Is the General Theory Applicable to ‘Underdeveloped Economies?

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Subject-Matter:

A favorite topic of discussion with some Indian economists in the 1950s was whether Keynes’ ‘General Theory’ is in any way applicable to underdeveloped economies like India.

Keynes never used the word ‘general’ to imply universal applicability of his theory.

It was Mrs. Joan Robinson who hinted the relevance of Keynesian policy in the context of the efforts at economic development of most underdeveloped countries.

1. As for the theoretical apparatus and model of ‘General Theory’, J.A. Schumpeter, an ancient economist and critic, had ruled out the direct, immediate applicability to all countries. He wrote: “Those who seek universal truths, applicable to all places and at all times had better not waste their time on the General Theory”. The idea was that the socio-institutional assumptions underlying the theory related mainly to U.K. or at least to advanced, rich, industrialized, nature economics of the West.

2. Schumpeter also considered the policy implications of Keynes’ theory as not only irrelevant to countries other than England but also as positively harmful. He observed: “Practical Keynesianism is a seedling which cannot be transplanted into foreign soil ; it dies there quickly and becomes poisonous before it dies….left in English soil this seedling is a healthy thing and promises both fruit and shade……. all this applies to every bit of advice that Keynes offered.”

3. Keynes never wrote for the economic development of undeveloped countries. Keynes wanted to give theoretical respectability to the allegedly ‘interventionist’ policies of public works, deficit financing and deficit budgets. He was evolving an anti-depression and later an anti-inflation policy for a temporarily ailing mature, capitalist economy. Under-developed economies differ fundamentally in their nature, structure and problems; as such a downright applicability of Keynes’ theory or policy is out of the question. Lecturing in Lucknow university, Professor A.K. Das Gupta had remarked in 1951 : “Whatever the generality of the ‘General Theory’; may be in the sense in which the term general was used by Keynes, applicability of the ‘General Theory’ to conditions of an underdeveloped economy is at best limited.”

4. The Keynesian concepts are also not very useful for policy purposes in less developed countries. In the same vein, in an important article on the working of Keynes’ multiplier in underdeveloped economies, Dr. V. K. R. V. Rao came to the conclusion that the multiplier fails to multiply real income in such economies mainly because of the supply in elasticities of the consumer goods needed for its working. He noted that under the Keynesian assumptions, such economies are ‘fully employed’ because the limited capital stock is fully worked; in the circumstances, multiplier increases only the money income to cause inflation when deficit financing is done.

Accordingly, he observed that the “blind application of Keynesian formulae to the problems of economic development has inflicted considerable injury on the economies of underdeveloped countries and added to the forces of inflation that are currently afflicting the whole world. The old-fashioned prescription of ‘work harder and save more’ still seems to hold good as the medicine for economic progress at any rate, as far as the underdeveloped countries are concerned.” Thus the consensus of opinion was that Keynes model is meant for and is applicable to ‘advanced economies only. Underdeveloped economies better look to traditional wisdom.

Inapplicability of Keynesian Conditions and Assumptions:

Keynes’ theory and policy applies if the following conditions are obtained: excess capacity in consumer-goods industries, a well-developed, monetized and organised sector including well integrated bonds and securities markets, involuntary labour force ready to work at current money wage rate and relatively elastic supply of the working capital required for increasing output.

These conditions are generally found in advanced capitalist economies of the West, not in less-developed economies like India even. In underdeveloped economics, there is chronic, massive unemployment and underdevelopment not due to temporary deficiency of effective demand, but due to the lack of productive factors complementary to labour.

The problem of depression and unemployment in advanced economies is like the temporary ailment of an otherwise healthy man to whom specialised Keynesian sugar-coated pills can be given to cure him and get him going. The problem of underdeveloped countries is that of a chronic patient, weak, debilitated anaemic and suffering from many ailments at a time. For the latter, a balanced well-considered prescription will not be enough. He needs tonic.

The pills meant for the former will definitely harm the latter Keynes has built-up his theory on the basis of a number of assumptions- institutional, technical and social. These assumptions are of the short-run, of closed economy, of involuntary unemployment, of techniques of production, organisation, capital equipment, size and efficiency of labour force remaining constant and availability of skilled labour at the current money wage rate. These assumptions do not hold true in underdeveloped economy; for once, the problem of underdeveloped economies is a long-run problem of economic development, of raising the economy from the bootstraps rather than a short-term problem.

The massive unemployment, disguised unemployment and lower incomes are the result of the stagnation of centuries and cannot be overcome within a short span of a few years. Again, most of the underdeveloped economies are not closed economics because the organised sector here is altogether foreign-trade oriented and suffers from fluctuations in business activity on account of the variations in international trade.

Besides, whatever little favourable multiplier effects are generated within the economy on account of public expenditure may be lost to other countries; world depressions travel through international trade to perpetuate stagnation in underdeveloped economies. Keynes takes for granted the conditions on supply side of effective demand by taking technology, capital equipment and efficiency of labour as given. In underdeveloped economics, however, more difficult problems lie on the side of supply than on the side of demand.

The problem in less developed countries is how to increase savings, help capital formation, improve means of production and how to raise efficiency of labour. It is only after these factors have been obtained that the supply of output can be increased. This is essentially a long run process. Thus, it appears as if Keynes had assumed away the real problems of an under­developed economy.

Moreover, the industrial sector in underdeveloped economies has to draw upon a pool of surplus labour present in the subsistence sector of the economy for its expansion, but mobility of the labour is low on account of the unwillingness of workers to leave the family farms.

Further, higher wages have to be paid to attract them to urban areas where there are problems of housing, congestion, overcrowding and high cost of living. Thus, it is altogether unrealistic to assume an elastic supply of skilled labour at the current wage rate in an underdeveloped economy. Thus, Keynes’s assumptions do not fit the ‘facts’ in underdeveloped economics.

Relevance of Keynes’s Theoretical Tools:

Some writers claim that Keynesian tools arc surely more relevant to less developed economics than his system. We can analyse these one by one. These countries are characterized by low effective demand not due to excessive saving but owing to low, poor purchasing power for the masses in general and pent-up demand for consumer durables from the higher-income groups in particular.

The problem is more on the supply side because the productive sectors of the economy are restricted in their supplying power due to in elasticities in supply of raw materials, managerial and technical talent and above all transport bottlenecks. Keynes’ theory of effective demand does not hold good because the problem is of the aggregate supply function which Keynes did not analyse. The problem here is of raising production rather than of generation of demand.

However, the Principle of Effective Demand does draw our attention to the necessity of giving priority to agriculture which must provide an expanding market for the industrial sector. In the urban areas the problem is to restrain effective demand to the extent of available supplies; this is where Keynes’ effective demand theory applies.

The consumption function in less developed countries presents interesting features. Both the average and marginal propensities to consume are unusually high, nearing unity. The percentage of income saved decreases with increases in income because of an extremely high income-elasticity of demand for consumables. The democratically ‘free’ people in backward economies are habituated to conspicuous consumption.

They are exposed to what is called the international demonstration effect. They would like to immediately use the household gadgets of underdeveloped countries. In the rural areas, small farmers withhold a part of the marketable surplus normally available with them for self-consumption as their production rises. This increases prices in the urban areas leading to a squeeze of consumer demand. All this does not fit in well in the Keynesian macro-economic where sectoral imbalances and intersectoral dependence of consumption propensities is not considered at all.

Let us now turn to the constituents at investment-demand function: liquidity function and the MEC. Keynes believed that the stagnation in countries like India is due to excessive liquidity preference: he wrote “the history of India at all times has provided an example of a country impoverished by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth.”

In underdeveloped countries, the demand for cash is just to gain the capacity to store essential commodities for speculative purposes rather than to earn from the changes in the rate of interest. With stock and capital markets underdeveloped, the pull of speculation in the commodity markets is strong.

The speculative demand for money arises mainly at the harvest time for purchasing food stocks. Further, due to shortage of essential goods, there is a demand for cash to hoard stocks. We, therefore, find that the transactions demand for money is interest- elastic as well as income-elastic. Moreover, in the ill-organised, loosely linked money market, the precautionary demand for money is high. Thus Keynes’s liquidity preference theory simply does not apply because Keynes concentrated only on speculative demand for money.

He narrowed down his speculative motive to the choice between money or bonds. He did not consider the choice of commodities at all. To him liquidity preference function was only a monetary phenomenon not related to commodities. For underdeveloped economies the liquidity preference function will have to be generalized to all the income-earning assets which are also a good hedge against inflation.

With underdeveloped bonds and securities markets, there is no the rate of interest in the sense of giving as integrated interest rate structure. The whole structure of interest rates stands at a very high level. Most rates are institutionally determined and inflexible in the downward direction. The differences in interest rates are too wide to be ascribed to liquidity preference alone.

In the unorganised money market, money­lenders make small, poorly-secured loans in which the costs of administration, risk and monopoly (usury) components are much more important than the pure rates of interest. Therefore, the monetary authority finds itself helpless. Its impact is felt only in the organised money market and that too in the post-harvest busy season. On the whole then the real theory of the rate of interest is more relevant than Keynes’s monetary theory.

Looking at the vast potential for development, some may take it that the MEC in less developed countries is high. So the investment-demand must also be high. But the low domestic investment and the shy foreign investment point to the poor investment opportunities. Many factors work to depress the MEC. Widespread uncertainties, shortages, high costs, inflation, limited extent of the market due to low purchasing power of the masses.

The uncertain unpredictable nature of markets arises from the highly variable agricultural production which forms the major source of national income. The uncertainty is accentuated due to fluctuations in export prices. The narrowness of the domestic market for industrial consumer goods does not allow the installation of modern capital-goods producing plants. Hence real investment in plant and equipment is mostly in imported machinery and technicians.

The multiplier accelerator effects are lost to foreign countries. Due to the risky nature of investment, the investment-demand function is extremely interest-inelastic. Not withstanding the low rates of interest at which loans may be offered, we find a conspicuous lack of initiative among entrepreneurs in starting new ventures. Foreign investment is only in export industries. If Keynes is relevant to less developed countries on investment, it is in the overwhelming importance which investment occupies in the programmes for development.

Relevance of Keynes in Development Policies:

Recently some writers have pleaded for a sympathetic consideration of Keynesian ideas in the context of economic development and have felt that “discarding the Keynesian thesis as altogether inoperative in underdeveloped countries is really throwing the baby with the bath water.” Professor K.K. Kurihara has tried to make policy use of what he calls the Keynesian Theory of Economic Development.

In fact, most planners in less-developed countries have made extensive use of Harrod-Domar growth model-a Keynesian construct. Further, much of the anti-inflation policy is Keynesian stuff. There can be only two reasons for this use of Keynesian theory and policy; one, they are somewhat relevant to the position here, or, second there is no alternative, well-founded theory and policy to replace Keynesianism.

There seem to be both these reasons at work. There is some sector or part of the underdeveloped economy where Keynesian assumptions are found quite applicable, for example in the organised sector. In so far as much of government interest and control is in this sector, economic policy tends to be of the Keynesian type. As this sector expands, it affords greater scope for applying Keynesian theory and policy.

Conclusion:

Dr. C.T. Kurien has nicely summed up the whole controversy on the relevance of Keynes to underdeveloped countries. In his opinion, the controversy revolved largely around the Keynesian prescriptions of deficit financing, cheap money policy etc. This amounts to putting the cart before the horse. Rather than first examining the basic premises of Keynes, the methodology he adopted, the kit of tools he used, we jumped to the discussion of the policies based on his theory. He wrote in an important article in the Indian Economic Journal:

“Whether Keynesian economics is applicable to economics like ours is a wrong question to pose, and that the relevance of Keynesian economics to our situation is to be sought in the basic methodology that Keynes used or he was using in arriving at the general theory.”

In his own time, Keynes was faced with a particular situation of depression and underdevelopment equilibrium. He had also before him the logically consistent classical theory which did not fit facts. He, therefore, questioned classical assumptions and went on to build his own theory, his own system which could nicely explain the facts of his time and his country. Likewise, the situation in underdeveloped countries is different. It is unjust to criticize Keynes’ theory and policy as irrelevant. Let the economists of these countries build their economics, their own theoretical system which explains facts here better. Let them meet the challenge as Keynes did.