Milton Friedman and India

Nobel laureate Milton Friedman, the legendary champion of economic freedom and the nemesis of Keynesian orthodoxy, strongly influenced the economic policies of Ronald Reagan and Margaret Thatcher, the growing opposition to Communism within the eastern bloc, and more controversially Chile under Pinochet.

Less well known is the fact that much before these events transpired he was engaged as consultant by India’s finance ministry, along with another prominent American economist, J K Galbraith, as Independent India embarked on a new economic trajectory.

Galbraith and Friedman were at opposite ends of the State-Market paradigm, and both died in 2006. Galbraith was close to both Kennedy and Nehru, and it is widely believed that his Keynesian influence had a role in the ‘commanding heights’ approach finally adopted by India.

In a memorandum dated November 5, 1955, submitted to the government of India Milton Friedman, who predicted the end of the post-war boom and stagflation, was at his prescient best while candidly critiquing the model of planned development being formulated under the auspices of the eminent mathematician P C Mahalanobis.

It is worthwhile revisiting Milton Friedman’s arguments, as valid now as they were then, with most of them quietly implemented over three decades later as part of India’s new economic policy from the 1990s.

Friedman believed that the projected 5% rate of growth was eminently feasible on account of India’s vast untapped technological and scientific potential, provided India followed a prudent monetary policy, invested in human capital and physical infrastructure, and ensured economic freedom.

He had serious qualms about an investment policy which relied too greatly on rigid capital input-output ratios. Capital input and output were only loosely related because the major productive power lay not in physical capital but in human beings.

According to Friedman the public sector resource gap could be reduced through a combination of productivity improvements and foreign resources. What was being considered, however, was transfer of resources from other uses, through a mixture of enhanced taxes and additional forced/voluntary savings that would raise interest rates and/or fuel inflation.

This would make public investment larger at the cost of potentially more productive private investment, leading to either inflation or a deadening network of direct controls. Cutting the size of the programme was preferable to such transfers.

India was attempting to do too much in the public sector, ignoring the unhappy experience of several European countries in the post-war period. Since the areas for which only government could take responsibility (read infrastructure) were so large in India, and resources so limited, it should avoid activities that could be taken up by others.

The attempt to control the private sector in a rigid and detailed fashion was counterproductive because this could direct potential investment into consumption or bullion. Detailed direction would waste the energy of civil servants because only the market could determine what lines of business would be most productive.

On the other hand, mollycoddling and protecting sections of the private sector would introduce new sources of inefficiency. There was no justification for the private sector unless it was competitive and sought out new markets, instead of trying to carve out inefficient protected sectors.

In retrospect, Milton Friedman’s fears were entirely justified. The Five-Year Plans grossly underinvested in both physical infrastructure and human capital, depressing productivity that kept India stuck at the ‘Hindu Rate’ of growth of 3% for three decades despite increases in savings and investment.

Monetary and fiscal profligacy elevated real interest rates, leading to financial repression and a huge public debt overhang. The combination of coddling and deadening network of direct controls destroyed the competitiveness of Indian manufacturing that had once given Manchester a run for its money, and now looks chillingly prophetic.

Protection and control has been reduced over the last two decades, and a belated attempt is being made to quickly bridge the infrastructural and human capital deficit. The faith in input-output models and public ownership of commercial assets is undiminished, however.

Opening up foreign investment from the nineties made available vast new resources to the country as predicted. Friedman was also spot on in his prediction that India’s comparative advantage lay in its untapped reservoir of technical and scientific knowledge which is India’s current engine of growth.

Friedman decried the reliance on the extremes of heavy and cottage industry, to the detriment of light (labour-intensive) industry. Both were sub-optimal in the Indian context. The former combined capital with too little labour, in which India had a comparative advantage, while the latter combined labour with too little capital to be competitive.

Left to their own devices under a free enterprise system Indian entrepreneurs would gravitate naturally towards the production of such items as bicycles, sewing machines, and radios.

The long-term impact of this policy was disastrous, for it allowed East Asia and China to steal a (permanent?) march over India in labour-intensive manufacturing. Friedman felt that the small share of direct taxes indicated a faulty tax structure.

He recommended a more broad-based tax with fewer exemptions. He cautioned against the cascading impact of indirect taxes and the use of tax policy to protect certain methods of production, such as cottage industry, which promoted inefficiency and was wasteful of revenue.

A portion of the higher revenue could be used for retraining and placement of handworkers. His recommendations were in line with current tax reform, including VAT, but his more radical suggestion on uniform production tax is still way off.

Friedman acknowledged India’s foreign exchange constraint, which could be better managed by a float than through arbitrary controls that discriminated between sources of purchase and provided implicit subsidy to licensees, thereby promoting economic inefficiency.

Auctioning of foreign exchange was the second best option as it would both increase government revenue and have a favourable effect on efficiency. It was the Friedman float which ultimately resolved India’s forex problem in the nineties.

(The writer is Secretary, Planning and Economic Affairs, State of Kerala. His views are personal.)

Some time ago I wrote what amounts to my own obituary on the passing of John Kenneth Galbraith. I did not write such an obituary at the passing of Milton Friedman and it reflects the fact that my cavities of understanding of economics were not to be properly filled until 13 years later when Milton Friedman was awarded the Nobel Prize in economics. I had the pleasure the other night of watching a Charlie Rose interview of Milton Friedman which I think was made in 2005 when the man was 93 years old and still brilliantly clear of mind. Few of us really know how much we are in the debt of Milton Friedman, the man who rescued us from the clutches of John Kenneth Galbraith (and one might add, John Maynard Keynes, one of the most destructive intellectuals of the modern age). Friedman, not falsely modest, said that he had convinced the world intellectually of the truth of his defense of the power and virtue of choice but that, sadly, the world was not ready practically to adopt what he had brought them to believe. So we, for example, witness the debacle of the Republican Party spending itself into defeat in the last election and even today conniving with the Democrats to pass the biggest spending bill in history.

It is good that India has discarded the discredited notions of John Kenneth Galbraith and Prime Minister Nehru who led the India into a dark age of socialism. It is sad that Venezuela has just stepped off the cliff.

Here is my take on John Kenneth Galbraith at the time of his death:

As part of a college honors program, we were required to read The Affluent Society over the summer and render a report first thing upon our return to college. I was a freshly minted college sophomore with strong but primitive conservative instincts and little wariness for the hidden agendas which motivated the political science professors running the honors program. I was shortly to be disabused of my ignorance.

Essentially, The Affluent Society, itself has an agenda, to rationalize the taking of your liberty and vesting it in the state. Galbraith exploited his agility with a pen and succeeded in convincing a large portion of our people that the elites who run the think tanks and universities and the government regulators are smarter than we are. His proof that we are stupid? We waste money on big fins attached to the back ends of our automobiles but fail to spend that money for the programs which later came to be known under the rubric, The Great Society. In fact, so well did Galbraith succeed that the popular justification for the great society was laid down in this book and ultimately accepted by the public at large.

My conservative principles, although not yet tempered, were strong enough and clear enough to see that the question was individual liberty versus collective control. Once one accepts Galbraith's premise, that society exercising individual choice squanders its resources, the argument is virtually over. One must maintain the high ground, that individual liberty is worth the inevitable waste. That waste is the price we pay for innovation, for growth, and ultimately for economic and political freedom. Finally, that waste, compared to the institutionalized waste committed by governments, is cheap indeed. Ultimately, the question is, do you want to pay the price the Italians paid to make their trains run on time?

To college professors, the temptation to make the trains run on time is irresistible. Galbraith's career itself demonstrates that. These were the heady days along The New Frontier. We had thrown off the shackles of the boring 1950s and we had inherited from that decade wealth beyond our experience. The professors were focused on how to get their hands on that wealth while forgetting how it was created. No, they did not want it for themselves, they wanted a great society do good with it. Lyndon Johnson gave them a chance and our elites gave us The Great Society.

These professors are all dead now, not enjoying Galbraith's longevity but their legacy and his survives mere mortal life span. The temptation to do good by ultimately invoking the physical power the state to control people's choices and spend their money for them is difficult for any generation or culture to resist.

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