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Heed the Words of Wisdom

 Arvind Panagariya

  “A FIVE per cent per annum rate of increase in real national income seems entirely feasible on the basis of both the experience of other countries and of India’s own recent past. The great untapped resource of technical and scientific knowledge available to India for the taking is the economic equivalent of the untapped continent available to the United States 150 years ago.” If these opening words in a memorandum addressed to the government of India do not impress you, think again: the date on the memorandum is November 5, 1955 and its author is Milton Friedman, the 1976 Nobel Laureate in Economics.

 Friedman visited the ministry of finance briefly during 1955 and wrote the memorandum at the invitation of the government of India. Less than 5,000 words long, today the contents of this memorandum have become standard thinking among reform-minded economists in India. But at the time it was written, it must have been nothing less than heresy. It certainly did not see light of the day for 37 years until it was published in a volume edited by Subroto Roy and William E James.

 In the memorandum, Friedman focuses on the policies that had just been adopted or were being considered for adoption and were contrary to the goal of development in his view. He begins by questioning the reliance on the ratio of investment to national income as almost the only key to development. He argues that the form and distribution of investment are at least as important as its sheer magnitude. Moreover, what is called capital investment is only part of the expenditure on increasing the economy’s productive capacity. Expenditures on increasing the productive capacity of human beings matter at least as much.

 Friedman goes on to criticise the emphasis in India’s investment policy on the development of two extremes: heavy industry and “handicrafts”. “This policy threatens an inefficient use of capital by combining it with too little labour at one extreme and an inefficient use of labour by combining it with too little capital at the other extreme.” Instead, he advocates a diversified and much expanded light industry as the foundation on which to build the heavy industry.

 Friedman warns against reliance on public sector for activities that can be performed by private sector. He cites the disappointing outcome of the flirtation with this sector by European countries in the immediate post-war period and reminds of the drastic change this experience had produced in the attitudes of labour and left wing towards state control over economic activity. “The elements in the parties that have not changed the approach are now being dubbed ‘reactionary’ by some of their fellows!” He warns that in India, the areas for which only government can take responsibility are so large that they alone would be a heavy burden on the limited administrative personnel of high calibre. “It seems the better part of wisdom therefore to avoid any activities that can be left to others.”

 Friedman also fully anticipates the pitfalls of rigid and detailed controls on investment. “It is impossible to predict in advance the lines of investment that will turn out to be the most productive — as the failure of so many private enterprises amply demonstrates. There is therefore great need for a system that is flexible and can change easily.” He also criticises detailed direction on the ground that it wastes scarce energies and abilities of public servants in producing and enforcing regulations and of private individuals in trying to evade or change them.

 Friedman comes down heavily on protection that promotes inefficiency irrespective of whether it applies to small enterprises or large concerns. Referring to the favours granted to small enterprises to promote employment, he writes, “The objective is fundamental, and would be worth achieving even at some cost in total output, but it seems to the present writer dubious that these means accomplish their objective even in the short run, and is certain that they work against it in the moderate or long run.”

 Turning then to large scale firms, he writes, “Granting them special favour in the form of especially advantageous loans, guaranteed markets, refusal of licenses to competitors, enforcing or even permitting private price-fixing and market-sharing agreements simply encourages inefficiency and wastes scarce resources. If private industry is granted special favours by the government, it is certainly inevitable that its use of these favours will be controlled; but this does not offset the harm done by the favours; it merely introduces new sources of rigidity and inefficiency.”

 Friedman is highly critical of the erratic monetary policy at the time and advocates a steady expansion of money stock at the annual rate of 4 to 6 per cent. He also warns against the wisdom of foreign-exchange controls. “They introduce delay, uncertainty, and arbitrariness into domestic business activities. The criteria the officials use — and must use — tend to perpetuate the status quo ante, and therefore constitute an obstacle to dynamic change and adaptation in an area that traditionally has been one of the most dynamic sectors.” He advocates either a move to flexible exchange rates or, less desirably, auctioning of foreign exchange to the highest bidder.

 What does the master himself think of the memorandum today? In a note to Subroto Roy, dated 14 September 1998, he writes, “I am sure that if I were writing it today, it would differ in many details and recognise the many changes that have occurred in the past 43 years. Yet I believe the general thrust would be the same. More important, I believe that the experience of those years around the world has led to far greater support for free markets, minimum government intervention, and floating exchange rates than existed then.”

  Economic Times, October 24 2001