The debate on economic planning often ends up with people in two opposite corners — those that believe in government-led central economic planning in one corner versus those that believe in relying completely on market signals in the other opposite corner. The reality is that neither corner is a desirable place. Government economic planning has a difficult time picking winners and avoiding being hijacked by powerful interests while market signals have just as often proven to be unreliable as shown, for example, by the recent 2008-09 global financial crises. This note contends that the best form of economic planning avoids either extreme corner.
Economic planning has been considered important in India at least ever since independence. We have had a number of five year plans over the last sixty plus years. India has made remarkable progress in this period with especially rapid progress since the deregulatory moves of the early 1990s. Nevertheless, the role played by economic planning can be and is being vigorously debated in India. Indeed, national industrial policy remains controversial globally.
Even in corporations and other organizations, where strategic and operational planning is widely adopted, smart executives recognize the limitations of such exercises. While planning allows an organization to prepare its responses to events and environmental changes, it limits flexibility and nimbleness – two qualities that become critical in environments that change rapidly. Business planning seems to work best in a static or slow moving environment. It seems the same may be true for nations.
The year 1989 seems to have been a turning point for economic planning. That year saw the break-up of the Berlin Wall, a symbolic affirmation of the fall of communism.1 It was also the year the remarkable growth of the Japanese economy peaked. The communist countries and Japan were both known to have built their considerable economic successes with heavy reliance on national economic planning and industrial policy (Aggarwal, 1999a). After 1989 most of these centrally planned countries started converting their economies to rely much more on market signals to guide economic growth. Similarly, other countries that already had market-based economies started down a similar path with a strong focus on de-regulation. Interestingly, this global move towards less reliance on national economic planning and regulation lasted for about two decades until the developed country financial crises of 2008-09. Over-reliance on free markets and too little regulation seems to have played a major role in this recent set of crises and the resulting recession, reminding us again of the need for light but appropriate regulation.
So, we are now at a cross-road in terms of national economic planning. What is the best mix of reliance on market signals and government regulation going forward? While the answers will undoubtedly change over time and be somewhat different for each country, and reasonable people can and will disagree on exact details, it would be useful to frame the debate with some general principles. This brief note is an attempt to provide the essentials of such a framework.
A few caveats are in order. This paper is not a comprehensive statement or analysis of economic development — a topic still not well-understood. Neither is this paper intended to be a rigorous analysis of economic planning. It represents somewhat of a personal view of economic planning and it includes somewhat simplified statements that are nevertheless directionally correct and appropriate. It is not a review of the voluminous economic planning literature as that has been covered elsewhere (e.g., Rostow, 1990).
The Environment for National Economic Planning
Limits of the Corner Solutions: Economic planning can fail because of many reasons. First, it may be impossible to anticipate important trends, inflexion points, and other changes. Central economic planning often places an undue burden of providing appropriate and timely information about consumption patterns to production organizations. As noted by many conservative economists like Hayek and von Mises, this is often impossible and seems to have been a major reason for the failure of the Soviet economic system. A second reason for the failure of central economic planning is the need to own or control the means of production to ensure that appropriate plans are carried out. However, the lack of private ownership or control makes it difficult to motivate workers to produce appropriate products efficiently (e.g., a collectively owned sick cow may die while a similar privately owned one may survive as the owner is more likely to take care of the cow in an all night session if necessary). A market based economy can overcome these and other limitations of central economic planning.
However, market signals are not perfect either. Markets can be inefficient and subject to bubbles. These imperfections can result from a number of possible factors. First, markets need reliable public information to function; but such information may be too costly to produce or be unlikely to be produced by private entities. Second, market participants may not behave rationally — numerous behavioral biases among market participants have been extensive documented. Third, price discrepancies in markets need to be arbitraged away efficiently but such arbitrage may be limited not only by information costs, but also by lack of capital, ability to assess or take on risks, or limited access to arbitrage opportunities. Fourth, many production processes often cannot respond instantly to new demand and this necessary delay may induce cyclical variations and instability in market responses. Finally, there are many market externalities that may limit the social value of market signals (Aggarwal, 2004). Many economic actions depend on free or underpriced resources in the “commons” and many economic actions benefit a wider set of agents than the one that bears the cost of such action. In such cases of market externalities, market signals based economic actions are usually inefficient and/or impractical.
Thus, it seems that both the extremes of central economic planning and complete reliance on market signals for economic guidance are imperfect and have many flaws and limitations; and neither extreme is an appropriate approach to national economic planning. Next we examine some additional factors that are useful in thinking about the middle way of economic planning.
Indian Environment for Economic Planning: There are numerous arguments that have been advanced to support economic planning. It should be noted that it is very difficult for any government (or even private) organization to pick industries and sectors that are winners or even those that are likely to succeed in the future. Nevertheless, based on market externalities, among the arguments put forward for economic planning in India are the following:
First, while India in the past was a wealthy country (even as late as the 18th and early 19th centuries India produced approximately 25% of the then global economy), in 1950 India was a poor country accounting for roughly two percent of global GDP. Since then while our economy has grown considerably to perhaps the fourth or fifth largest economy in the world (in purchasing power terms), on a per capita basis India is still a predominantly rural and poor country (e.g., Aggarwal, 2010). We are also a democracy and the poor in India know how to use their considerable voting power. Thus, adequate benefits of national economic growth must flow to the rural majorities. This may not happen automatically in an economy driven solely by market signals. There are many reasons for this type of market failure. For example, poor people are often uninformed consumers and often lack enforceable property rights (DeSoto, 2000). In addition, technological progress seems to increase economic inequality. Governments and economic planners may have a role in ensuring resource flow and encouraging businesses to serve the poor and those at the bottom of the pyramid (Prahalad, 2005).
Second, many hostile nations and forces surround India and some resources must be dedicated to national defense – another activity that cannot be driven by market forces. Economic planning and fiscal policy needs to ensure adequate resource flows to defense.
Third, the Indian government like other governments all over the world may want to provide subsidies and other support for high risk business activities that have social benefits – benefits that go beyond private benefits (Rajan and Zingales, 2004). Protection of “infant” industries is an example of this goal. Another example of this argument is the expressed need for governments to support basic research and technical activity that can be critical in economic development.2
Fourth, it is the role of the government to provide a level playing field for businesses limiting excessive market power through anti-monopoly legislation and regulation (Olson, 1982). These anti-monopoly measures need to account correctly for market size and for the global or local nature of the market for a given product or service. Another aspect of providing a level playing field that the government must provide for the uniform disclosure of reliable and audited financial statements.
Fifth, human capital is not infinitely available, tradable, or moveable and takes time to develop and deploy. The government must often provide subsidies and plans to encourage the efficient development and deployment of human capital (Aggarwal and Agmon, 1990). India faces a particularly significant demographic challenge in this regard as its population entering the job market is projected to be one of the largest in the world over the next few decades. While a country’s educational system influences its level and quality of human capital, the efficient deployment of human capital is much more complex, depending on gender policies, and other political, cultural, and social labor market rigidities. The importance of improving educational systems and of reducing such labor market rigidities is critically important in this information age.
Sixth, the government and economic planners must often take the lead in providing basic infrastructure such as transportation systems, power grids, and communication lines. The Indian government is finally focused on making major efforts in this area.
Role of Late Industrialization: Late industrialization has some advantages when a country develops economically and technologically later than some other countries. Such a late developing country can possibly learn from the experiences of the more advanced countries and avoid some of the pitfalls that may be suffered by the pioneering country. As pioneers, the leading economies often have to try various measures and developmental approaches not all of which work out (Aggarwal, 1999c). Nevertheless, some of these lessons may not apply to another country or may not be transferable. In any case, in developing national economic plans, it is often useful to study the experiences of other economies that have undergone similar challenges a few years or decades earlier. However, any such lessons of late industrialization are being rapidly made obsolete by rapid advances in technology and globalization.
Fortunately, there is a new twist to old advantages of late industrialization — countries can now skip some steps in the process of economic growth. Newly developed countries can leapfrog many intermediate technologies. For example, many countries have very successfully skipped the development of land lines and gone straight to wireless telephony. Now there may be opportunities in skipping the
development of centralized generation of electric power since distributed power generation (such as solar, wind, geothermal, etc) may become more economic in future. There may be similar opportunities in other areas too. It is important that economic planning and regulation encourage technological leapfrogging wherever possible.
Technology: It has been contended that we now live in a transformational age as we have been moving from the industrial age to the information age (moving from the age of the atom to the electron and the photon). The age of hulking industrial machines is being replaced by the age of small and svelte information appliances (such as computers, cell phones, and other objects with embedded intelligence).3 Aggregate consumption is getting lighter and more tradable as the proportions of heavy consumer products with mechanical components are declining while the proportions of services and lighter products made of plastics and consisting of photonics and electronics are increasing in every economy. Due to technological progress, much of the new production processes depend on electronic information flows (often over the internet) and the most important wealth producing assets are now intangibles. Another feature of the modern age is that fixed production costs (including the costs of development) are now much more important while variable costs have been declining as a proportion of total costs. This costing development allows much greater flexibility in pricing policies and for innovative corporate strategies especially against less well-heeled competitors. Lastly, in this information age, product life cycles are shrinking and the business environment is much more dynamic.
Economic planning must reflect this increased pace of change and the critical need to upgrade technologies used by domestic firms. Indeed, the traditional factors of production seem to be changing in importance. While still necessary, it is no longer land, labor, and capital that are critical in the production process. The information age processes require little land and labor, and with capital flowing globally with ease, good business ideas can attract the required capital. Instead, in this information age, the critical resources are ideas and entrepreneurship. The economic planning process must ease and encourage the implementation of entrepreneurship and new ideas, and the development and efficient deployment of human capital.4
Globalization: As the speed and ease of cross-border communication increases with technology, consumer tastes, production, and business organizations are all becoming more global. Barriers to trade and investment have been declining for the last half a century and the process accelerated with the move from central economic planning to market based economies in the late 1980s (Friedman, 2005). With the rise of the information age, products are getting lighter and so more cost-effective to move across borders and over long distances. Lastly, globalization is also being driven by the wealth creating effects of international trade and investment.
Finally, globalization makes technology more valuable by providing larger markets and, at the same time, technology facilitates globalization with increased ease of cross border communication and transfers. Thus, this mutually reinforcing process between technology and globalization creates a vortex of ever accelerating economic change (Aggarwal, 1999b). Neither economic organizations nor economic planning can any longer afford to take just national perspectives.
As this brief review indicates, there are many reasons for national economic planning and regulation. However, national economic planning and regulation must also account for the challenges of rapid change brought about by twin mutually reinforcing factors, technology and globalization. Finally, national economic planning and regulation must reflect a middle way between the extremes of central planning and over-reliance on market signals. The next section provides some guidelines to frame that balancing process and come up with that required middle way.
A Framework for National Economic Planning5
A useful way to think about a framework for economic planning that balances between the two extremes noted at the start of this note, is to think about a set of guiding principles. A minimalist framework for national economic planning based on just five principles is presented below. The implementation of these guiding principles/framework will, in many cases, require detailed explanations and implementation guidelines.
One of the first principles is that the nature and usefulness of planning will differ depending on particular conditions. It seems clear that planning is more useful in static or slow moving economies and industries. In environments that are dynamic and changing rapidly, directive planning is less useful and in fact may even be harmful. In such cases, flexibility and nimbleness are more important. One reason why the Japanese and communist strategies for economic growth stopped working may have been the fact that their economies had developed so much that they lost the advantages of late industrialization when a planning can be guided by the successes of the more developed economies. Planners need to assess which environments are fast changing and which ones are slow moving (e.g., the application of technology seems to speed up changes in any industry).
A second principle for government regulation and economic planning is the need to articulate and document the nature of market failure that needs to be addressed (markets are by no means perfect) with a given regulation or subsidy (Schleifer, 2005). This requirement is particularly important in implementing the next principle.
A third principle has to do with the nature of planning or regulation. Two extreme cases are 1) when planning or regulation states what cannot be done, with other actions allowed, or 2) when planning or regulation specifies what can be done, with other actions prohibited. The first, approach is clearly more flexible compared to the second approach. It
is safe to observe that before the reforms of the early 1990s in India the planners emphasized the second approach and Indian economic growth rose dramatically when the planners started emphasizing the first approach after the early 1990s.
A fourth principle of economic planning requires that each regulation should have a sunset provision when enacted. Conditions change and regulations must be re-assessed to see if they are still optimal. This is particularly true for regulations that are designed to protect “infant” industries or to correct another market failure. In most cases, each regulation will develop a set of economic agents that depend on that regulation and will oppose any changes no matter how useful for the country as a whole (Stigler, 1971). No country has just an economy, they are all political economies.
Fifth, instead of regulations prohibiting or allowing certain behavior in response to market failure, in some cases it may be necessary only to ensure greater and appropriate disclosure as a regulatory mechanism (Baumol et al, 2007). Information for markets is like oxygen for humans, and in some cases provision of appropriate and greater information disclosure may allow a market imperfection to decline or disappear, obviating the need for more extensive regulation of business activity.
It should be noted here that these five principles form a minimalist framework and should be considered to be the core to guide thinking on economic planning. Indeed, as indicated earlier, the implementation of these guiding principles/framework will, in many cases, require detailed explanations and implementation.
Neither the extreme of central economic planning nor the other extreme of reliance on market signals alone are appropriate approaches to national economic planning. Complete reliance on central planning or on market forces are each inadequate and fraught with serious limitations. Economic planning must find a workable middle way to encourage and support conditions that enhance economic growth. This note provides a pragmatic and balanced framework of five principles to guide thinking about national economic planning.
1 Serious fascination with communism and socialistic central economic planning started with the Congress of Europe in 1889 and so it seems that it lasted exactly a century.
2 China seems to be very successful in encouraging the import and adoption of foreign technology by Chinese firms.
3 In 1957, I was the proud owner of a new Japanese radio with one transistor that was much lighter than the existing tube radios. Half a century later it is contended that a modern well-connected person in 2010 owns and operates products with more transistors than he or she has neurons in their brains (Fortune, 6th September 2010, p. 64).
4 As has been noted earlier, a well-educated internet connected individual located anywhere can be a formidable global competitor.
5 The thoughts in this section are partially based on my experiences in training emerging market regulators at the US Securities and Exchange Commission in the early 1990s just after the Berlin Wall fell and many formerly centrally planned economies were starting to develop capital markets.
Aggarwal, Raj, (2010)," Indian Integration with the World Economy: Important Role of M&A and Corporate Restructuring” Review of Market Integration (Winter): Forthcoming.
Aggarwal, Raj, (2004),"Puzzles in International Economics and Finance: Central Bank of Ireland Edgeworth Keynote Lecture” Economic and Social Review 35 (No. 1, Winter): 241-250.
Aggarwal, Raj, (1999a), Restructuring Japanese Business for Growth (Boston: Kluwer Academic, 1999):
Aggarwal, Raj, (1999b), "Technology and Globalization as Mutual Reinforcers in Business: Reorienting Strategic Thinking for the New Millennium" Management International Review 39 (Special Issue No. 2): 83-104.
Aggarwal, Raj, (1999c),"Nature of the Asian Economic Crises: Role of Positive Feedback Cycles" Journal of World Business 34 (No. 4, Fall): 392-408.
Aggarwal, Raj, (1990), "Technology Transfer and Economic Growth: A Historical Perspective on Current Developments" in T. Agmon and M. Von Glinow, (eds.), Technology Transfer in International Business (New York: Oxford University Press): 56-76.
Aggarwal, Raj and Tamir Agmon, (1990), "The International Success of Developing Country Firms: Role of Government-Directed Comparative Advantage" Management International Review 30 (No. 2): 163-180.
Baumol, William J., Robert J. Litan, and Carl J. Schramm, (2007), Good Capitalism, Bad Capitalism and the Economics of Growth and Prosperity (Yale University Press).
De Soto, Hernando, (2000), The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books).
Friedman, Thomas L. (2005), The World is Flat (Farrar, Straus, and Giroux).
Olson, M. (1982), The rise and decline of nations. (New Haven, CT: Yale University Press).
Prahalad, C.K. (2005), The Fortune at the Bottom of the Pyramid (Wharton School Publishing).
Rajan, R. G. and L. Zingales (2004), Saving Capitalism from the Capitalists (Princeton University Press).
Rostow W.W., (1990), Theorists of Economic Growth from David Hume to the Present, (London: Oxford University Press).
Shleifer, Andrei, (2005), “Understanding Regulation,” European Financial Management, 11 (No. 4), 439–451
Stigler, G. J. (1971), ‘The theory of economic regulation’, Bell Journal of Economics, 2, pp. 3–21.
(The views expressed in the write-up are personal and do not re?ect the official policy or position of the organization.
The author is grateful to D. Haake, J. Goodell and his other colleagues for useful comments but remains solely responsible for the content.)