refers to the management of 

emotional arousal. Five kinds of affective competence are 

identifi ed for entrepreneurs - ability to control feelings of 

withdrawal and depression, competitive desire to excel, 

ability to persevere, high central life 

interest, dissatisfaction with status quo. 

Action oriented competence is the 

management of intentions and action 

orientations. Four main components are 

identifi ed - ability to take charge and 

lead employees, ability to infl uence 

external agencies, ability to fi nd, marshal 

and control resources, ability to 

establish strong networks. 

Motivations of the Study 

In this backdrop it seems imperative to study the prospect 

and potential of promotion of entrepreneurial opportunities 

in a region which has a glorious history of industrial 

development. Kulti-Asansol-Barakar region in West 

Bengal is one such region which might serve as a source of 

nurturing and promoting entrepreneurial qualities among 

potential risk taking entrants in the small industrial sector. 

Affective 

competence 

refers to the 

management of 

emotional arousal 

and there are 

five variants 


Characteristics With or above average frequency Percentage of such entrepreneurs 

Need for achievement 10 16.67 

Need for autonomy/independence 30 50 

Creative tendency 10 16.67 

Moderate/ calculated risk taking 45 75 

Drive and determination 8 13.33 


This sector exhibits ample scope for lessening the unemployment 

problem in our country, if proper motivation and 

leadership quality is manifest among the potential youth in 

a vibrant entrepreneurial environment. In our country, 

despite several fi ve year plans, the unemployment situation 

is still persistent with frightening magnitude. Also there 

exists various kinds of imperfections and ineffi ciency in 

the market functioning that hinders the prospect of newer 

jobs. In such a scenario, nurturing of small scale entrepreneurship 

may at least partially solve the present unemployment 

problem. 

Present Industrial Features of the Study Region 

The above argument is pertinent to the global problem of 

unemployment as far as Indian economy is concerned as a 

whole. In our study as already alluded to, 

we seek to analyse the potential of 

entrepreneurial development in a local 

perspective. The Kulti-Asansol-Barakar 

region in the Burdwan district of West 

Bengal has long been famous as the core 

industrial belt of the state. 

Notable major industries in the region 

had been 

1. Chittaranjan Locomotive works, 

Chittaranjan 

2. Hindustan Cables, Rupnarayanpur 

3. Indian Iron and Steel Company, Burnpur 

4. Indian Iron and Steel Company, Kulti 

5. Cycle Corporation of India, Asansol 

6. Damodar Valley Corporation , Mython 

7. Eastern Coalfi elds ltd, Asansol 

8. J.K Paper Mill, J.K. Nagar 

9. Raniganj Paper Mill, Raniganj 


161

M ICRO MACRO 

10. Burn Standard Company ltd, Burnpur 

11. Disergarh Power Supply Corporation, Disergarh 

12. Chinakuri Power Station , Chinakuri. 

13. Alumunium Factory , Asansol. 

14. A large number of mining companies 

However the present situation is a bit different as most of 

these major industries in the region have closed down and 

some are marked as sick industries. The aforesaid phenomenon 

has left many skilled workers jobless and many have 

retired with VRS. In the absence of any emerging alternative 

employment opportunities, small scale entrepreneurial 

fl ourishing can somehow mitigate the joblessness scenario 

in this predominantly industrial region. This can take place 

through two ways- (a) the existing small scale entrepreneurs 

are motivated to expand their market by diversifying 

the quality and type of their product. This might require 

employment of more workers to produce the output 

targeted at the market and employment of skilled personnel 

at the R&D sector to devise ways and means for the 

required diversifi cation, (b) on the other 

hand fl ourishing of an entrepreneurial 

environment can allure more and more 

skilled workers to the option of taking an 

entrepreneurial drive by setting up 

independent small industry. 

Objective and 

Methodology of the Study 

The objective of the study is to focus on 

whether the existing small industrial 

entrepreneurial spirit in the region is conductive to promotion 

and development of such an entrepreneurial environment 

as would to some extent mitigate the unemployment 

among the skilled / semi skilled population. 

With the purpose in view, 60 small entrepreneurs were 

interviewed in the concerned locality. Data were collected 

to refl ect on the demographic and educational background, 

nature of technology, risk perception etc. Further a questionnaire 

in line with General Entrepreneurship Test 

(GET) was also devised to elicit the psychological inclination 

of the said sixty industrialists to undertake entrepreneurial 

drive. The test is meant to serve as a psychological 

measure of entrepreneurial spirit or inclination among the 

respondents. In this context , it needs to be stressed that 

162 


There exists 

little scope for 

absorbing further 

employment in 

the existing small 

scale industries in 

the region 

entrepreneurship should be considered as the mix of 

intention, drive and capacity to undertake continuous 

process of change in accordance with risk calculated 

prospects of market demand. The selected entrepreneurs 

are mostly engaged in activities like steel casting, fi re 

bricks, machinery, parts and components, consultancy, 

trading etc. 

Findings Related to Demographic, 

Educational and Motivational Aspects 

The origin of the entrepreneurs pertaining to the state they 

belong to, has been classifi ed in Table 1. 

The striking feature of the entrepreneurial pattern in 

the region is that most of the entrepreneurs are non-Bengalee 

and it is further dominated by Marwari and Gujrati. 

It is startling to fi nd that the Bengalees are far behind in 

taking entrepreneurship as a career in their home state. 

The classifi cation of motivational support the entrepreneurs 

received from in building their career leads to 

Table 2. 

The data in Table 2, suggests that 

non-Bengalees are motivated mostly by 

their families. Most often in such cases 

the entrepreneurs joined in their family 

run enterprise which were started by 

their ancestors. The corresponding 

Yule’s co-effi cient of association between 

family and non-Bengalees is 

rather high at the value 0.952. The 

continued functioning of an enterprise 

from the past and its competitive existence in the present, 

marks the fact that adoption of an entrepreneurial career 

by the non-Bengalees appear to be devoid of any great 

perceived risk. So the very attribute of the risk taking is 

almost dissociated from these so-called entrepreneurs. In 

the case of Bengalees, however, motivation emerged from a 

variety of factors like family, no-job, VRS scheme, risk 

taking attribute etc. The academic background of the 

entrepreneurs as evident from Table 3, suggests a great lack 

of forward looking vision and an indifference regarding the 

importance of R&D expenses for continuing adoption and 

implementation of improved technology. 

Table 3, reveals that most of the entrepreneurs in the 

surveyed region are not well-educated, having little knowl-

edge of technical education in their fi eld of entrepreneur- 

ship. This is likely to adversely affect their ability and vision 

to have a dynamic view of the future and associated drive 

to undertake innovative efforts. This is important since 

movement and mobility have an integral part in the march 

of human history all over the world. Human advancement 

swings between two poles of movement and settlement. 

Education is one of the factors that infl uence dynamism in 

vision, spirit and drive. It enlarges one’s thinking ability 

and horizon of understanding. 

Attitude to Technology 

The fact that comparatively inadequate education of 

entrepreneurs has a negative bearing on the forward 

looking vision is evident from Table 4. 

Table 4 shows, that 33 entrepreneurs have shown inclination 

to adopt newer techniques but almost half of the 

number still go on using old fashioned techniques and 

unfortunately none of the sample entrepreneurs undertake 

any R&D expenditure to upgrade their 

existing methods. This is suggestive of a 

static view of their future promotional 

efforts. Other technical aspects of the 

surveyed entrepreneurs can be considered 

from Table 5. 

Table 5 reveals that, relatively larger 

investment in small scale industries have 

been made in enterprises which have 

continued to exist for relatively longer 

years. These are mostly family run enterprises 

from the past. Although the industries produce 

multiple products to avoid risk, in many cases this has been 

happening from the decision of their ancestors. Newer varieties 

are hardly introduced. In this context it may be noted 

that the age of the entrepreneurs vary from 29 years to 45 

years, the modal age group being 37-40 years. This indicates 

that most of them have inherited the enterprises from 

their earlier generation but lack the drive expected from 

them. The lack of forward looking entrepreneurial attitude 

is also vindicated by the results of GET test as devised by 

Durham University, U.K. 

Results of the GET Test 

The psychological orientation of the so-called entrepre- 

Comparatively 

inadequate 

education has a 

negative bearing 

on the forward 

looking vision of 

entrepreneurs 


neurs, supposed to be necessary to have a dynamic, 

innovative view for promotional efforts of the enterprise, is 

tested under several attributional headings. For instance 

frequencies corresponding to the following sections of 

attributes formed by several sub- attributes with the 

needed optimal and average scores are documented in 

Table 6. 

Table 6 reveals that excepting the fourth category, in 

terms of all the attribute characters, the entrepreneurs do 

not have the requisite scores in the corresponding category 

that might strongly refl ect on their enterprising spirit and 

tendency for a development oriented outcome. Majority of 

the so called entrepreneurs did not pass the test for being 

dubbed as persons with entrepreneurial acumen and vision. 

It is to be noted that only eight entrepreneurs passed all the 

tests and satisfy the criteria of possessing the requisite 

attributes expected of an entrepreneur. This also indicates 

that true intention refl ecting a person’s attention towards a 

specifi c goal in order to achieve something is not manifested 

in the psychological attitude of 

the interviewees. 

Flourishing of entrepreneurial 

resourcefulness requires a matching of 

positive entrepreneurial intention with 

positive entrepreneurial environment. 

Any deviation from the above combination 

may be viewed as a mismatch 

between entrepreneurial intention and 

environment. A sound environment in 

combination with positive drive is 

necessary for fructifi cation of entrepreneurial resourcefulness 

and concomitant ripples in the society in terms of 

more and more people opting for the entrepreneurial 

career. Entrepreneurial resourcefulness can be defi ned as 

the ability to identify opportunities in the environment 

and regulate and direct behaviour to successfully cope 

with the task of creating and managing an organization to 

pursue the opportunity. This may be viewed as the culmination 

of adoption of successful entrepreneurial activities 

in a region. 

A View of Entrepreneurial 

Environment in the Region 

An entrepreneurial environment, as already referred to, 


163

M ICRO MACRO 

implies a combination of socio-cultural, economic and 

political factors that infl uence an individual’s ability and 

proclivity (either positively or negatively) to initiate entrepreneurial 

activities in a region. The survey conducted 

among the entrepreneurs regarding their perception of 

entrepreneurial environment yields a mixed kind of 

information that is tilted towards a bleak view of the 

environment. There is a network or common forum for the 

small scale industries to discuss and solve their mutual 

problems. It acts as a representative for the small scale 

industries in the region. The forum gives a positive response 

for the dissemination and encouragement of 

entrepreneurship in the region but has hardly any vision or 

drive to achieve it. It has never taken any initiative to 

disseminate its prospects among potential entrants. It also 

does not have any information about whether entrepreneurship 

training programmes / institutes are available in 

the surrounding region. There exists good scope for 

obtaining loan on easy terms for bigger industries in the 

region but small industries are not so fortunate, they have 

to face various problems. The industries however can 

obtain counseling or support service from the forum. The 

forum strongly felt that goverment policies were not 

conducive to their fl ourishing; specially they felt that the 

VAT was inimical to their growth. These views are refl ective 

of the fact that the entrepreneurial environment in the 

study area is rather dampening of the entrepreneurial 

intention or spirit surrounding the region. 

Way Forward to Avoid the Present Gloom 

The aforesaid analysis reveals that there exists little scope 

for absorbing further employment in the existing small 

scale industries in the region. Although they produced 

multiple products to avoid risks, there was not any drive to 

diversify their quality and hardly any research and development 

initiative. So the potential of absorbing skilled 

technicians, personnel in the existing small scale sector has 

rather been bleak in the region. Besides this, the entrepreneurial 

environment in the region has been mostly discouraging 

for the potential entrants. Although the existing 

entrepreneurs stated in the affi rmative regarding the 

importance of fl ourishing of entrepreneurial spirit in the 

region, from the core of their heart they have not taken any 

initiative to disseminate it across the locality. Besides this, 

164 


they visualize the potential entrants as possible contenders. 

Hence the drive should emerge from NGOs or even from 

Government sponsored agencies to launch programmes 

that might activate the entrepreneurial vivacity in the 

adjoining region. The provision of loans on easy terms and 

with little complexity need immediately be introduced for 

potential entrants in small sector. Again entrepreneurship 

training institutes need to be established in every major 

industrial belt with suffi cient advertisement for the future 

prospect of its users. Entrepreneurship as a career has not 

yet gained currency in our society. This needs to be reversed. 

For this purpose, introduction of an entrepreneurship 

course at school as well as at college level can hardly 

await any further delay. Only then some tangible effect 

might be achieved in lessening the problem of unemployment 

through the fl ourishing of entrepreneurial resourcefulness 

in our society. 


• Balasubrahmanya, M.H. 2003.Technological Innovations 

in Small Enterprises- A Comparative Study of Bangalore 

and North- East England, EPW, May 24th . 

• Bhide, Sheela.2000. Development Of Small Scale 

Industries – A Collaborative Approach, EPW, November 

25th . 

• ICSI .1996 .Herald, Vol 7, Nov 4. 

• ICSI .1997. Herald, Vol 8, Nov 7. 

• Kanungo, R.N & S. Misra. 1992.‘Managerial Resourcefulness: 

A Reconceptualization of Management Skills’, 

Human Relations, 35-12. 

• Misra, Sasi & E.Sendil Kumar.2000. Resourcefulness: 

‘A Proximal Conceptualization of Entrepreneurial 

Behaviour’, The Journal of Entrepreneurship, vol 9,no 2. 

• Mukherjee, Robin., Pranab .K. Das & Uttam K 

Bhattacharya.1999.‘Small Scale Industries In West 

Bengal, 1971-97-Data Analysis For Study Of Growth’, 

EPW, November 27th . 

• Nath , V. 2000. Entrepreneurship By Region & Caste-A 

Survey , EPW, November 25th . 

• Streefkerk, Hein .1997.Gujrati Entrepreneurshp, EPW, 

Vol 32. No-7. February 15th-21st . 


refl ect the offi cial policy or position of the organisation.)

M ICRO MACRO 

Microfi nance at Turning 

Point: Success Factors of 

Microcredit in Bangladesh 

and Its Future Prospects 


166 


Tomohito Kanaizuka 

ODA Loan Program Specialist, 

Japan International Cooperation Agency 

(JICA), Tokyo, Japan 

Farhad Hossain 

Lecturer, Institute for Development Policy and 

Management (IDPM), School of Environment 

and Development, University of Manchester, 

Manchester, United Kingdom 

Introduction 


S OCIAL EDGE 

Based on the unique concept of utilising the abilities of the 

poor for improvement of their own lives, the scheme of microfi 

nance has been continuously expanding its outreach for 

approximately 30 years. In these 30 years, microfi nance has 

grown from only a tiny economic experiment to a major 

public policy of poverty alleviation and has reached more 

than 133 million people in developing countries around the 

world (Microcredit Summit Campaign (MSC), 2007). Furthermore, 

quite surprisingly, microfi nance is still growing its 

outreach at a remarkably rapid rate every year1 . It is undoubtedly 

one of the most important schemes of today’s poverty 

reduction initiatives. 

However, despite the extremely high popularity of the 

microfi nance movement and its positive impact to the lives of 

the poor, Hulme and Moore (2007) explained that the idea of 

enabling and empowering the poor by providing them with 

small loans was actually considered as ‘disastrous policy’ when 

movement was started in the late 1970s in Bangladesh. 

Furthermore, even after microfi nance established itself as a 

widely accepted policy of poverty alleviation, it continued to 

receive heavy criticism with regards to high interest rates, 

exploitation of women, loan repayment, unchanging poverty 

levels and failure to cater effectively to the target groups in 

addition to the numerous accolades (Mallick, 2002; Brau and 

Woller, 2004). 

As there are such criticisms, it still remains unclear what are 

the real success factors of microfi nance, which made it 

possible to become such an extremely successful scheme. 

Moreover, the future of the microfi nance scheme has rarely 

been considered. In order to explore these important themes, 

the authors have separately visited Bangladesh in July and in 

December 2007 and conducted a thorough evaluation of the 

operation of Grameen Bank and socio-economic environment 

of Bangladesh that surrounds Grameen Bank. Based on 

empirical fi ndings from these two fi eld visits reinforced by 

insights from relevant literature, this paper will fi rst look at 

the background of how microfi nance emerged. Second, the 

paper will explore the unique characteristics which differentiate 

microfi nance from other poverty-reduction initiatives and 

enable the microfi nance scheme to grow and be self-sustainable. 

Third, the paper will explore and identify success factors 

of the scheme. Finally, this paper will attempt to determine 

the future of the scheme by considering how socio-economic 

167

M ICRO MACRO 

changes would infl uence the success factors identifi ed in the 

previous section. 

II. Review of Origin and 

Potential of Microfi nance Scheme 

Origin of Microfi nance 

The source of poverty is not traced back to a single root; 

people become poor for various reasons such as civil war, 

corruption, natural disasters, lack of basic education and so 

forth. Among the different sources of poverty, Yunus identifi 

ed the lack of access to formal fi nancial services as a critical 

cause of poverty. In developing countries, the majority of the 

poor usually do not have any access to formal banking 

services and have to depend on usurers who charge extremely 

(often illegally) high interest rates on loans. Yunus and Jolis 

described the disastrous situation of the poor who borrow 

money from money-lenders as follows: 

‘…in all cases it is extremely diffi cult for the borrower to 

extricate him- or herself from the burden of the loan. Usually the 

borrower will have to borrow again just to repay the prior loan, 

and ultimately the only way out is death… Unless the poor can 

be liberated from the bondage of the money-lender, no economic 

programme can arrest the steady process of alienation of the 

poor.’ (Yunus and Jolis, 1998: 8) 

In the societies of Bangladesh and other low-income 

developing countries where the unemployment rate is substan- 

tially high2 , the creation of a job by 

starting a new business is one of a few 

effective ways to overcome poverty. 

However since the poor do not have access 

to the fi nancial services, they are not able 

to gain the seed capital to start up their 

business and as a result, it becomes an 

unrealistic option for them to pursue. 

From his fi ndings, Yunus concluded that a 

critical source of poverty stems from the 

lack of access to the fi nancial services, and he developed the 

mechanism of microfi nance, a scheme of enabling and 

empowering people through the provision of small-sized 

fi nancial services with affordable commission charges. 

Potential of Microfi nance Scheme 

In the domain of poverty reduction, although enormous 

effort has been spent and the proportion of the poor people 

168 


Microfinance 

utilizes the ability 

of the poor 

themselves for 

the purpose 

of improving 

their lives 

has signifi cantly decreased3 , a substantial number of people 

still remains poor. According to World Bank (2008), ‘it has 

been estimated that in 2001, 1.1 billion people had consumption 

levels below $1 a day and 2.7 billion lived on less than $2 

a day.’ This suggests that there has not been any scheme 

which has succeeded to fundamentally change the situation 

of developing countries. Although there is also no guarantee 

that microfi nance can change the situation radically, it 

has two signifi cantly different characteristics that may allow 

it to do so in the future. 

The fi rst characteristic is that, as previously mentioned, 

microfi nance utilizes the ability of the poor themselves for 

the purpose of improving their lives. In microfi nance, MFI 

lends seed or operating capital to the poor often without 

any collateral, credit history or steady income, for their 

proposed income-generating activities (Kota, 2007). Unlike 

such activities as giving of commodities (food, clothes, 

medicines, etc.), which would only satisfy the immediate 

needs of benefi ciaries, or provision of education and 

training, which requires time before one becomes able to 

use the acquired knowledge and skills, the provision of such 

capital funds brings benefi ciaries both immediate and 

long-term benefi ts. In order to reduce poverty, it is necessary 

for the poor to acquire the skills and build the foundation 

to sustain their lives on their own on a permanent basis; 

microfi nance is a scheme which helps to equip the poor with 

such skills and foundations. In fact, it is 

reported by Hulme and Moore (2007) 

that there are up to half a million people 

in Bangladesh alone who successfully 

escape from the poverty every year as the 

result of effective use of microfi nance. 

The second, yet probably more important, 

characteristic of microfi nance is 

that MFIs usually maintain and expand 

their activities by utilizing the contributions 

recollected from their own benefi ciaries (Felder-Kuzu, 

2005). Unlike conventional methods of poverty alleviation 

whose implementation almost always requires resources 

provided from donors (and therefore out of the control of 

the poor), this characteristic has given MFIs a solid basis for 

expansion. Indeed, microfi nance has been growing at 

remarkably rapid rate. According to MSC (2007), the total 

number of clients reached by MFIs has grown from 13

millions by the end of 1996 to 133 million by the end of 

2006 and numbers of MFIs reported to MSC also grew 

from 618 to 3,316 4 . From these fi gures, it can be seen that 

the number of clients of MFIs has grown by a remarkable 

120 million people at the rate of ten-fold in only a decade. It 

is important to mention that number of clients, 133 million 

people, does not include the clients’ families who would 

also be assisted by the funds provided by MFIs. MSC (2007) 

estimates 464.4 million people who have consumption level 

of $1 or less are currently being helped by MFIs and that 

makes up approximately 40 percent of world’s poor population 

who falls into that category. This signifi cantly high rate 

of growth and considerably wide outreach of the scheme 

suggests that microfi nance has the potential of reaching all 

the poor in the world. In fact, Yunus reported in his Nobel 

lecture in 2006 that 80 percent of poor families in Bangladesh 

have been reached by microfi nance and it is expected 

that 100 percent of them would be reached by 2010 (Nobel 

Foundation, 2006). Microfi nance has great potential to 

reach a signifi cant proportion of the poor population 

around the world. 

III. Success Factors of Microfi nance 

In the previous section, two unique characteristics of 

microfi nance were reviewed. Now, critical factors that made 

microfi nance a successful scheme will be 

identifi ed and explored based on fi ndings 

from the authors’ fi eld studies to 

Grameen Bank in Bangladesh and also 

relevant literature. 

Political Endorsement 

When one tries to implement a largescale 

scheme, which would affect the 

well-being of a signifi cant number of 

people, it is necessary to obtain support 

from the government. It was extremely lucky for Yunus that 

he could gain continuous support from the government by 

fully utilizing his personal network with high rank government 

offi cials. He was able to obtain government support 

from the stage the scheme was only a small experiment in a 

village until the experiment turned into a government 

regulated special bank (Grameen Bank) and now provides 

services to 7.4 million people (Grameen Bank, 2008). While 

464.4 million 

people who have 

consumption level 

of one dollar or 

less are currently 

being helped 

by MFIs 


S OCIAL EDGE 

any activity can be easily destructed by the government, the 

fact that Grameen Bank has always kept a friendly relationship 

with the government ruled by cabinets of different 

political parties contributes signifi cantly to the remarkable 

success of the scheme. 

Well-designed Strategies 

Unlike conventional banking operations which can expect 

certain amount of profi ts from each loan, profi ts from 

microfi nance loans are generally also ‘micro’ by their 

nature. Because of such conditions, it is critically important 

for an MFI to implement highly effi cient and effective 

management. From the fi eld studies, various techniques 

adopted by MFIs in order to realize low-cost management 

were observed. Following are some of the strategies used by 

Grameen Bank which are widely used by various MFIs: 

Group-lending: Among various techniques adopted by the 

scheme, group-lending was observed as Bangladeshi MFIs’ 

common lending strategy, which contributes to their 

effi cient management. By looking at peer-selection and 

peer-monitoring, two important mechanisms enacted as a 

part of the group-lending strategy, this paper will explore 

how group-lending contributes to the effi cient management 

of microfi nance. 

Peer-selection: For MFIs to secure sound 

operation, it is necessary to screen out 

bad borrowers who would not appropriately 

repay their debts. Peer-selection is a 

technique applied in the fi eld, which 

enables an MFI to cost-effectively avoid 

such bad borrowers. Ghatak (1999) 

explained the mechanism of peer-selection 

as follows: While gathering local 

information about potential borrowers is 

costly for an MFI, local prospective borrowers already 

know about each other’s projects. By contracting to selfformed 

groups of these prospective borrowers, MFIs can 

deliberately induce borrowers to select their groups in a way 

that exploits this local information. 

Peer-monitoring: Likewise to peer-selection, although it is 

important for securing sound repayment, monitoring the 

169

M ICRO MACRO 

activities of the borrowers is a costly business for MFIs. A 

useful tactic for transferring some of the monitoring costs 

to the borrowers is peer-monitoring. It is used as a part of 

the group-lending scheme. By designing the rules of loaning 

funds in such a way that one’s own loan activities positively 

or adversely affect the loan activities of other borrowers in 

one’s group, MFIs deliberately induce borrowers to monitor 

each other’s use of their loans. 

In addition to these two mechanisms, there was another 

commonly used strategy observed in the fi eld, which is 

important in terms of low-cost management of the microfi - 

nance scheme. 

Group Meeting: Another important method of saving 

operational cost is the weekly group meeting. This is 

designed as a mutually benefi cial system for both MFIs and 

their benefi ciaries. Group meetings usually take place in 

the vicinity of where benefi ciaries reside. By requiring 

borrowers to calculate their weekly 

instalments and discuss applications for 

new loans among their group members 

prior to the weekly meeting, MFIs can 

pre-sort their business concerns and 

quickly perform their functions. In the 

case of Grameen Bank, it was observed 

that a skilful manager collected and 

registered weekly instalments, accepted 

and evaluated new loan applications, and 

transmitted inquiries from the bank to 

50 borrowers all in one hour. If considering that most of the 

borrowers do not have any transportation means, the fact 

they can complete all these business in one hour without 

travelling far on foot contributes to the reduction of their 

work as well. 

Although group-lending and group meeting are typical 

strategies that are adopted by many MFIs that can considerably 

help them reduce their operational costs, they are 

still not the strategies that are universally adopted by all 

MFIs. In fact, strategies adopted by MFIs vary MFI to MFI 

depending on the environment within which each MFI 

operates. However although strategies adopted by MFIs 

vary a lot, their aim of reducing the cost as low as possible is 

common. There is no doubt that innovative strategies like 

the ones introduced above and the efforts of microfi nance 

170 


Ironically, 

relatively poor 

socio-economic 

conditions serve 

as important 

success factors 

of microfinance 

offi cers to develop such strategies have signifi cantly contributed 

to making the microfi nance scheme a major poverty 

alleviation policy today. 

Favourable Socio-Economic Conditions 

In addition to the two important success factors presented 

earlier, it was observed through the fi eld studies that 

relatively poor socio-economic conditions of Bangladesh, 

which are not necessarily good for their citizens, ironically 

serve as important success factors of microfi nance. Two 

important elements of the social and economic conditions 

which contribute to the success of microfi nance will be 

explored below. 

Ample Supply of Competitive Employees 

Based on Poor Employment Conditions: 

During the fi eld surveys in Bangladesh, extremely tough 

working conditions of Grameen Bank’s branch workers 

were observed. Regular working hours 

are already long, but during the rainy 

season they are even longer. Yunus and 

Jolis (1999) mentioned that the average 

working hours for local branch employees 

are 12 hours from 7:00 A.M. to 7:00 

P.M. with one hour break. During the 

authors’ visits, it was observed that staff 

stayed in the offi ce often until midnight 

due to the infl uence of rainy seasons. 

Moreover, from an interview with a 

senior principal offi cer of Grameen Bank, Ansaruzzaman 

(2007), it was discovered that while the staff have to stay 

long hours, no overtime allowance is paid to them as they 

are required to agree on an annual salary contract upon 

their employment. However, according a local branch 

manager Bhuyan (2007), Grameen Bank’s working conditions 

are actually still much superior to conditions at other 

employers in the country, and in fact, Grameen Bank is an 

exceptionally popular destination for work. In Bangladesh 

where a high degree of corruption exists5 and the supply of 

jobs is extremely limited, obtaining a decent job is something 

extraordinarily diffi cult. Yunus and Jolis (1999) 

mentioned job applicants must pay bribes which may be up 

to twenty times the monthly salary the job would bring, 

simply to obtain the job. These extremely severe employ-

ment conditions have made Grameen Bank salaries (which 

is equivalent to government employee with additional 

retirement benefi ts) competitive. Additionally, recruitment 

conditions that do not require application fees and enforcement 

of strong policies against bribes make Grameen Bank 

positions remarkably attractive. Upon such favourable 

hiring conditions for employers, Grameen Bank succeeded 

to hire more than 20,000 high-profi le employees6 (Grameen 

Bank, 2007) but there is no doubt that the commitment of 

such capable and dedicated staff signifi cantly contributes to 

the high-performance of Grameen Bank. As the socioeconomic 

environment affects not only Grameen Bank but 

also all the organizations in the country, it can be expected 

that all other MFIs in Bangladesh have benefi ted considerably 

from the unfortunate socio-economic condition, 

though favourable for employers. 

Dedicated Commitment of Borrowers 

Based on Severe Gender Inequality: 

The second socio-economic condition, 

which works favourably for MFIs in 

Bangladesh, is severe gender inequality 

in the country. In Bangladesh, there are 

many customs that considerably limit the 

scope of activities in which women can 

engage; under such conditions, men keep 

their dominating power over women. 

Among the different customs, there are 

two major ones that tremendously affect women’s lives. The 

fi rst one is called purdah. Purdah is a set of norms that 

exclude women from public spaces by enforcing restricted 

mobility, giving them specifi c gender labour roles, and 

prescribing legitimate behaviours (Newaz, 2001). The extent 

of activities regulated by purdah is extremely wide so that 

women often need to ask for their husband’s permission 

even to go to their neighbours (Tsuboi, 2006). Dowry is 

another custom, which adversely affects women’s lives. 

Dowry is a signifi cant value of property or money brought 

by bride to her husband and his family, which often determines 

the prospect of the wife’s position in the family 

(Newaz, 2001). Dowry is considered a detrimental custom 

for women’s status in the family because it often becomes a 

source of domestic violence and in the worst case becomes 

even a cause for murdering the bride (Tsuboi, 2006). In fact, 

Being poor in 

Bangladesh 

is tough for 

everyone, but 

being a poor 

woman is the 

toughest of all 


S OCIAL EDGE 

a woman’s position in a family is awfully fragile; a man can 

divorce his wife simply by telling her so three times (Yunus 

and Jolis, 1999) and indeed, they are often abandoned by 

their husband (Tusboi, 2006). While it is extremely diffi cult 

for a divorced woman to fi nd a job because of the high 

constraints of purdah, the family of the divorced woman 

may not allow her to come back in many cases as they 

cannot afford to feed an extra mouth. Because of such 

extreme situations, married women in Bangladesh generally 

live highly oppressed lives under the fear of being abandoned 

by their husband. For those women, microfi nance is 

an important and rare opportunity for them to improve 

their position in the family; in Bangladesh, the provision of 

a microfi nance loan is a rare privilege usually entitled only 

to women, not men. Regarding the provision of microfi - 

nance loans to women, Yunus and Jolis (1999: 88) mentioned 

‘Being poor in Bangladesh is tough for everyone, but 

being a poor woman is the toughest of all. When she is given 

the smallest opportunity, she struggles 

extra hard to get out of poverty.’ Arsheda, 

a village borrower interviewed by the 

author, mentioned that she was also a 

powerless woman totally ignored by her 

family before she enrolled in microfi - 

nance, but she gained respect and trust 

from everyone as she succeeded in her 

cattle raising business and became only 

literate person in the family. Arsheda 

said being trusted and respected by others are the most 

important values in her life, and the excitement from this 

motivated her to overcome the diffi culties of repaying debt. 

It is certainly important to remember that the desperate 

efforts made by literally millions of struggling women are 

the driving forces underlying the outstanding achievements 

of microfi nance. 

IV. Analysis of Success Factors 

and Future Prospects of Microfi nance 

The main success factors of microfi nance scheme were 

reviewed in the previous section. However as society is 

ever-changing, the importance of each success factor also 

changes. In this section, the paper will attempt to forecast 

the future prospects of microfi nance by analyzing the 

success factors as related to changes in the environment and 

171

M ICRO MACRO 

society in which microfi nance is performed. 

Changes in Importance of Political Endorsement: 

A good example of changes in the importance of the 

success factors is the changing importance of political 

endorsement for the microfi nance scheme. At the very 

beginning of microfi nance scheme when it was only a small 

experiment, fi nancial and legal support from the government 

were critically important. However in the current 

operation, Yunus has secured a solid legal background and 

also a strong fi nancial basis, which allows the bank to 

fi nance 100 percent of its loans from collected deposits 

(Yunus, 2007). As a result, the relative importance of 

political endorsement has drastically decreased. In the 

present operation, Grameen Bank and many other MFIs 

in Bangladesh have become strong enough to operate on 

their own as long as the government is not too destructive 

for them. 

Changes in Socio-economic Conditions 

and Their Infl uence to the Strategies: 

As mentioned above, political support is 

no longer a big issue for the current 

operation of microfi nance in Bangladesh. 

This is because MFIs have grown and 

become able to support their activities 

without receiving governmental assistance. 

However unlike government 

support, there are other factors such as 

socio-economic conditions, which are out of the control of 

MFIs. Regarding such factors, it is necessary to consider 

how these external factors would change in the future and 

how these changes would infl uence the scheme. This paper 

will look at the infl uence of potential changes in two 

socio-economic conditions and how these changes would 

affect the strategies adopted by MFIs. 

Possible Effects of the Changes in Employment Conditions: 

There is unfortunately no evident sign which foretells that 

employment conditions in Bangladesh would be signifi cantly 

improved in the near future. Nevertheless, it is important 

to consider this possibility because it would greatly affect 

the future operation of microfi nance. If employment 

conditions are improved, both the cost of staff recruitment 

172 


MFIs based on 

conventional 

group-lending 

strategies will face 

serious problems 

if they keep using 

old strategies 

and their wages will be raised. Although these additional 

costs must be fi nanced from the interest payment of borrowers, 

it would not be possible to do so if such costs 

become more than borrowers can afford. In the case of 

Grameen Bank, General Manager Shahjahan (2007) 

identifi ed two major countermeasures to prepare for this 

possibility. The fi rst measure is computerization of branch 

accounts. By computerizing branch accounts, Grameen 

Bank is trying to make their operation more effective while 

reducing the number of people required for operation. 

According to Grameen Bank (2008), almost all the branch 

accounts (2,418 out of 2,481) have already been computerized. 

Another measure is early retirement program. At 

Grameen Bank, if an employee works for 10 years, that 

employee will be entitled for early retirement and be able to 

leave the bank with a considerable amount of retirement 

benefi t7 . Shahjahan (2007) explained that about 25 percent 

of employees take this option. A policy like this one seems 

to give Grameen Bank greater control 

over their human resources as they can 

effectively control the size of the organization 

by manipulating the retirement 

policy and the number of employees to 

be recruited. These are just a few 

examples of the measures taken by a 

leading MFI in Bangladesh; further 

studies are required in order to fi nd out 

what preparations are taken by other 

MFIs. However one thing is sure at this 

point; each MFI must establish suitable measures for 

themselves as it is reasonable to expect that improvement in 

employment conditions would occur in Bangladesh at some 

point in the future. 

Possible Effects of the Changes in Gender Inequality: 

Regarding the gender inequality issue, there is some 

evidence which indicates that gender equality is being 

promoted in Bangladesh. For example, in the area of 

education, currently there are even more female students 

enrolled than male students (1.03 of female/male ratio) and 

as a result, the gap in literacy rate between the two genders 

has been quickly diminishing8 (UNDP, 2007). The Bangladeshi 

government also has been taking extra effort to 

increase women’s participation in their parliament. Accord-

ing to UNDP (2007), the Bangladeshi government added 45 

seats in their parliament exclusively for women in 2004 and 

as a result, the share of the seats occupied by women in the 

parliament was increased from two percent in 2003 (UNDP, 

2003) to 15 percent in 2007 (UNDP, 2007). These are just a 

few examples but there are many more examples of the 

promotion of gender equality in Bangladesh. 

Unlike improvement in employment conditions, which 

increases the management cost, promotion of gender 

equality does not necessarily infl uence microfi nance 

scheme in a negative way. This is because regardless of 

women’s position in the family, their fi nancial situation 

remains the same and the need for microfi nance remains. 

For that reason, although improved position of women in 

the family would reduce the degree of their commitment to 

microfi nance as they would no longer be as desperate as 

they are now, it also could be expected that commitment of 

men to microfi nance would be increased. 

A separate study would be necessary to 

evaluate the effect of promotion of 

gender equality on microfi nance. 

Evaluation of Effectiveness of 

Current Strategies in the Future: 

As reviewed earlier, the strength of 

microfi nance comes from the fact that 

microfi nance scheme is managed by 

utilizing the power of the poor themselves. 

In microfi nance, various strategies are adopted in 

order to make it possible for MFIs to run the scheme using 

the tiny amount of interest charges collected from the 

borrowers. It was reviewed that group-lending is an effective 

method of economizing the management costs adopted 

by different MFIs. However, it may become diffi cult to use 

such a method in the near future in Bangladesh. As mentioned 

earlier, Yunus said that microfi nance could reach 

almost 100 percent of the poor families in Bangladesh by 

2010 (Nobel Foundation, 2006). Whether or not that would 

become reality is still unknown however the possibility has 

signifi cant meaning. Microfi nance may reach a peak at 

which point there may be no way it could expand further. As 

more people escape from poverty and quit being clients of 

MFIs, the number of benefi ciaries which belong to each 

branch may decrease. At that point, it will cost more to 

Promotion 

of gender 

equality does 

not necessarily 

influence MF 

scheme in a 

negative way 


S OCIAL EDGE 

manage each branch and the interest rate charged to each 

borrower would need to be increased as a result. However, 

if the interest rate is too high, it would no longer possible for 

poor clients to borrow money from MFIs. On the other 

hand, if MFIs tried to merge branches in order to increase 

the number of people per branch, it would become diffi cult 

for borrowers to come to the weekly meetings and become 

no longer feasible for them to use microfi nance. In addition, 

as the number of people who need microfi nance loans will 

be decreased, it would become harder for potential borrowers 

to fi nd suitable group members as well. All of these 

situations mean that MFIs based on conventional strategies 

of group-lending will face serious problems which would 

not allow them to operate further if they will keep using 

these strategies without making further improvement. 

Improvement in strategies seems to be an absolutely 

necessary condition for the future of microfi nance. 

V. Conclusion 

Microfi nance is a unique method of 

alleviating poverty with the concept of 

empowering people with their own 

abilities. In microfi nance, even the 

maintenance and expansion of the 

scheme is usually done based on the 

contributions collected from the benefi - 

ciaries. These characteristics of selfsustainability 

and self-expansion have 

given the microfi nance an outstanding power of expanding 

its outreach. Currently 40 percent of world poor who live 

under the consumption level of $1 per day are expected to 

be benefi ting from the scheme (MSC, 2007). 

Through the results of recent fi eld studies conducted in 

2007 and literature reviews, this paper has concluded that 

political support, which provided legal and fi nancial basis, 

was a critical success factor of the microfi nance scheme 

during its initial stage. Regarding the current operation of 

microfi nance, this paper provided two key success factors. 

The fi rst factor was well-designed strategies adopted by 

MFIs. In microfi nance, by defi nition, MFIs can expect 

only a ‘micro’ profi t from each benefi ciary but they still 

have to grow from these tiny earnings. This paper explained 

how the strategies based on group-lending 

enabled MFIs to run their activities cost-effi ciently, so 

173

M ICRO MACRO 

that they could expand their activities from these small 

incomes. The second success factor was favourable 

socio-economic conditions (for MFIs). It was explained 

that severe employment conditions in Bangladesh enabled 

MFIs to recruit and use quality staff at relatively low cost. 

On the other hand, it was also explained that harsh gender 

inequality exists in Bangladesh makes microfi nance loans 

one of the rare opportunities for women to improve their 

status in the family, thus raising their commitment to 

repaying their loans. 

Socio-economic conditions in one country and the 

effectiveness of the strategies implemented by MFIs are 

changeable over an extended period of time. In this paper, 

the future prospect of the microfi nance scheme was 

evaluated by analyzing the success factors of current microfi 

nance operations. From the analysis, it was concluded 

that changes in socio-economic conditions would have 

considerable impact over the future of microfi nance, and 

therefore changes or improvements to the current strategies 

must be developed in order for microfi nance to remain 

a successful scheme of poverty alleviation in the future. 

In the past, reaching all the poor in the world was the 

fl agship target of microfi nance. Although it still has a long 

way until microfi nance reaches this target, on a national 

level in Bangladesh, it is close to becoming a reality. It 

seems highly possible that microfi nance would reach its 

peak in Bangladesh in near future because of the scheme’s 

high growth rate. Reaching the peak will mean that there 

will be fewer prospective new clients for MFIs in the 

country and the number of benefi ciaries will decrease. The 

number of clients served per branch would decrease and 

the cost of managing a branch per person would increase. 

That would also mean fewer potential clients in a village 

and more diffi culty in fi nding group members for prospective 

clients. All of these situations lead to the conclusion 

that MFIs based on conventional group-lending strategies 

will face serious problems if they will keep using these 

strategies without making further improvement. The 

moment microfi nance reaches its peak will occur in a 

relatively short period of time and it will be the critical 

turning point of the microfi nance scheme. For the future of 

all the poor in the world, further innovation on the strategies 

of microfi nance is eagerly desired and continuous 

attention must be paid for such efforts of innovation. 

174 


Endnotes 

1 The number of poorest clients reached by the all the 

MFIs reported to MSC in the world was increased by 22 

percent in average for past fi ve years (2001-2006) 

according to the data from MSC 2007 

2 According to Bangladesh Bureau of Statistics (2007), 

unemployment rate (including underemployment) for 

2005-2006 was 28.7 percent. 

3 According to World Bank (as quoted by United Nations 

Development Programme 2005), proportion of the 

people who live under $1 per day in the world was 

decreased from 40.4 percent in 1981 to 20.7 percent in 

2001. 

4 These fi gures merely represent the data of MFIs 

reached by MSC. There is high possibility that there are 

more MFIs and people reached by them but not yet 

recognized by MSC. Please refer to MSC (2007) for the 

details of the data. 

5 Transparency International (2006) ranked Bangladesh 

156th among 163 countries listed in Corruption Perception 

Index 2006. The Corruption Perception Index is an 

internationally accredited index released every year by 

Transparency International which ‘ranks more than 150 

countries by their perceived levels of corruption, as 

determined by expert assessments and opinion surveys’ 

(Transparency International n.d.: n.p.). For more 

information, please refer to http://www.transparency. 

org/policy_research/surveys_indices/cpi. 

6 According to Yunus and Jolis (1999), Grameen Bank 

requires applicants for branch manager to have a 

master’s degree with the average grades of B or better 

and applicants for center (the lowest unit of fi eld operation) 

to have at least two years of college education with 

average grades of B or better in college and high school. 

7 According to Shahjahan, approximately $10,000 is the 

amount to be paid for young center managers who 

started to work at 18 years old. 

8 Female/ male youth literacy ratio was increased from 

0.71 in 2005 (UNDP 2005) to 0.9 in 2007 (UNDP 

2007). 


• Bangladesh Bureau of Statistics (2007) Key Findings of 

Labour Force Survey 2005-2006, Bangladesh Bureau of

Statistics [Online], Available: http://www.bbs.gov.bd/ 

dataindex/labour_%20force05-06.pdf [Accessed: 23rd January, 2008] 

CIA (2008) The World Fact Book: Bangladesh, Central 

Intelligence Agency [Online], Available: https://www. 

cia.gov/library/publications/the-world-factbook/geos/ 

bg.html#People [Accessed: 24th January, 2008] 

Daley-Harris, Sam (2007) State of the Microcredit 

Summit Campaign Report 2007, (Washington D.C.: 

Microcredit Summit Campaign). 

Felder-Kuzu, Naoko (2005) Making Sense: Microfi - 

nance and Microfi nance Investments [Nyumon Microfi - 

nance], (Tokyo: Diamond). 

Ghatak, Maitreesh (1999) Group Lending, Local 

Information and Peer Selection. Journal of Development 

Economics 60(1999), pp. 27-50. 

Grameen Bank (2008) Grameen Bank Monthly Updates 

in US$: December, 2007, Grameen Bank, Dhaka. 

Grameen Bank (2007) Past Ten Years at a Glance 

(1997-2006), Grameen Bank [Online], Available: http:// 

www.grameen-info.org/bank/tenyearGBus$.html 

[Accessed: 17th January, 2008] 

Hulme, David and Moore, Karen (2007) Why has 

Microfi nance been a Policy Success in Bangladesh? in: 

Bebbington, Anthony and McCourt, Willy (eds) Development 

Success: Statecraft in the South, (New York: 

Palgrave Macmillan), pp.105-139. 

Kota, Ian (2007) Microfi nance: Banking for the Poor. 

Finance and Development 44(2), pp. 44-5. 

Newaz, Ware (2001) NGO Credit Programmes and 

Empowerment of Rural Women: Experience from 

Bangladesh, in: Farhad Hossain and Zahidur Rahman 

(eds) Microfi nance and Poverty: Contemporary Perspectives, 

(Tampere: University of Tampere Department 

of Administrative Science and Service Centre for 

Development Co-operation), pp 115-37. 

Transparency International (2006) CPI Table, Transparency 

International [Online], Available: http://www. 

transparency.org/news_room/in_focus/2006/ 

cpi_2006__1/cpi_table [Accessed: 17th August, 2007] 

Transparency International (n.d.) CPI, Transparency 

International [Online], Available: http://www.transparency.org/policy_research/surveys_indices/cpi,[Accessed: 

20th August, 2007] 


S OCIAL EDGE 

Tsuboi, Hiromi (2006) Do You Know Grameen Bank? 

[Grameen Ginko o Shitte Imasuka], (Tokyo: Toyo 

Keizai Sinhou). 

United Nations Development Programme (UNDP) 

(2007) Human Development Report 2006 Beyond 

Scarcity: Power, Poverty and the Global Water Crisis 

(New York: Palgrave Macmillan). 


(2005) Human Development Report 2005 International 

Cooperation at Crossroads: Aid, Trade and Security in 

an Unequal World (New York: UNDP). 


(2003) Human Development Report 2003 Millennium 

Development Report Goals: A Compact among Nations 

to End Human Poverty (New York: Oxford University 

Press). 

World Bank (2008) Understanding Poverty: What is 

Poverty?, World Bank [Online], Available: http://go. 

worldbank.org/RQBDCTUXW0, [Accessed: 9th January, 2008] 

Yunus, Muhammad and Alan Jolis (1998) Banker to the 

Poor (Dhaka: University Press). 

Yunus, Muhammad (2007) Grameen Bank at a Glance 

(Dhaka: Grameen Bank). 

Ansaruzzaman, Md.: Senior Principal Offi cer, 

Grameen Bank, International Department (2007) 

Personal Interview, Dhaka, 14th , 15th and 22nd July, 2007. 

Arsheda: Grameen Bank borrower (2007), Personal 

Interview, Fegunasher, Bangladesh, 9th July, 2007 

Baiddya, Ashim: Fieldworker, Grameen Bank, Panchkhola 

Branch, Madaripur (2007) Personal interview, 

Madaripur, Bangladesh, 23rd December, 2007. 

Bhuyan, Harun-or-Rashid: Branch Manager, Fegunasher 

Shirajdikhan Branch, Grameen Bank (2007) Fegunasher, 

Bangladesh, 9th-12th and 19th July, 2007. 

Biswas, Pabitra: Fieldworker, Grameen Bank, Panchkhola 

Branch, Madaripur (2007) Personal interview, 

Madaripur, Bangladesh, 23rd December 2007. 

Shah, Mozahid: Manager, Grameen Bank, Panchkhola 

Branch, Madaripur (2007) Personal interview, Madaripur, 

Bangladesh, 25th December 2007. 



175

S ECTORAL SNAP 

Consumer Behavior and 

Competition in Indian 

Retailing 

176 


Mohammad Amin 

Private Sector Development Specialist, 

Enterprise Analysis Unit, Financial and Private 

Sector Development, The World Bank Group, 

Washington, D.C. 


R ETAIL ROULETTE 

1. Introduction: Overview and Data Description 

It is commonly believed that India has one of the highest 

density of retail stores in the world and therefore competition 

in the retail industry is hardly an issue. Another common belief 

is that competition in an industry depends on the number of 

fi rms and fi rm-behavior with consumer behavior being largely 

irrelevant. However, beliefs and perceptions can be notoriously 

misleading and confi rmatory evidence using hard data is always 

welcome. Unfortunately, hard data on structure of retailing in 

India (or any developing country) is extremely rare. This is 

surprising given that the retail sector in India is the second 

largest sector (after agriculture) providing about 10% of the 

formal jobs, and contributing over a quarter of the value added 

in all services sectors and 14% to the national GDP. The sector 

has also shown strong growth in recent years, with an average 

annual growth rate of 7.3% over the 1990s compared with 5.9% 

in the 1980s and 4.3% during 1950-1979. 1 These numbers tell 

the story in the formal sector. But an estimated 95% of the 

sector’s activity takes place in the informal sector that is not 

accounted for in the offi cial fi gures. 

This article uses data on 1,948 retail stores in India and 

collected by the World Bank’s Enterprise Surveys in 2005 (data 

described in detail below). Using these data, we explore a 

number of issues relating to the level of competition in retailing 

and fi nd some surprising results. First, competition in the sector 

is low by international standards and also when compared with 

the same in the Indian manufacturing sector. Second, larger 

and richer metropolitan cities that have been the main hub of 

Indian retailing show signifi cantly less competition than the 

relatively smaller cities. Third, contrary to the popular belief 

that competition is all about how fi rms behave, we fi nd strong 

evidence that consumer behavior is an equally important 

determinant of the level of competition. Specifi cally, household’s 

shopping time opportunity cost as proxied by the number 

of non-workers per household in the city has a very large effect 

on the level of competition. The fi nding is particularly important 

for India that is witnessing a rapid decline in the number of 

non-workers driven in part by the ongoing economic boom. 

Fourth, we look at another popularly held belief that competition 

in retailing is greater in the poorer cities. The rationale for 

this is that poorer households value a Rupee of savings more 

than the rich and hence they are likely to search more intensively 

increasing the level of competition. Our results show that 

177


Figure 1. Percentage of Firms Facing Signifi cant Competition 

178 

Retailers (India) 

Retailers (Eastern Europe 

and Central Asia 

Manufacturing (India) 

0 


38.2 

20 40 60 80 

Percentage of fi rms/stores reporting 

competition as fairly important or important 

important or very important 

on the question. The survey 

also provides information 

on a number of store 

characteristics such as its 

age, fl oor area, fi nancial 

condition, annual sales, etc. 

We use these rich data to 

check for the robustness of 

the main results. 

Source: Enterprise Surveys and Business Environment and Enterprise Performance Survey (BEEPS, 2005). 

2. Low Level of 

Competition in Indian 

the negative income-competition relationship in India disap- Retailing 

pears when we account for the number of non-workers across Figures 1 and 2 show some important fi ndings on the competi- 

rich vs. poor cities. The fi nding casts doubt on the supposed tion variable: 

explanation of the income-competition link. Last, we provide • First, 38.2% of the retailers in India face signifi cant competi- 

some evidence on the likely effect of competition on effi ciency tion (Figure 1). The comparable fi gure for registered 

of the retail stores in India. Policy implications of the main manufacturing fi rms in India equals 82% (Enterprise 

fi ndings are discussed. 

Surveys, 2005) and 71% for retailers in 27 Eastern Europe 

Our main data source is a stratifi ed random sample of 1,948 and Central Asian countries (Business Environment and 

retail stores (Enterprise Surveys) located in 16 major states and Enterprise Performance Survey (BEEPS) 2005 conducted by 

41 large cities of India. Roughly, 64% of the stores in the 

the World Bank and EBRD). In short, competition in Indian 

sample are traditional stores, 26% consumer durable stores retailing seems low even though the country boasts of one of 

and the rest 10% are modern format stores. In one question, the highest density of retail stores in the world. 

the respondents were asked how important competition from • Second, the metropolitan cities of Bangalore, Chennai, 

other retailers is for the prices of the store’s main products. Delhi, Hyderabad, Kolkata and Mumbai have traditionally 

The response was recorded as not at all important, slightly been the retailing hubs of the country and also the main 

important, fairly important and very important. We defi ne a benefi ciaries of the ongoing retailing boom. Yet, competition 

store facing “signifi cant competition” if it reports fairly 

in these cities is signifi cantly lower than in the remaining 

cities (Figure 2). 

Figure 2. Percentage of Indian Retailers Facing Signifi cant Competition • Third, contrary to 

popular belief, the level of 

Metropolitan Cities 

31.9 

competition amongst 

Non-Metropolitan Cities 

40 

traditional stores (small 

Small Stores 

33 

stores selling grocery items) 

Large Stores 

Kozhikode 

Madurai 

5.7 

45.2 

100 

is signifi cantly less than 

amongst large stores 

(selling consumer durable 

0 20 40 60 80 100 and other items and often 

Percentage of Indian retailers reporting 

competiton as fairly important or important 

part of a larger shopping 

complex). One reason for 

Source: Enterprise Surveys. Metropolitan cities include Bangalore, Chennai, Hyderabad, Kolkata, Mumbai and New Delhi. Small stores this could be that smaller 

include tranditional stores selling grocery items. Large stores are large-sized stores selling various consumer items and usually part of a 

larger shopping complex. 

stores are better able to 

71 

82

segment the market by providing personalized retailing 

services to their customers. 

• Fourth, competition varies signifi cantly across cities with a 

low of 5.7% stores in Kozhikode and a high of 100% in 

Madurai reporting competition as fairly 

important or important. 

3. The Importance of Consumer 

Behavior for Retailing 

The traditional view of competition is that 

competition depends on the number of 

fi rms and their behavior. Consequently, 

competition policies are almost exclusively 

focused on preventing monopolies, predatory 

pricing and collusion by fi rms. How- 

ever, the simple idea that consumer behavior is also important 

for competition in consumer industries such as retailing, 

electricity distribution and personal fi nance is at the heart of a 

small but growing literature. This literature calls for greater 

emphasis in competition policies on consumer behavior as 

opposed to the number of fi rms or fi rm-behavior. For example, 

Waterson (2003) notes that 



Figure 3. Percentage Change Over 1991-2001 in the Number of Adult Non-Workers per Household 

% change between 2001 and 1991 in the 

number of non-workers per household 

10 

5 

0 

-5 

-10 

-15 

-20 

Uttar Pradesh 

Madhya Pradesh 

Maharashtra 

Rajasthan 

Andhra Pradesh 

Tamil nadu 

Source: Census of India, 1991 and 2001. Percentage changes in the fi gure above equal the number of adult non-workers per household in 2001 minus the 

same in 1991 and expressed as a percentage of the 1991 values of the variable. 

Gujrat 

Bihar 

Orissa 

Karnataka 

Competition 

seems low even 

though the 

country boasts of 

one of the highest 

density of retail 

stores in the world 

West Bengal 

Punjab 

Kerala 

“… traditional competition policy will not suffi ce to render the 

industry competitive and that, in such cases, quite different policy 

measure may well be more effective in enhancing competition. In a 

nutshell, consumer behavior and policy towards consumers matter 

signifi cantly for industry performance.” 

Policy makers and practitioners are also 

beginning to realize the importance of 

consumer behavior. For example, Stephen 

Byers, Secretary of State in the United 

Kingdom notes that 

“Active consumers who are prepared to 

check and shop around to ensure they get a 

good deal are a key driving force in helping to 

create truly competitive markets.” (Stephen 

Byers, Secretary of State, UK; Department of 

Trade and Industry, 2000) 

A good example of what the above quotes imply is a recent 

study by Giulietti et al. (2005) on the deregulation of the 

natural gas supply market in the U.K. This study fi nds that the 

incumbent (monopolist) continued to enjoy signifi cant market 

power even after complete deregulation (free entry) and that 

the cost of deregulation outweighed the benefi t. According to 

Haryana 

All states (average) 

179


Figure 4: Competition and Non-Workers 

that the ongoing economic 

boom is likely to make 

increasingly bigger demand on 

50 

household’s time (evidence 

45 

provided below). A key 

40 

question here is whether time 

cost of households matters for 

35 

the level of competition in 

30 

Indian retailing. 

25 

In this article we proxy for 

the time cost of households by 

20 

the number of non-workers 

15 

per household in the city 

10 

(henceforth, non-workers). 

The prediction is that more 

5 

non-workers imply lower time 

0 

cost for households and 

1 2 3 

Non-workers per household in the city 

(Quartiles, higher values imply more non-workers) 

4 

therefore more intensive 

search and hence more 

competition in the city. As 

Source: Enterprise Surveys and Census of India (1991). The horizontal axis shows the number of non-workers per household in the 

city grouped by their quartile values. A higher quartile indicates more non-workers. 

might be expected, non-workers 

have shown a sharp decline 

the study, the main reason for the failure of the deregulation over the last few years, most probably due to the economic 

effort was the perception among consumers that the cost of boom starting early 1990s. Figure 3 provides evidence on this 

searching and switching to a new supplier would be more than using data from Census of India (1991, 2001). Between 1991 

the associated benefi t. However, the perceived cost was much and 2001 and averaged over the 14 major states of India, 

higher than the true cost. Therefore, the study recommends non-workers declined by 7.2%. The decline was as sharp as 

correcting consumer perceptions through, for example, an 18.6% in Haryana, 12.7% in Kerala and over 10% in Punjab, 

information subsidy, as a key ingredient for the success of the Karnataka and West Bengal. Only two states (Uttar Pradesh 

deregulation exercise. 

4. What Shapes Consumer Behavior? 

and Madhya Pradesh) witnessed an increase of less than fi ve 

percent. 

There is very little by way of hard research 

on what shapes consumer behavior and 

therefore the level of competition in 

5. Relationship between Non-Work- 

Competition varies ers and Competition in Large 

significantly across Indian Cities 

consumer industries of the developing cities with a low In a recent study, Amin (2008a) looks at 

world. One possibility is that the intensity 

with which consumers search for best prices 

and deals depends on their shopping time 

opportunity cost (henceforth, time cost). 

When the time cost is low, consumers can 

of 5.7% stores in 

Kozhikode and a 

high of 100% 

in Madurai 

this relationship between non-workers and 

competition in Indian retailing in detail and 

we discuss below the main fi ndings from 

this study. For expositional convenience, 

we use graphical illustrations below while 

devote more effort and time searching, 

the formal econometric results are avail- 

driving up the level of competition. The issue of time cost and able in the stated study. 

competition in retailing is important in the Indian context given The fi ndings of the study are along predicted lines. Irrespec- 

Percentage of stores reporting competition as 

fairly important or important 

180 




tive of the set of controls, non-workers and the percentage of 

stores facing signifi cant competition in the city are strongly and 

positively correlated. Without any other controls, a move from 

the city with the least number of non-workers (2.01 in Noida) to 

the city at the 25th Figure 5: Competition and Children 

A number of tests were 

performed to guard against 

such possibilities. To begin 

45 

with, we controlled for a 

40 

number of city and store 

characteristics and found that 

35 

the non-workers and competi- 

30 

tion relationship discussed 

25 

above remained robust to the 

controls. Specifi cally, city level 

20 

controls included the level of 

15 

literacy, per capita expendi- 

10 

ture using NSSO data (closest 

available proxy for city level 

5 

incomes), sex ratio (a proxy 

0 

for overall development), 

1 2 3 

Children per household in the city 

(Quartiles, higher values imply more children) 

4 

number of children per 

household (discussed in detail 

below), duration of power 

outages faced by retailers, 

total employment in retailing 

as a percentage of city population (retailer density), fi xed 

effects for metropolitan vs. non-metropolitan cities, city-population, 

etc. Controls for fi rm characteristics included fl oor area 

of the shop, age of the store, whether the store is part of a 

percentile value of non-workers (2.59 in large chain or not, store-type fi xed effects (traditional, 

Bhubaneswar) increases the number of stores facing signifi cant consumer durable or modern format store), measures of fi nan- 

competition by as much as 9.8 percentage points (Figure 4). cial access of the store, etc. 

This is a large effect given that only 38.2% of the stores in the Some of the controls mentioned above were also found to 

full sample report facing signifi cant competition. We also be important for explaining the level of competition. For 

checked for the non-workers and competition relationship example, retailer density had a large positive effect on compe- 

separately for the set of traditional stores (small stores selling tition; power outages in the neighboring stores a negative 

grocery items) and the rest (consumer durable stores and effect while outages in one’s own stores increased the level of 

modern format stores). The relationship was slightly stronger competition faced by the store in question; and traditional 

for the former but not by much. 

stores were less likely to face signifi cant competition than the 

One could argue that cities with more non-workers may rest. In contrast, there was virtually no effect of literacy rates, 

happen to be more competitive because of other correlated income levels, and age, size and fi nancial access of the store on 

characteristics and not because non-workers search more 

intensively. For example, cities with more non-workers are also 

the level of competition. 

the relatively poorer cities (confi rmed in the data). It is possible 6. Overall Development of Cities and Competition 

that poorer households search more intensively not because An interesting contrast is provided by comparing how non- 

they have more non-workers but because a Rupee of savings workers and the number of children per household in the city 

(through more intensive search) means more to them relative (henceforth, children) affect the level of competition. One 

to the richer agents. 

possibility is that both, non-workers and children are reasonably 

Percentage of stores reporting competition as 

fairly important or important 

181


good proxy measures of overall development. Hence, if 

non-workers is simply a proxy for overall development then 

children and non-workers should affect the level of competition 

in the same direction. In contrast, if our claim of 

non-workers as a proxy for the time cost of shopping is 

correct then we should expect non-workers and children to 

affect competition in opposite directions. The reason for this 

is that having more children in the household increases 

household’s time cost of shopping, lowering search efforts 

and hence the level of competition in the city. As discussed 

above, the prediction with more non-workers is just the 

opposite: more non-workers imply lower time cost leading to 

more intensive search and therefore greater competition. 

Figure 5 shows the relationship 

between children and the level of 

compet competition. et e it itio i n. Clearly, the relationship 

is negative in contrast to the positive 

one we found in Figure 4. The childrencompetition 

relationship is 

s slightly weak 

in Figure 5 but be bbecomes comes much stronger 

when we account for differences in the 

number of non-workers across cities. 

This strong and negative relationship 

is robust to differences in various 

city and store characteristics such 

as the ones discussed discusse s d above. In 

short, shor o t, non-workers and children 

have separate, sep eparate, independent and n 

contrasting effects on the level of 

competition and so it is highly 

unlikely that they are a mere proxy 

for the level of development. 

7. Income and Competition 

A commonly held view is that the utility from a Rupee of 

savings (through more intensive search) is higher for the poor 

compared with the rich. What this implies is greater search 

effort and therefore more competition in the relatively poorer 

cities. However, this idea has not been rigorously tested, 

especially in the context of a developing country. 

Our results show that there is indeed a negative relationship 

between income and competition but this relationship virtually 

disappears once we account for differences in the number of 

non-workers across rich vs. poor cities. The result casts doubt 

on the supposed explan explanation a ation of the inco income-competition 

relationship (that the poor search more 

intensively because 

they value a Rupee of savings more than the rich). Rather, 

greater competition in the poorer cities ccould 

be due to the fact 

that the poorer cities have more non-workers non-wo and therefore 

more time to devote to searching for bes best prices. If this is 

indeed true, and more research is required requir to ascertain it, the 

policy implication is simply to lower shop shopping cost in the 

relatively richer cities through, for exam example, longer store hours, 

better dissemination of information on pprices, 

greater use of 

internet for shopping, etc. 

8. Competition and Productivity iin 

Indian Retailing 

To get a sense of how important the abov above fi ndings are, some 

connection connecti t on needs to be made betw between t een th the level of competition 

and effi ciency in retailing. At a broad lev level, the literature offers 

a number of insights on the competition 

competition-effi ciency relationship. 

The general belief is that competition is 

good for effi ciency. The 

fear of being wiped out by the competitors competito forces fi rms to cut 

costs. Amin (2008b) uses the same data as discussed above and 

fi finds nds that increased competition 

o has a ve very large positive effect 

on labor productivity of the stores. Estim Estimates suggest that 

increasing competition 

from its lowest level 

(traditional stores in GGhaziabad) 

to the 

highest level 

(modern format stores 

in Madurai) 

is likely to increase the 

effi ciency of the former stores by as 

much as 87% of the current level. 

These are large lar gains and could 

have a signifi significant 

impact on the 

overall economy. econ

9. Policy Implications and Conclusion 

The number of non-workers in India is likely to witness signifi - 

cant declines in the near future as the booming economy 

attracts more would be non-workers into the fold of the labor 

force. With fewer non-workers, the time cost of shopping will 

increase forcing consumers to search less intensively for best 

prices and deals. This article argues that as a result of declining 

non-workers, competition in Indian retailing may see a secular 

drop. The likely effect of lower competition on retailing 

effi ciency is shown to be potentially large. The impact of these 

changes on the overall economy cannot be neglected given that 

the retail sector in India is second only to agriculture in terms of 

its size. 

Two broad policy implications follow from the fi ndings above. 

First, one cannot take the level of competition in Indian 

retailing for granted, especially in the larger and richer cities. 

By international standards, competition in India’s retail sector 

is on the lower end. Second, competition policies that are 

currently focused exclusively on fi rm-behavior should pay more 

attention to consumer behavior and consumer attributes that 

shape consumer behavior. Some attributes such as non-workers 

may not be directly amenable to competition policies. However, 

even in such cases indirect policy measures can help alleviate 

part of the problem. For example, cities with fewer non-workers 

or where non-workers are decreasing at a rapid rate can be 

targeted with better e-commerce facilities, longer operating 

hours for retail stores, lower entry barriers and better dissemination 

of information on product prices. We hope that the 

present work will encourage more research on these issues. 

Endnotes 

1 Cities in the sample include (in alphabetical order): 

Ahmedabad, Bangalore, Bhopal, Bhubaneswar, Chandigarh, 

Chennai, Coimbatore, Cuttack, Delhi, Dhanbad, Faridabad, 

Ghaziabad, Greater Mumbai, Guntur, Gurgaon, Gwalior, 

Hubli-Dharwad, Hyderabad, Indore, Jaipur, Jamshedpur, 

Kanpur, Kochi, Kolkata, Kota, Kozhikode, Lucknow, 

Ludhiana, Madurai, Mangalore, Mysore, Nagpur, Nashik, 

Noida, Patna, Pune, Surat, Vadodara, Vijayawada and 

Vishakhapatnam. 

1 These estimates are based on National Accounts Statistics 

and taken from Gordon and Gupta (2004). 

2 The sampling frame for the survey was the list of retail stores 

regularly interviewed by AC Nielson for inventory verifi ca- 



tion on behalf of distributors of branded goods. This list 

covers stores in forty one cities across India for three major 

industry segments: Fast Moving Consumer Goods (FMCG) 

stores (traditional stores), consumer durable stores and the 

modern format stores. The sample was stratifi ed according 

to segment-specifi c criteria. FMCG stores were stratifi ed 

based on turnover, number of salesmen, number of FMCG 

product and the presence of cooling equipment. Consumer 

durable and modern format stores were stratifi ed based on 

turnover. The sample size was determined so as to minimize 

the standard error in the sample variables, given the available 

resources for each surveying stratum. Once the sample 

size was determined, the sample was allocated to strata using 

Neymann’s allocation rule. More information about the 

survey and methodology is available at www.enterprisesurveys.org. 

3 The difference in the level of competition between metropolitan 

cities and the rest is signifi cant at less than fi ve percent level. 


• Amin, M. (2008a), “Competition and Demographics,” Policy 

Research Working Paper 4514, World Bank, Washington 

DC. Available at http://www.enterprisesurveys.org/Research- 

Papers/. 

• Amin, M. (2008b), “Competition and Labor Productivity in 

India’s Retail Stores,” mimeograph available at www. 

enterprisesurveys.org. 

• Amin, M. (2008c), “Retailing in India: Assessing the Investment 

Climate,” India Economy Review, Sept. 2008: 188-197. 

Available at http://works.bepress.com/mohammad_amin/4/. 

• Department of Trade and Industry (2000), Switching 

Suppliers, London: The Stationery Offi ce. 

• Fan, C. S., C. Lin and D. Treisman (2009), “Political Decentralization 

and Corruption: Evidence From Around the 

World,” Journal of Public Economics, 93(1-2): 14-34. 

• Giulietti, M., C. Price and M. Waterson (2005), “Consumer 

Choice and Competition Policy: A Study of the UK Energy 

Markets,” Economic Journal, 115: 949-968. 

• Waterson, M. (2003), “The Role of Consumers in Competition 

and Competition Policy,” International Journal of 

Industrial Organization, 21: 129-150. 



183

C OUNTER CURRENTS 

Crisis in Academic 

Economics 

Amol Agarwal 

Economist based at Mumbai 

184 


one of the main reasons for the severity of the crisis. However, 

ECB looks at monetary targets extensively but failed to see the 

crisis. Bank of Japan also looks at these targets but has failed just 

like ECB. 

The question is how do we make money and credit variables 

more relevant for monetary policies? 

Zero Interest Rate Policy (ZIRP): Fed and other Central banks 

have shown in this crisis, that zero interest rates are not a 

constraint for central banks at all. They have continued to 

expand their balance sheets buying assets from fi nancial markets. 

However, the issue of effectiveness of these asset purchase 

programs still remains. We still do not know whether Central 

bank intervention has led to desired benefi t in the fi nancial 

markets. Some economists suggest it has helped and others 

disagree. There will be plenty of research on this matter in 

future. However, we can say one thing with some certainty. The 

economists made us believe that monetary policy can still be 

effective under ZIRP. In this crisis we have seen monetary policy 

can be expanded even at Zero Interest Rates. Riksbank even 

lowered its deposit rate (overnight deposit rate) to negative 

0.25% in its July monetary policy meeting. 

Hence, now even zero interest rates are not 

really a bound. However, the question of 

effectiveness still remains. The monetary 

transmission is weak in a fi nancial crisis 

leading to substantial lags in monetary policy 

to show desired results. 

Public Finance Economics 

Fiscal Policy has made a splendid comeback 

in this crisis. Just like monetary numbers, 

fi scal policy’s role was in oblivion. Fiscal Policy was hardly 

discussed and researched before this crisis. The macroeconomic 

models hardly included fi scal policy instruments for guiding 

policies. As a result, little is known about the role fi scal policy 

can play in business cycles. 

With this crisis, the role of fi scal policy is going has changed 

like never before. The leading institutions like IMF which had 

always advised not to use fi scal policy are increasingly calling for 

more fi scal expansion. The depth of the crisis has challenged the 

view that monetary policy can be effective under severe recession 

(discussed above). 

However, there are questions on fi scal policy as well. In this 

crisis both monetary and fi scal policy have been used to ease 

IMF which had 

always advised 

not to use 

fiscal policy are 

increasingly 

calling for more 

fiscal expansion 


T RUST BUSTING 

the crisis. Monetary Policy has tried to lower rates and fi scal 

policy has tried to support falling private demand and investment. 

However, an expansionary fi scal policy leads to higher 

fi scal defi cits and pushes interest rates higher. This becomes a 

dilemma for policymakers and confuses fi nancial markets (see 

our report for details- Interest Rate Dilemma for Policymakers 

and Markets, 3rd July, 2009). The research needs to solve 

this dilemma which has become quite a serious concern for 

the economies as high interest rates would prolong the 

economic recovery. 

Financial Globalisation 

If role of money and fi scal policy has made a comeback, the role 

of capital fl ows has once again come into question. Just like 

fi nancial liberalization, there is no empirical evidence for capital 

account liberalization but is still advocated by most economists. 

The usual basis for capital account liberalization is that it would 

lead to effi cient allocation of capital and in turn help capitalstarved 

economies prosper. However, both empirical and 

practical evidences do not justify this claim (see our report for a 

discussion- Capital fl ows in India and other 

developing economies: Are they truly 

benefi cial? dated 2008). The policymakers 

in emerging economies often expressed 

dissatisfaction with capital fl ows but were 

not heard. As there was limited empirical 

evidence, economists came up with other 

ideas to justify capital account liberalization 

(they provide collateral benefi ts; see 

Financial Globalisation: A Reappraisal by 

Kenneth Rogoff et al). 

Now, because of this crisis we are seeing some changes in 

economic thinking. IMF has long been a torchbearer for opening 

up capital infl ows. In a recent report (Initial Lessons of the 

Crisis, 2009), IMF economists remark: 

Surely, the lesson is not that capital fl ows should be sharply 

curtailed. But this crisis, as well as many episodes before it, 

shows the potential dangers of large capital infl ows. Such infl ows 

can lead to excessive risk taking and to exposure of domestic 

fi nancial institutions, households, fi rms, to exchange rate risk. 

They can lead to sharp appreciations, often followed by abrupt 

reversals and strong effects on balance sheets. They can put 

pressure on demand, and on output. Monetary policy may work 

poorly in this context, as the attempt to slow down activity 

193


186 

infl ation – seems ill suited to understanding the origins of the 

crisis or designing measures to solve it.” 

Marcus Miller and Joseph Stiglitz, March 2009. 

In another paper (The Financial Crisis and the Systemic Failure 

of Academic Economics by David Colander et al, 2009), the 

authors say: 

The economics profession appears to have been unaware of the 

long build-up to the current worldwide fi nancial crisis and to 

have signifi cantly underestimated its dimensions once it started 

to unfold. In our view, this lack of understanding is due to a 

misallocation of research efforts in economics. We trace the 

deeper roots of this failure to the profession’s insistence on 

constructing models that, by design, disregard the key elements 

driving outcomes in real-world markets. The economics 

profession has failed in communicating the limitations, 

weaknesses, and even dangers of its preferred models to the 

public. This state of affairs makes clear the need for a major 

reorientation of focus in the research economists undertake, as 

well as for the establishment of an ethical code that would ask 

economists to understand and communicate the limitations and 

potential misuses of their models. 

Now let us look at a few areas of economics 

where the concerns are being raised. 

Development Economics 

Before the crisis, most economies had a 

phase of high growth and low volatility 

(called Great Moderation). The economies 

followed variety of Growth models to 

generate economic growth. 

Some of these models are: 

Export driven (China, Korea, Germany, East Europe etc), 

Financial Services driven (Iceland, UK, US etc) 

Investment driven (India etc), 

Natural Resource driven (Middle East Economies, Russia, 

Chile etc), 

Agriculture exports driven (Australia, New Zealand etc). 

The crisis has impacted all economies and their models of 

growth via different channels (see our report for a preview - 

How the US originated crisis impacted other economies, 12th November, 2008). The question open to economists is as 

economies globalize further, what growth model should an 

economy choose? Growth Economics usually suggests that if an 

economy has proper institutions in place, it will be able to 


The importance 

of finance 

to economic 

growth has 

also frequently 

been ignored 

by economists 

manage sustained growth. The economists have been advising 

developing world to have institutions like developed economies. 

However, in this crisis it is the developed economies that have 

performed worst. 

Further, there is confusion as to whether free markets are 

same as unregulated markets. We think this debate was settled 

that markets works best with institutions in place. However, 

something else seems to be happening in fi nancial markets. 

There were institutions (regulators) but either they completely 

failed or market participants knew how to sideline them. Daron 

Acemoglu, leading economist of Institutional School in his 

recent paper said (The Crisis of 2008: Structural Lessons for and 

from Economics, 2009): 

Forgetting the institutional foundations of markets, we mistakenly 

equated free markets with unregulated markets. Although we 

understand that even unfettered competitive markets are based 

on a set of laws and institutions that secure property rights, 

ensure enforcement of contracts, and regulate fi rm behavior and 

product and service quality, we increasingly abstracted from the 

role of institutions and regulations supporting market transactions 

in our conceptualization of markets. 

Financial Economics 

There are many questions, which fi nancial 

economists need to answer. Some of them 

are: 

Finance as a Model of Growth: The earlier 

theories of development concentrated on 

labor, capital, institutions etc as the factors 

for growth and development. The leading 

works hardly include fi nance as a factor for 

growth. Frederick Mishkin in a lecture (JMCB-FDIC Lecture, 

September 22nd , 2005) remarked: 

The importance of fi nance to economic growth has also frequently 

been ignored by economists. For example, the leading 

undergraduate textbook on economic growth, Weill (2005) does 

not discuss the link between fi nance and growth at all. 

The main reason was initial fi nance theories like Modgillani 

Miller theorems and Effi cient Market Hypothesis (developed by 

Eugene Fama and Kenneth French). These were based on the 

assumption that markets are effi cient and there are no frictions 

(more on this later). But if these theories were correct then there 

was very little reason for fi nancial markets to exist. However, 

later development showed that there were imperfections in the

Table 1: Blame Game 

Economist/ 

Policymakers who 

Blamed Others 

William White & 

Claudio Borio 

important role to play in policies. ECB and BoE are directly 

responsible for their economies and both Trichet and King 

cite their own research which showed imbalances were 

developing. However, it all stops there with none seem to have 

had the will to do anything to resurrect the imbalances. IMF 

and BIS case is still understood as they can only infl uence policies 

but not make them (However, this still raises the question 

of their effectiveness). 

But what about ECB and BoE? Why didn’t they do anything in 

their own economies? Why did they choose the policies suggested 

by Alan Greenspan? There is a huge criticism on Alan 

Greenspan and his free-market policies but atleast he followed 

what he believed in (In his testimony to the Committee of 

Oversight and Reform (October 23rd ,2008) Greenspan also 

agreed that his belief was not really right). However, the beliefs 

of Greenspan do not imply Bank of England and ECB should 

have also made the same policies. The fallouts of the crisis could 

have been minimized if these key policymakers had backed their 

concerns more strongly. 

Apart from the above, there have been comments by other 

economists that their views were not heard (Like John Geanakoplos 

above). Some economists have dubbed above discussed 

ideas as “Jackson Hole ideas” (monetary policy for price 

stability, fi scal policy role is limited etc) which usually gained 

approval by leading US economists in the annual Kansas City 

Fed Symposium held at Jackson Hole, Wyoming. How do 

economists change this power equation? 

Concluding Thoughts 

The above analysis is an attempt to categorise the key questions 

Institutions Reasons for Crisis Blame 

BIS Nature of Financial Markets, 

Monetary Policy 

Kenneth Rogoff IMF Capital fl ows (Ken Rogoff), Role 

of incentives (Raghuram Rajan 



Alan Greenspan 

Alan Greenspan / 

US Treasury 

Jean Claude Trichet ECB Under-pricing of risk Financial Market 

Participants 

Mervyn King Bank of England Capital fl ows IMF 

Source: Speeches and Statements of the noted persons 

the crisis has posed to economists and economic thinking. This is 

not an exhaustive list and other issues could arise in future 

(infact number of questions over poverty, aid, welfare etc are 

being raised). The crisis is still taking shape and affecting all 

walks of economic life. These issues were visited in previous 

crisis but have been ignored by economic research. The previous 

crises were limited to developing countries and as a result were 

ignored by economists putting all the reasons under the common 

label – Poor institutional framework. With the crisis impacting 

developed economies more severely, the label cannot be the 

same. Hopefully, economists would work on the above areas. 

Moreover, economic policy and ideas seems to be increasingly 

driven more by powerful economists than quality of a 

research idea. Many economists are opining these days via 

personal blogs and other media channels. The arguments and 

opinions on both sides are so convincing that it does not 

provide a clear path for policymakers. The opinions are usually 

backed by research (own and others) and references and as a 

result one is never sure which is the right path and thinking. 

Economics has always been a debatable subject but we really 

need more clarity in times of crisis. All this has come at a time 

when we are made to believe that economic thinking has really 

advanced and most of the issues are addressed. Well, the crisis 

has opened up the fi eld of economics and shows we have still 

not answered the basic questions. 


the offi cial policy or position of the organisation. The author 

maintains a blog on economic research - http://mostlyeconomics. 

wordpress.com/) 

195

The ongoing crisis is not just a collapse in economies and 

fi nancial markets. The biggest impact of crisis has not 

been on fi nancial markets or economies but on economic 

thinking. All crises end at some point of time. Lawrence 

Summers in a speech at Brookings (13th March, 2009) said “.... 

there is onr ineluctable lesson of the history of fi nancial crisis: they 

all end”. 

Before the crisis there were numerous economic thoughts, 

which need to be reviewed as the crisis has taken shape. Moreover, 

leading economists are highly perplexed and are not sure 

how to summarize this crisis with their economic theories and 

beliefs. They are calling current economic thinking irrelevant 

and asking for a change in economic thinking. 

This paper reviews a few areas of economics that need to be 

reassessed. It also highlights a few areas which till now were 

considered hallowed but are found wanting. We have covered a 



few points in our earlier papers and this paper is an attempt to 

summarise all the previously raised issues and point to some new 

ones as well. 

A Few Quotes 

Willem Buiter, a former Member of Monetary Policy Committee 

of the Bank of England titles an article (www.voxeu. 

com, 6th March, 2009) as "The unfortunate uselessness of 

most 'state of the art' academic monetary economics". In this 

article he says how much of monetary economics is useless for 

practical purposes. 

Standard macroeconomic theory did not help foresee the crisis, 

nor has it helped understand it or craft solutions. This columns 

argues that both the New Classical and New Keynesian complete 

markets macroeconomic theories not only did not allow 

the key questions about insolvency and illiquidity to be answered. 

They did not allow such questions to be asked. A new 

paradigm is needed. 

David Blanchfl ower outgoing MPC Member of Bank Of 

England in a speech (24th March, 2009) said: 

As a monetary policy maker I have found the ‘cutting edge’ of 

current macroeconomic research totally inadequate in helping to 

resolve the problems we currently face. I am far from alone in 

these views. To take a couple of observations: 

“New classical and new Keynesian research has had little impact 

on practical macroeconomists who are charged with the messy 

task of conducting actual monetary and fi scal policy.” 

Gregg Mankiw, 2006 

“In fact “modern macro” has been notable for paying very little 

rigorous attention to data. …... I am left with the feeling that 

there is nothing in the empirical performance of these models 

that could come close to overcoming a modest scepticism. And 

more certainly, there is nothing to justify reliance on them for 

serious policy analysis.” 

Nobel Laureate Robert Solow, 2008 

“There is a danger that the macroeconomic models now in use in 

central banks operate like a Maginot line. They have been 

constructed in the past as part of the war against infl ation. The 

central banks are prepared to fi ght the last war. But are they 

prepared to fi ght the new one against fi nancial upheavals and 

recession? The macroeconomic models they have today certainly 

do not provide them with the right tools to be successful.” 

Paul De Grauwe, 2008. 

“The widely used DSGE paradigm – designed to help control 

185

I propose here instead to show how those propositions bear on 

current concerns about overleveraging – concerns that in some 

quarters actually border on hysteria. In particular I will argue, 

fi rst, that the highly visible losses and defaults on junk bonds do 

not mean that overleveraging did in fact occur; second, paradoxical 

as it may sound, that increased leveraging by corporations 

does not imply increased risk for the economy as a whole; third, 

that the fi nancial distress being suffered by some highly leveraged 

fi rms involves mainly private, not social costs; and fi nally, that 

the capital markets have built-in controls against overleveraging 

- controls, moreover, very much in evidence at the moment. 

Recent efforts by our regulators to override these built-in market 

mechanisms by destroying the junk bond market and by 

imposing additional direct controls over leveraged lending by 

banks will thus have all the unintended consequences normally 

associated with such regulatory interventions. That the current 

emphasis on the evils of overleveraging may be misplaced does 

not mean, of course, that all is well. My message is not: “Relax. 

Be happy. And, don’t worry.” Worry we should, in the U.S. at 

least, but about the serious problems confronting us, such as our 

seeming inability to bring government 

spending under rational control or to halt 

the steady deterioration of our once-vaunted 

system of public education. Let us not 

waste our limited worrying capacity on 

second-order and largely self-correcting 

problems like fi nancial leveraging. 

It would have been very interesting to get 

Merton Miller’s views in this crisis. The issue 

of leverage is again haunting the policymakers 

and fi nancial markets. 

Hence, the issue of leverage arises in times of crisis but is 

ignored soon after the crisis is over. Even much of the suggestions 

in times of crisis which talk about minimizing leverage 

are ignored in future papers. It seems research is as procyclical 

as leverage. 

Recently, John Geanakoplos (Yale University) paper on 

leverage cycle has become very popular. His idea is that leverage 

too has a cycle. His broad idea is that till now we assume in a 

loan market, demand and supply only determine the interest rate 

on loans. He adds apart from interest rate it also determines the 

leverage (or collateral) with the loan. In good times, lenders 

don’t require collateral leading to a higher leverage. In bad 

times, the lenders demand more collateral and as a result 

The role leverage 

plays in one’s 

financial decisions 

is pretty basic but 

has been ignored 

by financial 

economics 



leverage declines (deleveraging). This simple and powerful idea 

was not really accepted amidst researchers. In his own words: 

“After it was fi nally published, as “Liquidity, Default, and 

Crashes” in the conference volume in 2003, I gave that Seattle 

paper at every major university. It was exactly about the liquidity 

cycle, but it didn’t really catch on,” Geanakoplos recalled last 

week. The time for it wasn’t ripe. The Asian fi nancial crisis had 

been contained. No lender lost a dollar when LTCM failed. The 

consequences of the dot.com crash had been confi ned mainly to 

the stock market. For the next seven years, business as usual 

resumed. “This time they are more interested.” 

Financial Regulation: There is a tome of research being 

written on this subject. Every regulator is taking a relook at 

the spectrum of fi nancial regulation in their own economies. 

On a quick look across the various tomes, most of the 

suggestions coming forward are quite common: 

- More inclusive fi nancial regulation; no light touch regulation 

- Macroprudential regulation 

- A Financial Resolution framework 

- A special entity to manage non-depository fi nancial institutions 

(has come from Fed offi cials after AIG 

fallout) 

- Some measures to make bank balancesheets 

less procyclical - Leverage ratio/ 

some cap on leverage, increase provisions 

during boom times, a capital insurance 

scheme that leads to shoring up capital in 

times of stress. 

Apart from capital insurance scheme most 

of the suggestions have been discussed 

earlier in each crisis. Why weren’t they 

implemented? There is plenty of research on fi nancial stability 

and crisis but the lessons are hardly applied. The recent crisis is 

also a result of complacency on the part of fi nancial regulators. 

There was this belief that self-regulation is the best form of 

fi nancial regulation. As a result, research and discussion on 

fi nancial regulation has moved to form (single regulator Vs. 

multiple regulator, rule based Vs. principles based) etc) than the 

real issue of managing fi nancial stability. 

There are some additional thoughts on the macroprudential 

fi nancial regulation which merit serious discussion. Lord Turner 

in a speech (29th March, 2009) said: 

The Review sets out eight sets of recommendation for regulatory 

reform. ……Fourth, the importance of macro-prudential 

189

fi nancial market and the various fi nancial fi rms actually played a 

role in minimizing these very imperfections. Fed Chairman, Ben 

Bernanke in his speech (15th June, 2007) explains: 

The blossoming of work on asymmetric information and 

principal-agent theory, led by Nobel laureates Joseph Stiglitz and 

George Akerlof and with contributions from many other 

researchers, gave economists the tools to think about the central 

role of fi nancial markets in the real economy. For example, the 

classic 1976 paper by Michael Jensen and William Meckling 

showed that, in a world of imperfect information and principalagent 

problems, the capital structure of the fi rm could be used as 

a tool by shareholders to better align the incentives of managers 

with the shareholders’ interests. Thus was born a powerful and 

fruitful rejoinder to the Modigliani- Miller neutrality result and, 

more broadly, a perspective on capital structure that has had 

enduring infl uence. 

Since then there has been numerous research analyzing how 

fi nancial systems help in developing an economy. The research 

has not just looked at how fi nance helps economic activity but 

also social aspects like poverty, hunger etc. 

The role of fi nance took a different shape 

in few economies. Few economies like UK, 

Iceland, Hong Kong etc became fi nancial 

services driven economies. The economies 

started depending increasingly on their 

ability to attract large fi nancial fi rms and 

becoming preferred markets for raising 

fi nancial resources. This model soon became 

very popular as these economies grew really 

well. So much so, some developing economies 

also decided to develop an international 

fi nance center/region (India, Dubai etc). 

However, it was a period of low fi nancial market volatility and 

all was good. In this crisis this growth model has been completely 

opened up. The policymakers have realised the problem with 

this approach. The recent Turner report for UK fi nancial system 

was quite a change from precrisis days, when asll was considered 

good with this growth model. UK Government also released a 

report on Status of UK as a International Finance Centre after 

the crisis. 

The problem was not just limited to fi nancial driven economies. 

Large number of East European economies had reformed 

during this crisis and had become export-driven 

economies. They did not have a proper banking system and so 

It is indeed 

quite ironical 

that perverse 

incentives are 

being seen as 

the major causes 

of the crisis 



opened up their fi nancial markets. They invited foreign banks 

to set bases and soon Western Europe Banks were the major 

banks in the East European economies. As crisis deepened, the 

exports of these economies slowed leading to problems in 

paying off the loans to foreign banks. As a result foreign banks 

were not able to give credit worsening the crisis. Further, these 

foreign loans became a problem for their home regulators. 

Austrian Banks have lent huge amount of loans to these 

economies and is under severe pressure. So, both models 

became a problem. One, UK model which invited foreign banks 

to set bases in their economies and then offer services around 

the globe and two, the East Europe model which invited 

foreign banks to lend to domestic companies. 

Are Financial Markets Effi cient? Answering this question is 

like dealing with fi re. After this crisis, the economists are divided 

in two camps. One says fi nancial markets are anything but 

effi cient and are cyclical in nature with booms followed by busts. 

If they were effi cient we should not be seeing this crisis at all 

(read Turner review for a critique). The second camp says 

markets are effi cient as the crisis shows that excesses do get 

corrected albeit with a lag. 

The second camp is right in saying 

markets are effi cient as they have self-corrected. 

However, market effi ciency only 

matters if markets correct in a shorter span 

of time. We cannot have a situation where 

years of excesses are corrected in a matter of 

few days. The EMH theory has discussed 

effi ciency mainly from an information 

perspective but not from this time angle. If 

markets correct in four years of time can we 

call them effi cient? 

Another issue of EMH which has been completely ignored is 

incentives in fi nancial system. It is quite ironical that perverse 

incentives are being seen as the major causes of the crisis. In an 

effi cient market the question of incentives does not arise at all. 

The theory says markets have priced everything and people 

cannot generate profi ts unless they have private/insider information. 

To prevent this holding of private information we have 

regulators. Now, the leading fi nancial centers have always 

marketed themselves as effi cient fi nancial markets. How is it that 

in these effi cient fi nancial market centers, fi nancial fi rms make 

so much profi ts? Moreover, we expect with better technology 

markets have become more effi cient overtime but the profi ts 

187


continue to rise. This aspect of effi ciency has been completely 

ignored by fi nancial economics. 

Too Big to Fail: “A large non-fi nancial fi rm can fail but a large 

fi nancial fi rm cannot fail”. This principle has been followed by 

regulators but has reached its zenith and deserves a re-look. The 

reason behind this principle is that a large fi nancial fi rm is 

counterparty in many transactions and leads to a run on the 

other fi rms leading to a collapse of the entire system. We have 

seen this come true with bankruptcy of Lehman Brothers and 

collapse of other large fi nancial fi rms. 

However, not letting a fi nancial fi rm fail makes the managers 

complacent and they know their mistakes would always be 

socialized. This leads to much higher risks and a much bigger 

crisis in future. Andrew Haldane of Bank of England, in an 

excellent review on UK’s risk management noted: 

A few years ago, ahead of the present crisis, the Bank of England 

and the FSA commenced a series of seminars with fi nancial 

fi rms, exploring their stress-testing practices. The fi rst meeting of 

that group sticks in my mind. We had asked fi rms to tell us the 

sorts of stress which they routinely used for their stress-tests. A 

quick survey suggested these were very 

modest stresses. We asked why. Perhaps 

disaster myopia – disappointing, but 

perhaps unsurprising? Or network externalities 

–we understood how diffi cult these were 

to capture? 

No. There was a much simpler explanation 

according to one of those present. There 

was absolutely no incentive for individuals 

or teams to run severe stress tests and show 

these to management. First, because if there 

were such a severe shock, they would very likely lose their bonus 

and possibly their jobs. Second, because in that event the 

authorities would have to step-in anyway to save a bank and 

others suffering a similar plight. 

This statement from a policymaker is pretty disappointing and 

sums up the state of affairs in fi nancial markets. Simon Johnson 

(ex-Chief Economist of IMF) has created quite a stir by calling 

these TBTF fi rms as Financial Oligarches. Recently, quite a few 

policymakers have expressed that if banks are too large but are 

insolvent they should be allowed to fail. Thomas Hoeing, 

President of Kansas City Fed has been a leading advocate of this 

measure. This is quite a reversal from the previous thinking on 

TBTF. Minneapolis Fed President Gary Stern has written a lot of 

188 


The focus was 

on short-term 

incentives and not 

really asking right 

questions over 

the overall health 

of the firm 

research to prevent TBTF but has not gained ground. And all 

these economists cannot be dubbed as socialist variety. They add 

that in order for markets to function properly, we need to do 

away with TBTF. Then only we can have a market discipline. 

This crisis would lead more thinking on this matter. As said 

above, this crisis is going to change quite a few ideas. 

Corporate Governance: This is another branch of fi nancial 

economics that gained huge ground. The corporate boards were 

made the center of governance of fi rms. However, what we have 

instead witnessed is that these were instead cozy clubs in leading 

fi nancial fi rms. The focus was on short-term incentives and not 

really asking questions over the health of the fi rm. The central 

principle of corporate governance was having independent 

directors on the board. These are usually people of high acumen 

and stature and collectively failed to see the huge risks the fi rms 

were carrying. 

It is important to note that it is this growth of corporate 

governance which made regulators complacent. Corporate 

Governance was seen as a robust model of self-regulation and it 

was felt that the quality of board will ensure that the fi rm is on 

right track. The board turned out to be more 

complacent (perhaps due to TBTF) and we 

are all seeing the results now. 

Role of Leverage: The role leverage plays 

in one’s fi nancial decisions is pretty basic but 

somehow has been ignored by fi nancial 

economics. Despite numerous crisis showing 

it is mostly high leverage that compounds 

problems, it has been ignored by policymakers 

and fi nancial economics research. Much 

of the research is still based on M-M theory 

that debt does not matter or is irrelevant. Merton Miller’s Nobel 

Prize Lecture in 1990 was titled as “Leverage”. At that time 

Leveraged Buyouts were seen as the new devil that led to many 

failures then. Miller remarked: 

That Franco Modigliani and I should be credited with inventing 

these takeovers is doubly ironic since the central message of our 

M&M Propositions was that the value of the fi rm was independent 

of its capital structure. Subject to one important 

qualifi cation to be duly noted below, you couldn’t hope to 

enhance shareholder value merely by leveraging up. Investors 

would not pay a premium for corporate leverage because they 

could always leverage up their own holdings by borrowing on 

personal account.


hence they are reacting. But this is the case for rising asset 

prices as well. Justin Lin (Chief Economist World Bank) in a 

paper The Impact of the Financial Crisis on Developing 

Countries, 2008) says: 

Throughout the US dot-com and housing price bubbles, the 

Federal Reserve continued to adhere to its view that its mandate 

was to pursue price stability and full employment, not to defl ate 

asset price bubbles. But amid the wreckage caused by the second 

burst bubble in a decade, it is clear that this view needs to be 

rethought. If the Fed is not able to keep these bubbles from 

infl ating, it will not be able to achieve its other objectives. There 

are reasonable questions about just how effective monetary 

authorities will be in preventing asset-price bubbles, but it is no 

longer reasonable not to rethink the issue carefully. 

Guardians of Financial Stability and Role in Financial 

Regulation: A linked point to the two above issues is the role of 

central banks in fi nancial regulation and stability. The regulatory 

structure to manage fi nancial system is too diverse. In some 

countries central banks are responsible to manage and supervise 

the banks and another authority to manage the capital markets 

(like India), in some economies there are 

multiple authorities managing the banks 

(USA) and in some economies there is a 

single authority regulating the fi nancial 

system and Central banks only look at price 

stability (UK). 

After this crisis, there is little doubt that 

central banks need to be at the center of 

fi nancial regulation and need to manage 

fi nancial stability along with price stability. 

Mervyn King, Governor Bank of England in 

a now-famous speech said: 

The Bank of England has a new statutory responsibility for 

fi nancial stability. Bank Rate is the instrument we deploy to 

achieve monetary stability, and should be used exclusively for 

that purpose. To achieve fi nancial stability the powers of the 

Bank are limited to those of voice and the new resolution powers. 

The Bank fi nds itself in a position rather like that of a church 

whose congregation attends weddings and burials but ignores the 

sermons in between. Like the church, we cannot promise that 

bad things won’t happen to our fl ock – the prevention of all 

fi nancial crises is in neither our nor anyone else’s power, as a 

study of history or human nature would reveal. And experience 

suggests that attempts to encourage a better life through the 

192 


These days most 

central banks 

only use the 

interest rates to 

influence demand 

conditions in 

the economy 

power of voice is not enough. Warnings are unlikely to be 

effective when people are being asked to change behaviour which 

seems to them highly profi table. So it is not entirely clear how the 

Bank will be able to discharge its new statutory responsibility if 

we can do no more than issue sermons or organise burials. 

A simple focus on price stability is not likely to work anymore. 

It is not that Central Banks do not look at fi nancial stability. The 

Central Banks publish reports on fi nancial stability regularly but 

all this is done passively. A more active approach and constant 

endeavor, just like in the case of price stability is needed. 

US and UK Governments have released reports to reform 

their fi nancial systems and regulation. The report focuses on 

giving the Central bank more powers. The debates are ongoing 

in these respective economies and we will know the actual status 

only when they are implemented. owever, initial reactions of 

economists on the proposed reform is mixed. 

Role of Money and Credit Makes a Comeback? There has 

been a really strange development in central banking. Their 

principles are based on Monetary Economics but money 

hardly plays any role in central bank’s decisions! These days 

most central banks only use the interest 

rates to infl uence demand conditions in 

the economy. 

Earlier, central banks used growth in 

money stock to monitor infl ation. But 

because of fi nancial innovation it became 

diffi cult to maintain monetary growth and 

infl ation. Hence, instead of money the 

central banks started to use interest rates. 

But the focus on interest rates was taken to 

one extreme with complete ignorance to 

developments in monetary numbers. The role of money was just 

limited to a casual mention in the central bank’s press release. 

Only ECB maintained its focus on monetary targets and still 

bases its decisions on the monetary pillar along with the economic 

pillar. The ECB watchers criticized ECB for their focus on 

monetary targets when they had become irrelevant. They added 

that ECB was using monetary targets just to emulate Bundesbank 

(Germany’s Central Bank is considered to be successful at 

monetary targeting; however, it is still under debates) and 

needed to do away with money. 

This crisis brings the role of growth in money and especially 

credit back in the limelight. The central banks had been ignoring 

the substantial rise in credit in lineup to the crisis. This is seen as


need is intellectual challenge to conventional wisdom. Because 

where we did do macro-prudential analysis, it often still failed to 

see the emerging problems. 

Each edition of the IMF Global Financial Stability Report is 

full of macro-prudential analysis. But in April, 2006 it said this 

(Exhibit 16): 

"There is a growing recognition that the dispersion of credit risk 

by banks to a broader and more diverse group of investors, rather 

than warehousing such risk on their balance sheets, has helped 

make the banking and overall fi nancial system more resilient". 

The improved resilience may be seen in fewer bank failures and 

more consistent credit provision: consequently the commercial 

banks may be less vulnerable today to credit or economic shocks’ 

Which was not just wrong – but 180° wrong. So how do we 

ensure that we don’t in ten years’ time get it wrong again, going 

along with a dominant conventional wisdom? Market prices are 

subject to self-reinforcing herd effects: policymakers and policy 

intellectuals can be subject to intellectual herd effects; and there 

is no failsafe way to offset this human tendency to collective 

error. But we need as best possible to embed challenge into our 

institutions. 

Bernanke in a speech (22nd August, 2008) 

had said: 

Some caution is in order, however, as this 

more comprehensive approach would be 

technically demanding and possibly very 

costly both for the regulators and the fi rms 

they supervise. It would likely require at 

least periodic surveillance and informationgathering 

from a wide range of nonbank 

institutions. International regulatory coordination, 

already quite extensive, would need to be expanded 

further. 

Macroprudential supervision also presents communication 

issues. For example, the expectations of the public and of 

fi nancial market participants would have to be managed 

carefully, as such an approach would never eliminate fi nancial 

crises entirely. Indeed, an expectation by fi nancial market 

participants that fi nancial crises will never occur would create its 

own form of moral hazard and encourage behavior that would 

make fi nancial crises more, rather than less, likely. 

Hence, it seems only normative analysis has been done on 

macroprudential fi nancial regulation. There is not much of a 

thought on how to make it workable. Once again research has 

190 


The complacency 

was not limited 

to financial 

regulators. 

The biggest 

complacency was 

in central banking 

just looked at the issue minus the operational details. 

Financial Innovation: We had looked at this issue in details in 

our previous report – Time to reassess Financial Innovation 

(dated 13th February, 2009). In sum, fi nancial innovation has 

just focused on risk management function of fi nancial system 

and has ignored the other functions. 

Monetary Economics/Central Banking: 

Dr. YV Reddy, former RBI Governor in an address at Singapore 

(Hindu Business Line, 11th October, 2008) said: 

“An outcome of the crisis, according to Dr Reddy, is the “historically 

signifi cant redefi ning of the concept of the central bank”. 

This statement neatly sums up the challenges for central banks 

ahead. This crisis has asked many questions from central banks. 

In most of our research reports on the ongoing crisis we have 

posed numerous questions for central banks. Let us just summarise 

them. 

Infl ation Managers: The complacency was not limited to 

fi nancial regulators/supervisors. The biggest complacency was 

seen in central banking. The recent thinking backed by substantial 

research was that central banks should 

focus only on price stability. As long as 

prices are stable, all other economic 

variables will be stable as well – growth, 

fi nancial markets etc. The usual policy 

advise for central banks in developing 

economies was to just pursue price stability 

and rest would follow. Before the crisis, this 

view held very well. 

However, the crisis struck at times when 

infl ation was relatively stable. In addition, 

most of the fi re-fi ghting was left for central banks. In order to 

justify their moves to protect fi nancial systems, the Central 

Banks started pointing to their ignored objective to look at 

fi nancial systems (payment systems etc). The ignored objective 

became the most important objective. To prevent fi nancial 

collapse, central banks reduced rates substantially and did it 

frequently. The sharp easing was appalling in the beginning of 

the crisis as the infl ation was at record high levels. The infl ation 

lowered later much to the relief of central banks but questions 

over this sudden switch need to be answered. Can Central banks 

cut rates at times when infl ation is at record high levels? 

What is also not understood properly is the asymmetric 

response of central banks. At times of high infl ation, the usual


through higher interest rates may make domestic assets even 

more attractive. 

Thus, the crisis raises two issues. The fi rst is the need to revisit 

when and how to react to large imbalances, through macroeconomic 

and structural policies that affect saving and investment. 

As elsewhere, an attitude of benign neglect has proven to be a 

mistake. The second is the potential role for prudential measures 

to reduce systemic risk associated with large capital infl ows—e.g., 

through constraints on the foreign exchange exposure of domestic 

institutions and other borrowers. 

Some other economists who were leading advocates of 

fi nancial globalization have also reviewed their models. They 

now say that economies need to have certain thresholds to 

qualify before they completely open to capital fl ows (see this 

paper- Thresholds in the Process of International Financial 

Integration by Ayhan Kose et al). This is exactly what the 

policymakers of developing economies were saying after their 

experiences with capital fl ows. However, it found no takers and 

the problem was limited to ineffi cienbt institutions and policies 

in developing economies. 

Economic Models 

One of the main criticisms of Willem Buiter 

and Paul de Grauwe (quoted in the beginning) 

is centred on the models used by 

Central banks for their policies. These 

models are known as Dynamic Stochastic 

General Equilibrium Models (DSGE). Paul 

de Grauwe adds: 

Modern macroeconomics as embodied in 

Dynamic Stochastic General Equilibrium 

models (DSGE) is based on the paradigm of the utility maximizing 

individual agent who understands the full complexity of the 

world. Since all individuals understand the same “Truth”, 

modern macroeconomics has taken the view that it suffi ces to 

model one “representative individual” to fully represent reality. 

Thus as a consumer the agent continuously maximizes an 

intertemporal utility function and is capable of computing the 

implications of exogenous shocks on his optimal consumption 

plan, taking full account of what these shocks will do to the plans 

of the producers. Similarly, producers compute the implications 

of these shocks on their present and future production plans 

taking into account how consumers react to these shocks. Thus 

in such a model coordination failures cannot arise. 

194 


If there were so 

many concerns 

with current 

economic 

thinking, then why 

didn’t economists 

correct them? 

The DSGE models actually have the same features that we 

have noted as a problem above. The DSGE models assume the 

fi nancial markets to be effi cient and thus accord a minimal role 

to fi nancial markets. It also does not have a role for fi scal policy, 

money or credit. Some models have started to account for 

fi nancial frictions but are very limited. These models despite 

their limitations have been used actively by monetary policymakers. 

The leading central banks have their own versions of 

DSGE models. 

As these models don’t include the main factors seen in this 

crisis, it is time to redo these models. The linkages between 

economy and fi nancial markets have become very strong and 

have to be incorporated in the models. However, no economic 

model can help predict a crisis. The economists should remember 

not to over-rely on models and avoid complacency. 

Economic Theories/Policies - 

Infl uenced by Personalities? 

This point is not about any specifi c branch of economics but 

about economists in general. The question that comes to mind is 

if there were so many concerns with current 

economic thinking why didn’t economists 

correct them? 

The more one reads into economists 

account on the current crisis the more one 

gets the feeling that current economic 

thinking is more driven by personalities/ 

economists behind the theory. How else can 

you explain these developments/errors? We 

had discussed this issue in our previous 

report (Crisis 2007-?: Policymaking at the 

crossroads?, 2009). However, at that time we had looked at the 

issue from a different angle. In summary, the crisis has seen a 

number of blame games being played. The market participants 

have blamed the regulators for not acting fast enough, the 

regulators blame the market participants and we have other 

economists blaming a bit of both. Recent statements from key 

policymakers and policy infl uencers suggest they had raised fl ags 

about the bubble and impending crisis (via their research, 

statements etc) but no one listened. 

We had pointed to recent statements/speeches from leading 

economists/policymakers that had played the blame game. Table 

1 summarises the results. 

IMF and BIS are independent institutions but have an


hence they are reacting. But this is the case for rising asset 

prices as well. Justin Lin (Chief Economist World Bank) in a 

paper The Impact of the Financial Crisis on Developing 

Countries, 2008) says: 

Throughout the US dot-com and housing price bubbles, the 

Federal Reserve continued to adhere to its view that its mandate 

was to pursue price stability and full employment, not to defl ate 

asset price bubbles. But amid the wreckage caused by the second 

burst bubble in a decade, it is clear that this view needs to be 

rethought. If the Fed is not able to keep these bubbles from 

infl ating, it will not be able to achieve its other objectives. There 

are reasonable questions about just how effective monetary 

authorities will be in preventing asset-price bubbles, but it is no 

longer reasonable not to rethink the issue carefully. 

Guardians of Financial Stability and Role in Financial 

Regulation: A linked point to the two above issues is the role of 

central banks in fi nancial regulation and stability. The regulatory 

structure to manage fi nancial system is too diverse. In some 

countries central banks are responsible to manage and supervise 

the banks and another authority to manage the capital markets 

(like India), in some economies there are 

multiple authorities managing the banks 

(USA) and in some economies there is a 

single authority regulating the fi nancial 

system and Central banks only look at price 

stability (UK). 

After this crisis, there is little doubt that 

central banks need to be at the center of 

fi nancial regulation and need to manage 

fi nancial stability along with price stability. 

Mervyn King, Governor Bank of England in 

a now-famous speech said: 

The Bank of England has a new statutory responsibility for 

fi nancial stability. Bank Rate is the instrument we deploy to 

achieve monetary stability, and should be used exclusively for 

that purpose. To achieve fi nancial stability the powers of the 

Bank are limited to those of voice and the new resolution powers. 

The Bank fi nds itself in a position rather like that of a church 

whose congregation attends weddings and burials but ignores the 

sermons in between. Like the church, we cannot promise that 

bad things won’t happen to our fl ock – the prevention of all 

fi nancial crises is in neither our nor anyone else’s power, as a 

study of history or human nature would reveal. And experience 

suggests that attempts to encourage a better life through the 

192 


These days most 

central banks 

only use the 

interest rates to 

influence demand 

conditions in 

the economy 

power of voice is not enough. Warnings are unlikely to be 

effective when people are being asked to change behaviour which 

seems to them highly profi table. So it is not entirely clear how the 

Bank will be able to discharge its new statutory responsibility if 

we can do no more than issue sermons or organise burials. 

A simple focus on price stability is not likely to work anymore. 

It is not that Central Banks do not look at fi nancial stability. The 

Central Banks publish reports on fi nancial stability regularly but 

all this is done passively. A more active approach and constant 

endeavor, just like in the case of price stability is needed. 

US and UK Governments have released reports to reform 

their fi nancial systems and regulation. The report focuses on 

giving the Central bank more powers. The debates are ongoing 

in these respective economies and we will know the actual status 

only when they are implemented. owever, initial reactions of 

economists on the proposed reform is mixed. 

Role of Money and Credit Makes a Comeback? There has 

been a really strange development in central banking. Their 

principles are based on Monetary Economics but money 

hardly plays any role in central bank’s decisions! These days 

most central banks only use the interest 

rates to infl uence demand conditions in 

the economy. 

Earlier, central banks used growth in 

money stock to monitor infl ation. But 

because of fi nancial innovation it became 

diffi cult to maintain monetary growth and 

infl ation. Hence, instead of money the 

central banks started to use interest rates. 

But the focus on interest rates was taken to 

one extreme with complete ignorance to 

developments in monetary numbers. The role of money was just 

limited to a casual mention in the central bank’s press release. 

Only ECB maintained its focus on monetary targets and still 

bases its decisions on the monetary pillar along with the economic 

pillar. The ECB watchers criticized ECB for their focus on 

monetary targets when they had become irrelevant. They added 

that ECB was using monetary targets just to emulate Bundesbank 

(Germany’s Central Bank is considered to be successful at 

monetary targeting; however, it is still under debates) and 

needed to do away with money. 

This crisis brings the role of growth in money and especially 

credit back in the limelight. The central banks had been ignoring 

the substantial rise in credit in lineup to the crisis. This is seen as

G LOBAL GOVERNANCE 

196 

New Resources for an 

Unreformed IMF? 

Massive crises can be excellent news, as the present 

US Crisis proves, which resulted from deregulating 

and liberalising the fi nancial sector. Although 

much larger, it is a crisis like other neoliberal crises 

earlier in Chile, Mexcio, East Asia or the Savings & Loan 

Crisis in the USA. Those policies the IMF forced on or 


recommended to Southern Countries (SCs) were carried to 

their logical extreme. Deregulation went as far as to encourage 

practices such as "liar" or "NINJA" (No Income No Job 

or Assets) loans that can only be explained by the fact that 

securitised debt was quickly sold on and regulatory checks 

were not applied. Lenders were off the hook after cashing

Kunibert Raffer 

Associate Professor, 

Department of Economics, 

University of Vienna, Vienna, Austria 

their fees. 

The basis of the crash was again the Robichek (now rather 

Greenspan) doctrine: markets know best and should not be 

"overregulated". The government should not interfere as it 

can only make things worse. Historically one of the fi rst 

cases, Chile's military dictatorship provided an ideal precondition 

to implement neoliberal ideas, producing the fi rst 

neoliberal fi nancial crash. State enterprises were privatised, 

public expenditure was reduced and the economy opened up. 

As the market knows best banking supervision was cut down, 

as in the US recently. Moral backing came from the Bretton 

Woods Institutions, especially from the IMF. The IMF's 

Director of the Western Hemisphere, E. 

Walter Robichek, assured Latin Americans 

that exchange and other risks would 

presumably be taken into account as 

private fi rms can be expected to be 

careful. Private borrowers (as opposed to 

governments) were very unlikely to 

overborrow, even with offi cial guarantees. 

Briefl y, private, voluntary transactions 

were the private sector’s own business 

and presumably Pareto optimal. This 

view is sometimes called the Robichek doctrine. The 

"Chilean miracle" turned into a catastrophe in 1982, GDP 

fell by over 14%. The government was forced to socialise 

private losses, another parallel to the present US Crisis. 

These international crises had positive effects on the IMF. 

The perpetrator was called in to save its victim; the alcoholic 

was put in charge to guard the bar. Recently, though, richer 

SCs had become able to free themselves from the IMF's grip. 

Early repayments to the Fund started to threaten its existence. 

On the brink of bankruptcy due to early repayments 

and a corresponding shrinking of its outstanding claims 

The IMF was 

granted more 

power without 

any meaningful 

reform, and may 

now continue 

as before 


IMF 

from SDR 70 billion (2002) to some SDR 15.5 billion (end 

2006) as well as income shortfalls projected to surpass 40% 

during 2008-10 (Torres 2007, p.9), this Crisis saved the IMF 

once again, also making it more powerful. After the demise 

of Bretton Woods, the IMF should have been dissolved. The 

Southern debt crisis of the early 1980s saved it, allowing the 

IMF to usurp the task of “debt manager” after having egged 

SCs on to borrow. Again, an international debt crisis the 

IMF had helped come about saved it in 2008. 

Iceland broke the ice. On 24th October, 2008 an IMF 

package totalling $2.1 billion was announced under the 

Fund's fast-track emergency fi nancing mechanism. A 

Stand-By Arrangement for Hungary was approved in 

November. The G20 decided to increase the IMF's role and 

fi nancial base substantially. This neoliberal crisis has again 

put the neoliberal Fund back into business. In March 2009, 

the IMF "overhauled" its lending structure, also establishing 

a Flexible Credit Line (FCL). When the fi rst country, 

Mexico, availed herself of the FCL, IMF First Deputy 

Managing Director John Lipsky spoke of "a historic occasion", 

"the largest fi nancial arrangement in the Fund’s 

history", and "the consolidation of a major step in the process 

of reforming the IMF and making its 

lending framework more relevant to 

member countries’ needs." (IMF Survey 

online, April 17th , 2009). The IMF in 

particular was saved by the Crisis triggered 

by those neoliberal policies it 

recommends. Money is rolling in from the 

leading economies. Apparently due to 

criticism of her surpluses meanwhile even 

called one main reason of the US Crisis, 

China signalled her intention to invest up 

to US$50 billion in notes issued by the Fund in June 2009. 

The worst result, though, is that the IMF was granted 

more power without any meaningful reform, and may now 

continue as before. Reform proposals abound, especially 

with the IMF they have become some kind of cottage 

industry. It is all the more surprising that the most urgent 

problem has practically eschewed attention: making the IMF 

obey its own statutes and the principles it preaches - applying 

good governance and the Rule of Law to itself. "Reform" is 

limited to a few basis points of voting being shifted between 

regions, one tangible though economically irrelevant 

197


outcome. It might be quite nice if China has a few votes more 

than Belgium instead of a few votes less, but this will hardly 

change things fundamentally. 

Open violations of its statutes have caused substantial 

damage to SCs, and increased IMF-income. IMF-fl ops have 

created IMF-jobs. This paper argues that any "reform" 

remains meaningless as long as the IMF is allowed to 

continue to breach its own statutes and to infl ict heavy 

damages on its Southern members and clients with impunity, 

fi nancial and institutional gain. 

Capital Controls - A Membership Right 

Although the IMF's Articles of Agreement clearly stipulate 

the right to capital controls, even explicitly restricting the 

use of Fund resources to fi nance speculative outfl ows, the 

IMF has made its Southern members resist from exercising 

their membership right and fi nanced such outfl ows. It foisted 

high interest rates and keeping capital accounts open onto 

members in distress, at great costs to 

them and violating its own statutes. 

Art. VI(3) establishes the right of 

members to “exercise such controls as are 

necessary to regulate international 

capital movements, but no member may 

exercise these controls in a manner which 

will restrict payments for current transactions”. 

Art. XXX(d) defi nes these as “not 

for the purpose of transferring capital”, 

including “Payments of moderate (emph. KR) amount of 

amortization of loans or for depreciation of direct investments”, 

or “moderate remittances for family living expenses”. 

Although this defi nition is somewhat opaque, even restricting 

fl ows such as amorisations is a member's right. 

Not only has any member the right to control capital fl ows, 

but the IMF is not allowed to fi nance outfl ows as it did in 

Asia 1997-8. Pursuant to Art. VI(1)(a), a 

“member may not use the Fund's general resources to 

meet a large and sustained outfl ow of capital except as 

provided in Section 2 of this Article [this refers exclusively 

to reserve tranche purchases ] and the Fund may request a 

member to exercise controls to prevent such use of the 

general resources of the Fund. If, after receiving such a 

request, a member fails to exercise appropriate controls, 

the Fund may declare the member ineligible to use the 

198 


Routinely, short 

term speculators 

have been bailed 

out in breach of 

the International 

Monetary Fund's 

statutes 

general resources of the Fund.” 

By fi nancing large and sustained outfl ows in East Asia and 

in other countries, the IMF clearly and openly violated its 

own Articles of Agreement, infl icting considerable damage 

on its member countries. Although the IMF may but is not 

obliged to request controls and declare members ineligible, 

its statutes clearly show that it is not supposed to press for 

liberalisation of capital movements in the way it actually did. 

Clearly, Asian countries had not only the right to control 

capital outfl ows in 1997, as the IMF had to admit when 

Malaysia courageously exercised it (Raffer and Singer 2001, 

p.157), the Fund's forcing members to fi nance large and 

sustained outfl ows by speculators is defi nitely a violation of 

the IMF's own constitution. Routinely, short term speculators 

have been bailed out in breach of the Fund's statutes. 

The intentions of its statutes are clear. Rather than forcing 

or even encouraging members to keep capital accounts open, 

the Fund is meant to request controls from members not 

imposing such controls as appropriate 

themselves It may even sanction them. 

However, when it comes to protecting the 

rights of developing members, legal 

regulations and obligations are apparently 

insignifi cant. Art. VI(1)(b)(ii) allows 

members to meet outfl ows “out of a 

member's own resources, but members 

undertake that such capital movements 

will be in accordance with the purposes 

of the Fund.” Members are even encouraged not to fi nance 

large and sustained outfl ows. Current transactions can be 

restricted with the Fund's approval. 

In plain English, members have always had the right to 

stop amortisations. In 1997-8 there was no obligation to 

fi nance outfl ows fully, nor is there an economic need to keep 

extremely high reserves against capital account crises, as 

several Asian countries do now to shield against having to 

call in the IMF again. They do so at great costs. Exercising 

their statutory rights would be cheaper and not expose them 

to the blame of contributing to "global imbalances", thus 

being “responsible” for the present US-made crisis. 

Falsely Claiming Preferred Creditor Status 

Although the status of preferred creditor is alien to the 

statutes of the IMF, the impression has quite successfully

een created over decades that its claims are entitled to 

preferential treatment. This perception is completely 

unfounded and at odds with the truth, both regarding the 

IMF and multilateral development banks. In fact, IFIs have 

undone their founders’ intention, reversing it into its 

opposite. De facto preference of the IMF and other 

multilaterals has made debt reductions more ore 

diffi cult as other, bona fi de creditors must 

accept larger haircuts. 

The IMF knows that it enjoys no legal 

or contractual preferred creditor status, 

as can be read on its very own homepage 

(Boughton 2001, p.820). When problems 

with SCs unable to service their 

debts to the IMF in time could no longer 

be ignored around 1988, it was tried to fi nd d 

arguments in favour of preference. But the e 

fact that the IMF has no legal or contractual ual 

status as a preferred creditor could not be 

denied. Supporting their institution’s drive 

for undue preference, its "Executive 

Directors stressed the ... need ... in 

practice ... to treat the Fund as a preferred 

creditor." In September 1988, the Interim 

Committee endorsed this position and 

"urged all members, within the limits of 

their laws, to treat the Fund as a preferred 

creditor." (ibid, p.821, emphasis added) 

The qualifi cation "within the limits of their laws" shows that 

even this IMF-organ could not bring itself to demand 

unconditional preference for the Fund from its own members. 

The Committee accepted that national laws may forbid 

such treatment. In contrast to the impression the IMF tries 

to create, there is no legal hindrance to treating it like any 

other creditor. Therefore, the IMF’s SDRM-proposal 

attempted to obtain de jure preferred status for IFIs in an 

extremely self-serving way. 

Before the Second Amendment, the IMF’s Articles of 

Agreement "contained a provision suggesting that others 

would have preference on the Fund" (Martha 1990, p.825). 

The author refers to Schedule B, paragraph three on the 

calculation of monetary reserves on which repurchase 

obligations were based. It seems logical that the exclusion of 

holdings "transferred or set aside for repayments of loans 


IMF 

during the subsequent year" was done "to give preference in 

repayment to lenders other than the Fund." He argues that 

the intention of deleting this calculation and with it Schedule 

B, paragraph three from the statutes by the Second Amendment 

"was not to repudiate the underlying thought that it was 

benefi cial to eencourage 

bank lending by giving banks 

and oth others a preference in repayment" (ibid., 

p.8 p.814). Unfortunately, this initial intent was 

blurred b when conditionality was introduced, 

rather than making the IMF 

fi nancially accountable as indicated by 

economic reason, and legally and 

ethically proper. 

One has to concur with Martha (1990, 

p.814) that the IMF’s statute contains "a 

presumption p 

against a preferred creditor 

stat status", and that "general international law 

contains contain no compulsory standard of conduct 

requiring the preferential treatment of 

any external creditor, including the 

Fund" (ibid., p.825). However the IMF 

has no explicit statutory obligation to 

grant debt relief, which can again be 

explained by its initial role as a helper 

without conditionality. Important 

multilateral development banks violate 

their own constitutions by not giving 

members in default relief as stipulated. 

Preference as interpreted by the multilaterals and the Paris 

Club creditor cartel and forced onto the South includes absolute 

exemption of multilateral claims. This is done in open 

breach of their own statutes by multilateral development 

banks whose statutes foresee appropriate relief mechanisms 

explicitly (cf. Raffer 2008; fc, Chapter 13). These membership 

rights are just denied to SCs. 

Forced by external auditors, the IMF started to provide 

for non-payment by building up loan loss provisions. This 

means that borrowers have paid for the eventuality of 

default. Nevertheless they have continuously been refused 

the relief they had already fi nanced with the "argument" 

that the Fund were preferred and could not survive losses. 

It has charged its clients for the event of default, but also 

claims it cannot use these reserves for the very purpose 

they were established for. This is like an insurance com- 

It might be 

quite nice if China 

has a few votes 

more 

than Belgium 

instead of a 

few votes less 

199


pany charging necessary fees but refusing to cover damages 

once they occur. Unlike the Fund no insurance 

company could get away with such behaviour, not even if 

the client were from the South. Legal double standards 

may exist, but not everywhere. 

Paying for Unlawfully Infl icted Damage 

While statutes of other IFIs contain mechanisms of legal 

redress – most clearly so in the cases of the IBRD and IDA - 

the IMF clearly differs. Art. IX(3) of its Articles of Agreement 

grants it total immunity “except to the extent that it 

expressly waives its immunity for the purpose of any proceedings 

or by the terms of any contract”. Obviously, this is 

explained by the fact that initially the Fund was to help member 

countries to overcome short-term dollar/gold-parity 

problems by unconditional short-term drawings (=loans). It 

would be diffi cult to perceive any need for legal procedures 

and redress in the case of an emergency 

helper unconditionally giving money, 

except cases such as money paid to 

dictators fully knowing that large parts 

would routinely be embezzled (as did the 

IBRD in Suharto's Indonesia). Probably 

such eventuality made the IMF’s founders 

insert this waiver to provide for proper 

legal dispute settlement. When conditionality 

became enshrined in the IMF's 

statutes in 1969, the appropriate change 

regarding immunity was not made for whichever reason, 

although its founders would doubtlessly have stipulated the 

possibility of legal redress as they did with the IBRD if they 

had approved conditional drawing. Arguably, this was the 

fi rst step to establish legal double standards globally. Nevertheless, 

the IMF may not only submit to arbitration or 

courts, but contractual clauses stipulating this remain 

expressly allowed. Nothing in its statutes prevents the Fund 

from applying civilised legal standards. On the contrary, the 

existence of this waiver seems an encouragement to do so if 

and when appropriate. 

By not availing itself of this option when and where 

appropriate, the IMF has knowingly created a system 

incompatible with the very idea of the market economy, good 

governance, or the Rule of Law. As members are always 

forced to repay fully, also when avoidable damages are 

200 


Evaluating the 

Fund’s role in 

Argentina, its own 

internal controllers 

found many 

cases of grave 

negligence 

infl icted by gravest negligence or even wilfully by the Fund, 

more damage created by it leads necessarily to larger 

involvement of the IMF as a "trouble shooter". Its fl ops 

create more IMF-jobs, and increase its importance. This is 

an intolerable moral hazard situation, unless one agrees to 

double standards based on nationality. The only exception of 

the generally accepted principle that someone infl icting 

damage unlawfully must compensate their victims is unfortunately 

development co-operation, the last sphere where 

damage can still be infl icted with impunity and even fi nancial 

and "reputational" gain. If normal accountability 

standards applied to Southern debtors there would in all 

likelihood be no multilateral debt problem. 

The IMF may advise (or force, as skeptics may formulate) 

SCs to implement programmes that it had "known to be 

counterproductive ... or that had proved to be 'ineffective 

and unsustainable everywhere they had been tried'41”. (IMF 

2004, p.91). Footnote 41 further clarifi es 

that the IMF was fully aware of proven 

ineffectiveness and unsustainability: "As 

expressed by FAD [the IMF’s Fiscal 

Affairs Department] at the time" (ibid., 

p.55).This does not result in damage 

compensation but in increased earnings 

and more control over the client. A quick 

and effi cient solution would in comparison 

have reduced earnings. The difference 

may be illustrated by Stiglitz’s 

(2000) famous story "of one unfortunate incident when team 

members copied large parts of the text for one country's 

report and transferred them wholesale to another", leaving 

the initial name in some places. Any private consultant 

would be liable to pay damage compensation. In most 

countries penal consequences would not be unlikely. 

Evaluating the Fund’s role in Argentina, its own internal 

controllers found many cases of grave negligence, if not 

worse (IMF 2004). In addition to applying policies fully 

aware that these were counterproductive, Argentina’s 

programme did not “address the now clear overvaluation of 

the exchange rate". Another "critical error" (ibid., p.46) in 

2001 was, that there was no suffi ciently clear understanding 

what to do should the approach fail. The Board supported "a 

program that Directors viewed as deeply fl awed" (ibid., p.50). 

The "September 2001 augmentation suffered from a number

of weaknesses in program design, which were evident at the 

time. If the debt were indeed unsustainable, as by then well 

recognized by IMF staff, the program offered no solution to 

that problem" (ibid., pp.54f). In a footnote the IEO corroborates 

this last point by quoting a "memorandum to management 

dated July 26th , 2001", stating that IMF "staff estimates 

that a haircut of between 15 and 40 percent is required". 

Instead, new loans were granted to Argentina. The IMF not 

only "failed to use the best analytical tools" (ibid, p.66), but 

"[a]vailable analytical tools were not used to explore potential 

vulnerabilities in suffi cient depth" (ibid., p.67). It goes 

without saying that the IMF was as usual unduly "optimistic" 

in its forecasts, as the report documents. This is just a small 

selection from a limited part of the period evaluated in one 

country. May this suffi ce to show that, if the IMF were a 

consultancy fi rm and Argentina its client, the plaintiff’s 

lawyers would have a feast. But the IMF is not a consultant 

and Argentina had to pay for programmes that (as the IMF 

did know, according to its own documents) contributed to 

her ruin. The IMF got more interest income from Argentina 

than it would have got if it had refrained from such strategies. 

One cannot but concur with the Statement of the 

Argentine Governor: “Recognising errors is, however, just 

the fi rst step in a healthy self-criticism exercise. The second 

step is bearing responsibility for failures, namely sharing the 

burden of redressing their consequences” (ibid., Annex) as 

allowed by the IMF’s statutes. Equal treatment of all 

creditors in the case of a country's incapability to pay fully 

would be a fi rst yet important step to provide incentives for 

good institutional governance and for applying due care. 

Furthermore, arbitration and courts could be used to 

provide decent legal relief (see Raffer 2004; fc). The IMF’s 

statutes authorise it to behave properly by waiving its 

immunity in such scandalous cases. 

Conclusion 

More voice and representation of the South within the IMF 

is necessary and fair. But all present reform proposals will go 

nowhere unless one forces the IMF to obey its own statutes. 

A seven percent shift of voting in the IMF is doubtlessly a 

well justifi ed demand, but making the IMF obey its statutory 

obligations even if and when these safeguard rights of SCs is 

much more important. Obeying one’s own statutes is the 

cornerstone of the Rule of Law and good governance – with- 


IMF 

out enforcing this self-evident necessity any other reform 

will remain fairly useless. One may fl out one version of one’s 

statute as well as any other if allowed to do so. 

Reference and Additional Thinking 

• Boughton. James M (2001), Silent Revolution: The 

International Monetary Fund 1979–1989, Washington, 

DC: IMF; Chapter 16 also at www.imf.org/external/pubs/ 

ft/history/2001/ch16.pdf (12/08/2009) 

• IMF, IEO (2004) Report on the Evaluation of the Role of 

the IMF in Argentina, 1991–2001, at http://www.imf.org/ 

external/np/ieo/2004/arg/eng/pdf/report.pdf (10/08/2009) 

• Martha, Rutsel Silvestre J. (1990) "Preferred Creditor 

Status under International Law: The Case of the International 

Monetary Fund", International and Comparative 

Law Quarterly 39(4), pp 801ff. 

• Raffer, Kunibert (2004) "International Financial Institutions 

and Financial Accountability", Ethics & International 

Affairs 18(2), pp.61ff; or http://www.cceia.org/ 

resources/journal/18_2/articles/5019.html (08/08/2009) 

• Raffer, Kunibert (2008) "Bretton Woods Institutions and 

the Rule of Law”, Economic & Political Weekly 

XLIII(38), 20-26 September, pp.49ff; or http://homepage. 

univie.ac.at/kunibert.raffer/KR-acc.pdf (08/08/2009) 

• Raffer, Kunibert (fc) Debt Management for Development 

- Protection of the Poor and the Millennium Development 

Goals, forthcoming at Edward Elgar, Cheltenham (UK)/ 

Northampton (US) 

• Raffer, Kunibert and HW Singer (2001) The Economic 

North-South Divide: Six Decades of Unequal Development. 

Cheltenham (UK)/Northampton (US): Elgar 

[paperback eds: 2002; 2004]. 

• Stiglitz, Joseph (2000) "What I Learned at the World 

Economic Crisis: The Insider," New Republic, 17 April, 

pp.56ff; or http://www.mindfully.org/WTO/Joseph- 

Stiglitz-IMF17apr00.htm (12/08/2009) 

• Torres, Hector R (2007) "Reforming the International 

Monetary Fund – Why its legitimacy is at stake", The 

Journal of International Economic Law 10(3), pp.1ff, 

http://www.networkideas.org/featart/aug2007/fa10_Hector_Torres.htm 

(12/08/2009). 



201


The Unbearable Lightness 

of Financial Markets 

Heiner Flassbeck 

Director, Division on Globalization 

and Development Strategies, 

United Nations Conference on 

Trade and Development (UNCTAD), 

Geneva 

Sonia Boffa 

Associate Economic Affairs Offi cer, 

United Nations Conference on 

Trade and Development (UNCTAD), 

Geneva 

Financial markets have a long history of speculative 

bubbles and crashes. From the 1622 currency bubble of 

the Holy Roman Empire, the Tulip mania in 1637 and the 

South Sea Bubble of 1720, through the Railway mania in 1840s, 

the Poseidon Bubble in 1970s and the dot-com bubble in 2000 up 

to the recent real state bubble1 , fi nancial markets seems not to 

fi nd a safe and calm haven but to create the basis for a new storm 

as soon as the last one has settled. Surprisingly, despite the 

previous and the present over-shooting and undershooting of 

fi nancial markets, the strong belief that markets "are getting the 

prices right" is only rarely as fundamentally questioned as one 

could have expected in the light of the shocks? 

The Effi cient Market Hypothesis (EMH), supposedly the 

most widely accepted theory in economics over the last fi ve 

decades, is still seen as the cornerstone of the whole neoclassical 

macroeconomic edifi ce. The EMH claims that, in an 

effi cient market, the prices of traded assets (e.g., bonds, 

currencies, stocks, or property) refl ect all available 

202 

THE IIPM THINK K TANK 

information, and instantly change to refl ect new information. 

In this manner, the markets always gets the prices right and 

assets are always traded at their “fair value”. In this theory, 

fi nancial markets, even more than goods markets, allocate 

resources in an effi cient way and regulation is unnecessary. 

In a different theoretical setting, however, the most important 

lesson of the recent global crisis is that fi nancial markets 

hardly do "get the prices right". In this view, the information 

processing of fi nancial markets results systematically in overshooting 

or undershooting and in misallocation of resources. As 

all market participants react in a more or less uniform manner 

to new information or "new shocks", the winding or unwinding 

of their exposure to risk takes place almost in unison. 

This has never been better demonstrated than by the 

current crisis, where fi nancial markets for very 

different types of assets and in all major countries 

were hit almost simultaneously. As Figure 1 

shows, the fi nancial shockwave submerged 

stock and bond markets in many countries, 

ex-change rates of some emergingmarket 

currencies and primary 

commodity mar-kets all at the 

same time. The same strong 

correlation can be seen for the 

fi rst quar-ter of 2009, with a 

nearly parallel in-crease 

among totally different 

assets that are 

traded on

fi nancial markets or on markets with a high degree of fi nanciali- 

zation. The extremely high correlation of the day-to-day price 

movements in so many different markets can only be 

ex-plained by a common force like fi nancial speculation, 

which moves all the prices in the same 

direction despite their different fundamentals. 

Take, for example, the currency market. 

High infl ation countries are the main target 

for short-term capital fl ows because they 

usually offer high interest rates. In doing 

so, "investors" can gain large profi ts by 

carrying money from countries with low 

interest rates to those with high interest 

rates. At a macro level, this “carry 

trade” causes an appreciation of the 

U NBEARABLE LIGHTNESS 

THE T HE HHE 

H IN INDIA DI DIA DI DIA D DDI D I A EC E EECONOMY C ONO ON ONO NO N O MY Y REVIEW RE R EV IEW 203 0


recipient country currency despite its fundamental need to 

depreciate to stabilize trade fl ows. The long lasting real appreciation 

of high yielding currencies is a clear signal of the ability of 

speculative fl ows to drive prices in the “wrong direction”. 

On commodity markets fi nancial "investors" have been very 

active since the early 1990s as a strategy to diversifying portfolios 

through exposure to commodities as a new asset class. When their 

involvement took on new proportions in the aftermath of the 

dot-com crash in 2000 and started a meteoric rise in early 2005 

prices were clearly distorted2 . The parallel development of 

commodity prices and fi nancial investment on commodity futures 

markets is a fi rst indicator for the role of large-scale speculative 

activities in distorting commodity prices (UNCTAD, TFR 2009). 

Among economists, however, scepticism prevails with regard to 

the link between speculation and commodity price development 

and this scepticism is based on the effi cient market hypothesis 

(EMH). EMH believers still sustain that if 

speculators were driving market prices above 

fundamental levels, consumer will demand 

less than producer are supplying. The result 

would be visible inventories of speculators. 

As the evidence on inventories is inconclusive 

the traditional view declines the role of 

speculation. However, reality may be more 

complex than this simple model. 

Speculation in Commodity Prices: 

Spot Prices and Future Expectations 

First, there is no doubt that the most basic form of speculation, 

hedging, can play a useful role in markets with volatile prices: 

Thales was a poor philosopher from Miletus who forecasted the 

olive harvest would be exceptionally good the next autumn. 

Confi dent in his prediction, he made agreements with local olive 

press owners to deposit his money with them to guarantee him 

exclusive use of their olive presses when the harvest was ready. 

Thales successfully negotiated low prices because the harvest was 

in the future and no one knew whether the harvest would be 

plentiful or poor and because the olive press owners were willing to 

hedge against the possibility of a poor yield. When the harvest-time 

came, he let them out at any rate he pleased, and made a large 

quantity of money. 

A futures contract of this kind is a standardized contract to buy 

or sell a specifi ed asset at a certain date in the future, at a 

pre-determined price. In agri-cultural markets, risk averse 

204 


The policy 

lesson is simple: 

macroeconomic 

prices are too 

important to be 

left to the vagaries 

of these markets 

farmers may sell their future harvest through such a contract in 

order to be sure about the price and avoid bad surprises at the 

time of the harvest. The farmer may indeed accept what seems to 

be a rather low price to hedge the risk of a much lower price later. 

In this sense, Thalesian futures market are driven by a reasonable 

kind of speculation, where a more risk adverse person is hedging 

its risk with a person that it is less risk adverse. 

What happens when futures contracts are traded in purely 

fi nancial markets without producers of the commodities being 

involved? Trading a futures contract of commodities, like trading 

stocks or currencies, implies the anticipation of the future price of 

the traded asset. The farmer after having planted its crop may 

have an idea of the future supply, its quality and the local demand 

for such a quality that allows him to estimate roughly the present 

value of his coming harvest. However, in a truly global market and 

long before the food stuff is planted, for example olives for the 

harvest in 2010, no one has a clear idea about 

the outcome in terms of the fi nal price. 

The main difference between the 

thale-sian futures market and the fi nancial 

fu-tures markets nowadays is the impossibility 

of an acquisition of reliable information 

in the latter about prices in the future. 

In fact, pricing in fi nancial futures markets 

is no longer based on some knowledge of 

the concrete supply and demand but it is 

based on "more sophisticated” techniques 

and procedures. But even with these techniques like deep 

digging analysis of supply and scientifi c studies of future 

demand (like "The Chinese or Indian demand for oil or food”) 

the information is not more accurate; the state of objective 

uncertainty prevails. But another nexus may come into play: As 

the futures market normally is a highly active, very visible and 

centralized market, the farmer and the hedger may prefer to 

set their price according to the futures "markets view" instead 

of relying on their own judgment (especially when the forward 

price in that market is higher than the one the farmer had 

expected). Then the futures markets becomes a vital source for 

information about spot prices and may indeed force both, the 

producer and the hedger, to adjust accordingly. 

It is exactly in this way in which information, unrelated to the 

fundamentals of the concrete market drives many different 

fi nancial prices into the same direction over remakably long time 

spans. The rumor about a recovery of the global economy is more

important than any “fundamental” in driving the prices up or 

down. Then the futures markets dominate the price formation in 

the spot markets and not the other way around, as traditional 

theory suggests. Remains the question about fi nal demand: what 

will consumers do to protect against the volatility of the fi nancially 

determined prices? The simple answer is that in most cases they 

have no choice. They continue to satisfy their needs irrespective 

of the price and take the implied overall income effect that is 

implied by the price moves as good or bad luck respectively. 

Overall, fi nancial markets are not compa-rable to the ideal 

atomistic market of economics textbooks. In an atomistic market, 

each seller's and buyers size is too small relative to the market as a 

whole to infl uence prices. Moreover, each seller and each buyer in 

the ideal market comes with an independent set of information 

concerning his or her individual supply and demand. In fi nancial 

markets, the uniformity of the available information provokes 

herding and highly correlated movements in 

and across markets with the power of 

infl uencing the futures market and the future 

spot prices of all traded assets. 

Herd Behaviour and the 

Irrelevance of Fundamentals 

The EMH claim that relevant new information 

induces the economic agents to update 

their expectations appropriately doesn’t solve 

the general information problem. Which 

kind of information is driving the expectations of market participants? 

Are expectations driven by individual needs, by individual 

preferences, or by individual strategic targets of companies? Obviously, 

none of them is relevant. Fundamentals like these are not 

important anymore in modern fi nancial markets. The market 

participants in a fi nancial market are much more concerned with 

guessing how certain "news" will infl uence the behaviour of other 

fi nancial market participants and consequently with betting on an 

outcome that can be expected if many participants' expectations 

are infl uenced by the same piece of information. 

Keynes introduced in 1936 the example that investment 

strategies in such markets resemble a beauty contest; where 

guessing the result is mainly driven by trying to second guess 

which the prettiest woman for other observers is, instead of 

judging the true beauty of the ladies. In the same way, the 

“fundamental” value of a particular asset is less relevant for the 

guessing market participant than his expectations about the 

In the great events 

of man’s history, 

in the unwinding 

of the complex 

fates of nations, 

justice is not 

so simple 


judgment of the other speculators. This phenomenon systematically 

encourages the emergence of price bubbles if the herds 

infl uenced by certain bits of information are large enough. If this 

is the case fi nancial markets systematically "get the prices wrong" 

since betting on ever-rising prices appears to be a rather risk-free 

and high-return business for an extended period of time. 

As long as the “madness of the crowds" prevails, the individual 

judgement on the fair value of an asset is useless. In this sense, 

fi nancial markets have a lot in common with the historical Spanish 

tradition of encierros (running with the bulls): since you have to 

run in the same direction, the best strategy is to be far ahead and 

out in front of the bull and exit in the right moment. And this is 

exactly what each speculator tries to do: to move fi rst because only 

moving fi rst guarantees the biggest gains. But in doing so, "the 

unbearable lightness of fi nancial mar-kets" leads the whole 

economic system into an unsustainable situation. If farming were 

to be organized like the stock market, a 

farmer would sell his farm in the morning 

when it rains, only to buy it back in the 

afternoon when the sun comes out. 3 

In reality, the future equilibrium price is 

absolutely unknown. Financial investors 

even ignoring available information about 

fundamentals can guess the price that 

proves to be the right one eventually. 

Relying on what other market participants 

may believe and/or the prediction about 

others views on the average value of a share, a commodity or a 

currency is suffi cient for temporary success. In such a framework, 

speculation destabilizes, instead of stabilizing, the prices 

of the targeted assets. 

Policy Conclusions 

The events of recent months have revealed a huge misallocation 

of resources and a destruction of enormous values driven by 

fi nancial markets. The policy lesson is simple: macroeconomic 

prices are too important to be left to the vagaries of these 

markets. However, if the failure has shattered the naïve belief that 

unfettered fi nancial liberalisation and de-liberate non-intervention 

of governments will not only maximize the benefi t of some 

players but also the social benefi t, the crisis offers an opportunity 

for a new start. Governments, supervisory bodies and international 

institutions have a vital role to play to allow the society at 

large to reap the potential benefi ts of a system of decentralized 


205


Evolution of Prices in Selected Markets and Countries, June 2008-July 2009 

(Index numbers, 2 nd June 2008 = 100) 

Equity markets Commodity Market 

140 

140 

120 

100 

80 

60 

40 

20 

0 

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 

National Bond Marketa National Bond Marketa 140 

120 

140 

100 

120 

80 

100 

60 

80 

40 

60 

20 

40 

0 

03/07/2009 

20 

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 0 

03/07/2009 

United States 

New Zealand 

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 

Germany 

Australian Dollar to Japanese Yen 

United Kingdom 

New Zealand Dollar to Japanese Yen 

Japan 

Brazilian Real to Japanese Yen 

Source: UNCTAD Secretariat Calculations, based on Bloomberg. 

206 

Budapest Stock Exch Index (Hungary) 

Jakarta Composite Index (Indonesia) 

FTSE/JSE Africa All Shr (South Africa) 

Bolsa Index (Mexico) 

NIKKEI225 (Japan) 


03/07/2009 

120 

100 

80 

60 

40 

20 

0 

03/07/2009 

02/06/2008 02/09/2008 02/12/2008 02/03/2009 02/06/2009 

a Yields on 10-year bonds. 

S&P GSCI Cotton Offi cial Close Index 

S&P GSCI Soybeans Offi cial Close Index 

S&P GSCI Brent Crude Offi cial Close Index 

S&P GSCI Copper Offi cial Close Index

decision makers. Only consistent and forceful interventions by 

institutions with knowledge about systemic risk can transform a 

system of markets for goods, for services and fi nance into a 

functioning entity. The neo-liberal laissez faire of the last twenty 

years has dramatically failed its fi nal test. 

Interventions in fi nancial markets that are part of the global 

economy ask for cooperation and coordination of national 

insti-tutions and for specialized institutions with a multilateral 

mandate to supervise national action. In midst of the crisis this is 

even more important than in normal times. The tendency of 

many governments to grant to fi nancial markets the role of 

referee or judge over the success of policy adjustments has to be 

rejected energetically. For example, it is indispensible to stabilize 

exchange rates by direct and coordinated government intervention 

instead of letting the market fi nd the bottom line and trying 

to “convince” fi nancial markets about the credibility of the 

government of the depreciating currency through pro-cyclical 

policies like public expenditure cuts or interest rate hikes. 

In the same vain, the problem of newly issued government 

bonds at “penalty” rates that are demanded by the “markets” 

can be tackled. The paradox that the same market participants 

that have driven governments of many countries into a 

disastrous budgetary and current account situation ask for 

“risk premia” because they do not trust these governments any 

more and fear government default, has to be answered by the 

global community of governments in a strong and dedicated 

manner. Very rarely only the governments of the negatively 

affected countries are to be blamed alone for failure and 

governments of the unaffected countries very rarely are 

without any guilt. Hence, global solidarity and not a blame 

game is the imperative of the day. As Keynes once put it: “In 

the great events of man’s history, in the unwinding of the 

complex fates of nations, justice is not so simple.” 

A global answer should follow the same principle: If everybody 

defaults nobody defaults. Only if some countries try to avail 

themselves of the opportunity to get cheaper credit at the 

expense of others, the “markets” have a choice and can de-mand 

a “risk premium” from the more vulnerable ones. If every 

country and every government acknowledges that the global 

crisis is foremost a systemic crisis, i. e., due to the failure of the 

global community to govern the globalized economy properly, 

the solution of a global bond that can be used by all countries at 

fi xed exchange rates is less utopian than it sounds. 

In the same spirit of cooperation all different sorts of specula- 


tive activities that have been responsible for the distortion in 

national and international price relations have to be tackled at 

the same time to avoid speculative arbitrage. The tragedy of the 

modern forms of speculation is their very short half-value period: 

the more people on the globe concentrate on the speculation in 

certain markets and the more effective they are, the quicker the 

results will be contradicted by economic reality because the real 

economic system can no longer bear the burden of largely 

distorted prices and exchange rates. 

A coherent and effective approach can only be found at the 

international level and with the inclusion of as many coun-tries as 

possible. A broad international agreement about the distortive 

effects of large scale speculation in different areas on trade and 

investment is absolutely crucial to create the framework for a 

globalization that has the potential to de-liver rising living 

standards for all. However, the effects of the improvement in 

terms of material wealth have to be miti-gated by a strategy to 

minimize the cost of higher living standards for the natural 

environment and the global climate to be sustainable. 

Endnotes 

1 Kindleberger has listed 42 bubbles in the history of economics. 

2 The number of futures and option contracts outstanding on 

commodity exchanges worldwide increased more than fi vefold 

between 2002 and mid-2008. 

3 Keynes quote attributed by Hutton (2008). 


• Aristotle, Politics, trans. Benjamin Jowett, vol. 2, The Great 

Books of the Western World, ed. Robert Maynard Hutchins 

(Chicago: University of Chicago Press, 1952) book 1, chap. 11, 

p. 453. 

• Hutton, Will, "Will the real Keynes stand up, not this sad 

caricature?", Guardian, November 2nd , 2008. 

• Keynes, John Maynard The economic consequences of the 

peace, Volume II of the Collected writings of John Maynard 

Keynes published for the Royal Economic Society in 1971, 

page 142. 

• Kindleberger, Charles P. (2000) Manias, Panics, and Crashes: 

A History of Financial Crisis, 4th edn. New York: John Wiley 

& Sons. 




207

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