#43 The China Question + Dispelling The Many Myths Of Our Readers Part #2

Everything you always wanted to know about the economy* (*but were afraid to ask)

This newsletter is really a public policy thought-letter. While excellent newsletters on specific themes within public policy already exist, this thought-letter is about frameworks, mental models, and key ideas that will hopefully help you think about any public policy problem in imaginative ways. It seeks to answer just one question: how do I think about a particular public policy problem/solution?

Welcome to the mid-week edition in which we write essays on a public policy theme. The usual public policy review comes out on weekends.

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We received many new queries from our readers after our last gyaan session with Prof Arthananda Ilyich Smith-Hayek (AISH). This wasn’t a surprise. People have a lot of time on their hands these days. When the clock is counting down the 30 seconds between episodes 3 and 4 of Snowpiercer on Netflix, they settle in for deep contemplation about the business of life. That’s when they come up with the kind of questions they have sent us. Soon, episode 4 starts, Nikki is murdered (happy belated spoiler alert to you) and life goes on.

A Word on the Conflict at the LAC

But before we get into them, there’s the other set of questions about India-China conflict at LAC in Ladakh. There’s dearth of information about the on-the-ground situation. There’s not a lot that you can take away from the official positions of both sides. The situation has escalated and India’s official statement yesterday suggested China had intruded into its territory.

We have written about the post-pandemic world order and two-level games in previous editions that partly explains the timing of this conflict. There are conjectures by talking heads all over but with such sketchy details we don’t have any framework on offer to understand this now.

Instead, we have these 5 questions.

Q1: Why is China flexing its muscles across so many fronts – Hong Kong, South China Sea, Vietnam, Philippines, India?

A1: Because it can, and it believes it can get away with it now. This is the privilege of the strong.

Q2: Why is it doing now? Everything that India has been doing on its side of LAC was going on for years.

A2: Because it must. Merely getting away with something isn’t the reason why a country will act on it. The timing is determined by its compulsions.   

Q3: Why is it a must?

A3: This is where conjectures start. Distracting its people’s attention away from oncoming economic hardships, domestic political compulsions, regional assertion and showing India its place, global hegemonic ambitions, responding to a provocation or a combination of all of these – who knows?

Q4: How is this likely to play out now?

A4: At the tactical level, this might escalate a bit but is likely to settle down thereafter. The reason being that both sides are trying to downplay the opposite side's role in the fight in their statements and conduct.

At the strategic level though, China has alienated India and Indians for a long, long time. India’s answers to questions on Huawei's 5G, BRI, relationship with US-Australia-Japan-Taiwan, Indian Ocean presence, have all become clearer than before. Because this is a game of relative power, these countries are more likely to come together now despite their differing interests.

On the other hand, the risk is that GoI might choose to increase protectionism in the false belief that India can hurt China in the economic domain through tariffs.

Q5: What should we do?

A5: The PLA has encroached into our territory and insists it is theirs. That’s why the dispute. Generally, such disputes are resolved by an equivalent tactical action from the Indian side but this time maybe we waited for too long, perhaps for a decision to filter down from the top. It is difficult to push the Chinese back now from where they are. China has used this fait accompli strategy with many of its neighbours.

Our best bet is to use a combination of diplomatic, political, and military instruments to seek ex ante status on either side of LAC. Lt Gen Prakash Menon, a decorated officer, who has years of experience commanding forces on the LAC, has this advice in ThePrint:

The Narendra Modi government must take a political stand and stop underplaying the issue. Such a stand must be founded in the trust that the Indian military is not a pushover and can match the Chinese in escalation, which must necessarily be backed by political will. India must remind itself that military capability and valor cannot be a substitute for defective policy. China is a bully and when viewed in the larger global context, India must base its risk calculations on relative power and not get taken in by its absolute power. China has enough trouble of its own, and India has the capacity to weaken its capability for its primary problems in Taiwan and South China Sea. The main point is that the playbook is a mind game.

In the medium-term, we must pursue an Indo-Pacific alliance with countries like Vietnam, Indonesia, Philippines, Australia and Japan that have a common interest in keeping a rising and coercive China in check and that can act in tandem during a face-off with China. India needs to invest in what we call an Aggressive China Insurance Policy. The motive of this policy is simple: should PRC get aggressive with India, India should have readily available capacity to inflict significant pain to China in return. The insurance “premium” for this policy includes a variety of measures:

1. Establish contacts with the key members of the World Uyghur Congress and other such organisations.

2. Shift the focus of “Act East/Look East” to one country — Vietnam.

3. Offer Trump deals that can deepen the US-India engagement.

4. Sponsor studies that puncture the “Chinese Leaders Do No Wrong” narrative.

We have been caught off guard multiple times and it is necessary to improve our border surveillance infrastructure and intelligence. The lessons from Kargil haven’t been fully learnt. And the 21 years since Kargil have been split equally between UPA and NDA. Blaming army, past governments and Nehru will only help save face with the base. Nothing more.

Lastly, there’s only matsyanyaya in international relations. The long-term solution is economic growth and prosperity that translates to geopolitical and geoeconomic strengths. That’s how China got here in the first place.

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Back to readers’ queries

Q1: Professor, I’m an engineer so I know everything. My question is why do people study economics? That Hindi proverb – jitni munh, utni baatein – was coined keeping economists in mind. Everyone has a theory, and no one agrees with the other. And I’d trust the Bangalore Mirror horoscope column for predictions than any economist. They couldn’t predict 2008 financial crisis. Now, not one of them can say what will be our GDP growth this year. What’s the point of such a subject? Why shouldn’t they all learn Python, work at the Wells Fargo development centre (good adrak chai) and be useful to the society?

Your etc

Anjaneyar Sethuraman (bridge builder)

Prof AISH: Why, indeed? You’ve touched a raw nerve there. During moments of existential crisis, I ask the same question.

Let’s get the dismal science accusation out of the way first. This term is used to deride economics as a field of study that makes dire predictions and debases everything by putting a price on them. It was coined by historian Thomas Carlyle but for a specific reason. Carlyle, and others like him, were opposing the views of the utilitarian philosopher John Stuart Mill on the question of slavery. Mill, drawing upon works of Adam Smith, argued in favour of equality of men. His view was differences in character and social position among people can be attributed to legacy, opportunity and luck instead of race or ethnicity. The economists believed deep down all humans are equal. They respond to incentives which forms the basis of economics as a discipline. So, dismal science is more a badge of honour for economists than an insult.

Alfred Marshall, whose Principles of Economics was the standard textbook for almost a century, gave the simplest definition of economics – it is the study of mankind in the ordinary business of life.

Two problems emerge from here.

First, how do you study mankind (or humankind)? Do you study her intent or her actions? This is the old mind-body dualism problem in philosophy. Human intent changes over time and it is difficult to decipher real intent. Economists, therefore, study human actions which is the material manifestation of intent. They are interested in both the seen and the unseen effects of those actions. Human actions though could go against the grain of their intentions. This is where trouble starts.

Let’s take an example. We all know hoarding things during an emergency has bad outcome for the society. Economics can prove it. Yet, we all hoarded Maggi, Parle-G and toilet paper during the lockdown. An economist would study previous human actions and suggest methods to prevent hoarding. One of them could be to price the first unit of Maggi at normal price but increase the price of buying the second unit to 10x of normal price. This would be good solution for the society overall but to our mind it would appear Maggi profiting in our time of misery. Economics can appear non-intuitive or amoral on the surface. The bad reputation follows.

Second, what’s ordinary business of life? Economic models are based on assumptions – rational human being, ceteris paribus, normal course of events – but we know these assumptions don’t hold every time. In fact, the whole field of behavioural economics has evolved by questioning the rational actor assumption. Economics gets questioned in a crisis when we aren’t in the ordinary business of life. That’s a tad unfair. The basic models of economics aren’t there to explain every intricacy of human behaviour in extreme situations. They are useful and accurate tools to understand it at a generic level.

Economics is not the only field of science that has this problem. Take physics. Now, we know the world doesn’t operate on Newtonian laws of motion. Quantum field theory explains the universe better. But for all of us leading our everyday lives, Newtonian laws work quite well to explain our world. The difference is with economics we can see the assumptions failing while in physics the assumptions break down at sub-atomic levels.

Now, coming to the charge that economists couldn’t save the world from the 2008 financial crisis. Fair enough. But neither were epidemiologists able to save us from COVID-19 nor have medical scientists found a vaccine yet. Our response to this hasn’t been to say that epidemiology and medical science are useless. In fact, the focus is on increasing funding to solve more puzzles in these disciplines. So is the case with economics — a lot remains to be studied about individual and group behaviour driven by incentives.

There’s something to that old joke about one-handed economists. It is difficult to predict human behaviour correctly everytime. So, the economists prefer giving scenarios based on underlying assumptions. This is where the differences emerge among them. They don’t differ over the fundamentals of the science. They differ on which assumptions about human behaviour in future will hold true. Economists divide themselves into camps based on this. To draw an analogy with physics again, it is like the string theory versus quantum loop gravity or Copenhagen versus MWI camps.

Economists do get a lot of predictions right and they learn from previous failures. It is a rigorous science that helps policymakers choose the most optimal option based on trade-offs and projected outcomes. Economics plays a key role in anticipating the unintended (and the intended). It is the bedrock of public policy like mathematics is that of engineering. You could argue both the bedrocks are weak for their practitioners in India. But you can’t dispute its utility.

Q2: Professor, I read on Whatsapp that in 1947, 1 dollar was equivalent to 3 rupees. In 2020, it’s equivalent to 76 rupees. We have become 25 times poorer. Why could we not continue with the 1947 rates? iPhones would have then cost us Rs. 500 only?

Your etc

Rashi Badhkar (money grower)

Prof AISH: Dear Rashi, I’m afraid I will have to bore you with some history of non-Whatsapp variety now. At the end of WW2, many western countries came together at Bretton Woods to agree to a global currency framework. This was called the gold exchange standard. The US was to maintain the price of gold fixed at $35 per ounce and it would exchange dollars for gold to other countries without any constraints. US dollar became the reserve currency of the world and other currencies were valued directly in relation to it and indirectly to gold. The countries were allowed a leeway of 1 per cent for the currency to fluctuate around the par value.

India at the time of independence joined this system. The rupee’s value was linked to the pound sterling which was then pegged to the value of gold. In 1949, 1 pound was equivalent to Rs 13.3. This translated to 1 dollar = Rs. 4.76.

In the 50s and 60s, the Indian state went about rebuilding our economy. The five-year plans focused on building dams, industries, infrastructure and agriculture. We had to be self-reliant. But all this cost money. The British had left us with very little. The people were poor and banking hadn’t reached beyond big cities. Our national savings were meagre. Since we didn’t trust private capital, the government had to borrow money from abroad to fund nation-building efforts. The wars of 1962 and 1965 and the failure of monsoon in 1965-66 meant we ran up huge fiscal deficit. We couldn’t service our debt obligation and we had to devalue the Rupee. This led to 1 dollar = Rs. 7.5   

By 1973, the Bretton Woods system collapsed (another story for another day). The oil crisis of 1973 when the OPEC cartelised to cut the production of oil and increased its price hurt shocked the global economy. The Indian economy was hurt too. The subsequent years of political instability and low growth meant we pegged Rupee to a basket of currencies instead of the Pound, and it kept sliding further. By the mid 80s, 1 dollar = Rs. 12.3.

In 1991, India had a Balance of Payment crisis where we were struggling to meet our debt obligations and pay for our imports. The reasons were the collapse of our biggest exporting partner Soviet Union, rise in crude oil prices because of the Gulf War, and our weak economy. We were at risk of a sovereign default. On July 1, we devalued Rupee by 9 per cent and followed it by another 11 per cent on July 3. By now, 1 dollar = Rs. 24.5.

In March 1993, we moved our currency to a managed floating rate model where the market-determined the value of the rupee within a certain range managed by the central bank. Over the years, the Rupee continued depreciating and trades at 76 to a dollar today.

This doesn’t mean we have become 25 times poorer. There are four reasons why any currency is devalued.

• Managing Sovereign debt: Like in India’s case in the 60s, the sovereign debt burden can force a country to devalue its currency. If the payments to foreign lenders are fixed, a devaluation means the burden of debt reduces. This would lead to other problems of increasing costs of imports and making payment of bonds issued in the foreign currency more expensive, but the country avoids a sovereign default

• Helping exports: An economy that has a small domestic market will look to grow through exports. It would help if its currency is valued low to make its exports competitive in global markets. Also, a lower-valued currency increases the profits for the exporters and helps them make investments to build more capacity or to innovate. A devalued currency increases the import costs and makes domestic products cheaper in comparison. This helps the domestic industry too. There are limits to this model since others could devalue their currency too.

• Managing the balance of payment: Higher exports and lower imports help reduce the trade deficit. By itself, trade deficit isn’t a problem but in the event of any economic shock, a big deficit can be difficult to serve.

• Relative strength of dollar: The dollar is seen as a safe haven in times of distress. Investors flock to it because it is the reserve currency of the world. That apart, the fiscal and monetary stimulus that followed GFC in 2009 took too long to unwind (for India). Inflation went out of control and we had to harden interest rates. Growth suffered and the Rupee weakened during this phase.

On the balance, we have not become poorer since independence. Since the first wave of liberalisation and the big Rupee devaluation in 1991, we have become more competitive in global markets. Over 200 million people have moved out of poverty in the last 30 years even as Rupee has depreciated by 3X compared to the dollar.

On the other hand, the rupee’s close linkage to the pound in the pre-independence era hurt India enormously as that made exports from India costlier and imports from Britain cheaper. In fact, a lot of the Swadeshi economic nationalism at that time was about devaluing the rupee!

At the cusp of the 1991 economic reforms, precisely this point was explained by the then Finance Minister Manmohan Singh thus:

Let me say that in this country there seems to be a strange conspiracy between the extreme left and extreme right that there is something immoral or dishonourable about changing the exchange rate. But that is not the tradition. If you look at the whole history of India’s independence struggle before 1947 all our national leaders were fighting against the British against keeping the exchange rate of the Rupee unduly high. Why did the British keep the exchange rate of the Rupee unduly high? It was because they wanted this country to remain backward and they did not want this country to industrialise. They wanted the country to be an exporter of primary products against which all Indian economists protested. If you look at Indian history right from 1900 onwards to 1947, this was a recurrent plea of all Indian economists—not to have an exchange rate which is so high that Indian cannot export, that India cannot industrialise. But I am really surprised that something which is meant to increase the country’s exports and encourage its industrialisation is now considered as something anti-national.

If this is the case, why are exchange rates thought of as indicators of economic health and well-being even today? That’s only because a declining exchange is used to tell a story of decline — an intuitively powerful and evocative narrative arc. Stories of decline want us to believe that the world was much better in the past than what it is today.

In this narrative, an overvalued currency correlates with a stronger economy. Regardless of the fact that the overvalued currency was disastrous for exports from India, the story of decline wants us to believe otherwise. Just another case of how numbers can work up magic in public policy. Under the garb of indicating accuracy, they are essentially ambiguous, leaving room for political struggles.

So remember, the rupee’s strength alone isn’t an accurate indicator of our economic performance or of our national pride.

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HomeWork

Reading and listening recommendations on public policy matters

1. [Article] A short history of Gold Standard by Michael D. Boro at one of my favourite sites - The Library of Economy and Liberty

2. [Article] C. Raja Mohan in The Indian Express on what’s driving China’s recent aggression

3. [Article] A summary of John Stuart Mill’s views - ‘On Liberty and Freedom of Character and Action’ that prompted the ‘dismal science’ jibe from Carlyle

4. [Paper] Fait Accompli — grabbing lands instead of coercing and threatening is not as uncommon as you would think. Dan Altman finds that ‘from 1918 to 2016, 112 land grabs seized territory by fait accompli. In that same span, only thirteen publicly declared coercive threats elicited cessions of territory.’ We should have known better.

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