Why the Modi govt should pick Friedman over Keynes and cut its expenditure

Taking Friedman's advice can help improve the govt's finances and then it can return to Keynes again

Ever since the first quarter GDP numbers came out saying it had grown by only five percent, everyone — particularly economists with little or no knowledge of past theories — have been shooting from the hip. They have all blamed lowered consumption as the main reason. 

In some extreme cases the criticism has been coloured by political preferences. If someone disapproves of the BJP’s political agenda, its economics has also been criticised. The same thing has been true of Mr Modi personally, too. 

The reverse has also been true. An approval of the BJP’s political agenda and an adulation of Mr Modi has made this group overlook several major policy mistakes and glaring incompetence. 

All this has been magnified by the ignorance of both the critics and admirers of two basic theories of consumption. Both need to kept in mind. One was enunciated by John Maynard Keynes in the latter half the 1930s as part of his explanation for the Great Depression and what to do about it. Keynes, for those who don’t know, was an English economist. The other was enunciated by Milton Friedman in the latter half of the 1950s. Friedman was an American economist. 

Keynes thought it was the duty of governments to enhance consumer purchasing power during a downturn. Friedman thought the opposite. 

Both gave very cogent reasons for their analysis of consumer behaviour. But Keynes’ theories were more attractive to politicians. They ignored Friedman. 

 

Keynes’ called his concept the ‘marginal propensity to consume’. It said - after a lot of economic huffing and puffing - that sometimes it was necessary, in order to boost consumption, to hand over money to consumers because investment alone would not do the trick. 

Productivity did not enter the picture. Our entire bureaucracy has been the biggest beneficiary of this theory. 

Friedman called his theory the ‘Permanent Income Hypothesis.’ It said consumers have a reasonably good idea of how much they will earn over their working lives and therefore adjust consumption accordingly. 

Like Keynes, Friedman also used a lot of economic mumbo-jumbo to explain his theory. The implication was that any effort towards income smoothening by the government would be offset by consumption smoothening by the consumer.

In the event, for the want of enough data, neither theory was put fully to empirical testing. But, as I said above, the Keynes option was more attractive to politicians. In recent years NGOs and economists-turned-columnists have also advocated it.

Why is this important in today’s indian context? Because, while the Keynesian solution is predicated on a government that can tax and spend, the Modi government is not in that position at all. 

Nor, arguably, was the UPA when it tried to reverse the slowdown of 1997-2004. But it went ahead anyway and bankrupted the government and impoverished the consumer via the high inflation it generated. 

Hence, for whatever its worth, and even if it’s counter-intuitive, here’s my advice to government: be patient, cut expenditure. You have four and a half years to reap the benefits. Expenditure cuts will improve everyone’s finances and consumer demand will return on a more sustainable footing. Once your finances improve you can become Keynesian again. 

Until then pay heed to Friedman because his theory explains the indian consumer’s today predicament better than any other.
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