The Three Failings of Economics

Economics, at least as it is expected to function in the West, aims to achieve normatively three fundamental and sacrosanct principles: free markets, free trade and growth. Governments try to minimize their involvement in market activity and regulate carefully so as not to interfere in the investment decisions of firms, in the mechanism of price discovery, and to also prevent private actors from influencing prices such as through price fixing of goods and services or through insider trading in the financial markets. Trade is, likewise, directed by policy to be as free as can be feasible between countries, without barriers to flow of goods and services, capital and labor. Free markets and free trade are expected to allocate scarce resources efficiently within countries and between countries for both individual countries and for the world economy to continue to grow, with growth keeping up at least with the population growth rate assuming constant availability of natural resources and continuous technological advancement to use resources efficiently. Yet, these very principles constitute the critical failings of economics in practice.

Adam Smith, the moral philosopher and classical economist during the Enlightenment in Europe, had postulated that free markets, on net, raise social welfare because they are guided by an “invisible hand” as people work in enlightened self interest. Smith had perhaps overestimated the goodness and rationality in human nature. People work in self interest and many a time in selfishness and greed with little concern for the systemic affects of their actions. John Maynard Keynes in his critique of classical economics, in fact, far from seeing people as enlightened, had postulated that they act in “animal spirits”, quite irrationally, leading to dramatic ups and downs in the markets as has been evidenced several times in economic history. Still, however, governments around the world, with a bias for laissez-faire, hesitate to thoughtfully intervene, with their visible hand, to correct anomalous market behavior during times of both market euphoria and downturns. Importantly, countries which have unstable governments and poor institutions give rise to unstable economies and corruption where laissez-faire reigns in an unenlightened condition.

David Ricardo’s theory of comparative advantage, in contrast to Adam Smith’s absolute advantage driving international trade, under free trade, leads countries to import goods and services because they are cheaper to procure from abroad even though they can make them themselves. As a result, in the current global trading system, countries which benefited first from the massive technological change of the industrial revolution, the first movers, are specializing in innovation – their comparative advantage – and moving up the production value chain, increasingly substituting capital for labor thereby reducing the labor share of their national incomes causing rising income disparities and displacement of workers from their employment with capital moving to countries with low production costs. Rising welfare abroad is threatening to reduce welfare at home which eventually may also reduce welfare globally as technology diffuses more quickly around the world increasing the capital share of national income is most countries. Capital mobility was not considered by Ricardo when he postulated comparative advantage. The capitalists – the owners of capital – will benefit while the rest see heightened economic uncertainty and a fall in their living standards.

It is estimated that the rate of consumption of natural resources on Earth requires 1.7 times what the planet can provide. Economic growth is rapidly becoming the Achilles heel of economics because no amount of technological advancement and efficiency of consumption of natural resources can prevent their depletion especially as per capita incomes rise around the world and as population grows to almost 12 billion by the end of this century. Growth theory in economics does not take into account the natural resource constraint and assumes that technological change will continue to raise average living standards by raising productivity. The average living standards may rise but the distribution of income in the society would be lopsided. This will, therefore, turn out to be the wrong model of the economy particularly in light of the increasingly skewed income distribution favoring capital between the two factors of production: capital and labor.

Economics requires radical rethinking if humanity is to achieve balanced development of all in ecological harmony.

The Challenge of the Disconnect Between Employment and Economic Growth in India

India, since 2014, has been the lone star on the economic firmament, growing consistently above 7% per year as the rest of the world struggled with economic recovery. One would expect that such a relatively stellar growth rate would create jobs but disappointingly this is not happening. The disconnect between growth and employment has only become worse. About 12 million enter the labor force every year and for India to reap the demographic dividend – of having more people of working age than those dependent on them – over at least the next four decades requires creating highly productive, well-paying jobs.

Employment elasticity, defined as the percentage change in employment resulting from a 1% change in gross domestic product (GDP), has been falling for India since the late 1990s, dropping steeply from 0.3% to 0.15%. This clearly signals that India needs significantly more growth if it is to provide quality employment to its vast, young workforce to be able to create a large consumer class which feeds back into the GDP.

What is causing this disconnect between employment and GDP? The low employment elasticity shows that growth is not being labor intensive enough. In the short run, such growth which results from structural changes in the global market in industries such as telecommunications, information technology and financial services and automation in manufacturing could result in higher output per worker, but in the long run it depresses consumption and hence GDP because unemployment and underemployment will weigh on the economy.

In India, the telecom industry has been consolidating thereby shedding workers. Information technology has been subject to the impact of technological change that is happening which requires complex job skills, thus displacing workers without them. The upskilling of workers is now a major challenge. Financial services is automating many business processes such as trading and portfolio management requiring far fewer workers than before and this is a trend that is only in its beginning.

The manufacturing sector has not been immune to technological change that has been happening around the world. Even as shifting manufacturing jobs to low-wage countries in the world has played its part in the loss of jobs in developed countries, by some estimates 1 robot is displacing 7 workers in manufacturing including in developing, lower middle income countries like India.

By liberal estimates an unemployment rate of 2-3% and by most conservative estimates a rate of 5-8% could statistically respond to the critics of India’s unemployment, but dependence on the strategy of attracting manufacturing from China to India because of relatively lower wages in India does not solve the underemployment problem nor does it help in creating the high-quality, high-wage jobs the government is aspiring to especially in a global environment where outsourcing has become a bad word. Exports are necessary but not critical for the development of India.

There is a way for India to be competitive in the world market without continuing to buy into the neo-liberal paradigm which worked for China but may not work for India given the political-economic milieu the world is now in that is legitimately critical of unbridled free trade. It is important for India to be open to foreign multinational corporations (MNCs) on the condition that they “Make in India”, across all industries including national defense, for the Indian market employing Indians and reinvest their profits in India. This will help formalize and organize the large informal sector and produce Indian corporations that are globally competitive. Liberalizing the large government sector is crucial to creating Indian MNCs of the future that can compete on an even keel with the foreign MNCs from developed countries.

After all the United States is a USD 18 trillion economy for a country of 315 million people. With 1.2 billion people India can likewise do much better. The development of the vast domestic market must be the vision that India ought to pursue.