The late James Buchanan successfully punctured the innocent belief that governments seek to dispassionately promote the public interest. He showed that politicians tend to pursue policies that promote the private interests of the groups they represent.
Buchanan, who died on 9 January, was a constitutionalist. He paid more attention to the rules of the game rather than individual policies that emerge from the inevitable compromises of everyday politics. Economists usually do not give much importance to such rules of the game, though how individual choices are made is crucially dependent on the incentives created by these rules.
The problem has deep roots. Buchanan once said that economists introduce their subject matter by referring to Robinson Crusoe, who has to allocate scarce resources among competing uses. This is the core concern of modern economics. Then the choices of the lone man on an island are transferred to the study of the economic choices of society as a whole, despite the fact that the way individual choice in any society is not made independently of the choices of other individuals. That is where rules come in, because they affect interactions in a social setting.
“The same individuals, with the same motivations and capacities, will interact to generate quite different aggregate outcomes under differing sets of rules, with quite different implications for the well-being of every participant,” Buchanan wrote in The Constitutional Imperative, which he co-wrote with Geoffrey Brennan.
The debate between the importance of rules and discretion in economic policy is an old one. Indian economic policy has been dominated by discretion rather than rules. It has not been constitutional in the Buchaninite sense of the word. Too much has been bet on the good sense or the technical ability of administrators to efficiently, ceaselessly tweak policy. Such discretion is particularly damaging when it is handed over to an irresponsible political system.
The constituent assembly that debated the political constitution did not seem to have given too much thought to the economic rules of the game. It did empower Parliament to impose limits on government borrowing. It set up the Finance Commission that till today gives a formula on how tax revenues are to be shared by different levels of government. But the thrust of the debates seem to have been on economic outcomes rather than the rules that would bring us closer to those outcomes.
There have been a few other attempts at imposing rules on policymakers. The landmark Fiscal Responsibility and Budget Management Act of 2003 essentially meant that Parliament was using its powers to impose limits on government fiscal policy. Being part of the World Trade Organization automatically forces the Indian government to respect global trade policy rules.
Another example: The terms of reference of the 14th Finance Commission headed by former Reserve Bank of India (RBI) governor Y.V. Reddy has an interesting item: “The need for insulating the pricing of public utility services like drinking water, irrigation, power and public transport from policy fluctuations through statutory provisions.” This was pointed out in an email by R. Srinivasan of the department of econometrics at Madras University.
But discretionary policies have been far more important through the decades. The Indian central bank has generally argued against either a formal inflation target or a money supply rule or an interest rate rule such as that devised by John Taylor. Fiscal policy has also been run by the whims of the government of the day. Some of the most malign policies in the planning era—the introduction of ad hoc treasury bills that automatically monetized the budget deficit or the bizarre web of import controls that came up after the foreign exchange crisis of 1957—were a classic case of discretion run wild.
Some amount of discretion is needed in a volatile world. A policy regime based exclusively on rules would be unnecessarily rigid, as the world discovered during the gold standard. But the other extreme is not very welcome either, since it puts too much trust in either the honesty or the knowledge of policymakers.
So here is a question: Does India need an economic constitution? It need not be a single document, but a set of laws that impose clear guidelines on what governments can or cannot do? It will not only discipline the government but also add to the credibility of policy.
Of course, all this assumes that the government will play by the rules of the game. It will respect the rule of the law. One should not take that for granted in these times. The move to tax on a retrospective basis—which this government is trying—is a classic case of contempt for the rule of the law. It is precisely such actions that Buchanan warned us about and the main reason why we need to pay attention to his wise advice on constitutional rules.
Niranjan Rajadhyaksha is executive editor of Mint. Comments are welcome at email@example.com. To read Niranjan Rajadhyaksha’s previous columns go to www.livemint.com/cafeeconomics-