The ‘impossible trinity’ choices India will need to make

Economics shares with religions a fascination for trinities, though more as impossible choices of policy than as objects of worship. They’re sometimes called trilemmas. Here are, well, three examples.

The first example: The most famous trilemma in economics is undoubtedly the one proposed by Robert Mundell and John Fleming in the 1960s. The two economists showed in their stellar work on open economies that a country cannot simultaneously have an open capital account, a flexible exchange rate and an independent monetary policy. It has two choose two of these three policy goals at any one point of time. The Reserve Bank of India has grappled with this trilemma for much of the past 25 years, especially how to balance its monetary policy goals with managing the external value of the rupee. The Mundell-Fleming trilemma is based on sound theory, but others have used the idea of an impossible choice to make more general points.

The second example: Dani Rodrik proposed a triangular paradox of globalization in a book published in 2011. The three sides of his triangle had political economy variables. Rodrik argued that it is not possible to maintain national sovereignty, economic globalization and democracy simultaneously. One of the three goals has to be abandoned in a quest for the other two. Rodrik argued that democracies should not abandon their national priorities to meet the demands of the global trading system.

The third example: Pramit Bhattacharya wrote a few years ago in this newspaper about an impossible trinity of Indian fiscal policy that the second Manmohan Singh government was grappling with. It is not possible to keep farm-support prices high, retail food prices low and overall inflation under control. The United Progressive Alliance lost control of inflation in its bid to raise procurement prices for farmers while keeping retail food prices low. The National Democratic Alliance has chosen to be very conservative about increasing farm support prices in a bid to put a lid on retail food prices as well as overall inflation.

The idea of all such impossible trinities is to show that all economic policy involves a complicated balancing act. There are few simple choices. In a similar vein, here is another impossible trinity to think about in our current era of rising trade frictions. No country can simultaneously have trade protection, competition in its domestic market and manufacturing at a global scale.

That leaves a country with three distinct choices. First, it can choose to abandon protectionism to attain both global manufacturing scale as well as a competitive domestic market. Second, it can protect its domestic market as well as keep it competitive, but only by abandoning its quest for scale in manufacturing. Third, it can protect its domestic market as well as achieve global manufacturing scale, but only at the cost of letting oligopolists destroy local competition.

The idea is explained best by examining the Indian development path. India had one of the most protected economies in the world before the 1991 reforms. A small protected economy is always exposed to the risk of dominance by a few businesses that are large enough to dominate the domestic market. The stringent industrial licensing policy further restricted entry into any market by new players.

Such industrial concentration became a lightning rod for popular ire as early as the mid-1960s. The result was a series of policy actions—the Monopolies and Trade Restrictive Practices Act being the most important—that sought to put limits on industrial size. The result was manufacturing units of sub-optimal size and wildly diversified business groups. Except for a few significant examples, lack of size is a persistent problem in the Indian industrial sector.

The alternative would have been a few large business groups getting a tight grip on the Indian economy. Domestic competition would have been even less than it was. Many Asian countries also had dominant business groups during these years—the Korean chaebol are among the best known in this category—but their domestic economic heft was tempered by relatively lower trade barriers. Integration into the larger global economy at the very least forced Asian conglomerates to be competitive. India embraced that model in 1991, by abandoning protectionism to re-integrate itself with the global economy.

The world is at a turning point right now, and protectionist sentiment is growing. The geopolitical need to contain China is also a valid concern. India is also showing signs of moving towards a limited form of protectionism, though not as severe as what we saw in the 1970s. The economic case for global economic integration is a powerful one, and some of the arguments about why India should be a trading nation were mentioned in a joint article in this newspaper by Vijay Kelkar, Raghunath Mashelkar and me.

The impossible trinity I have outlined is more a political economy question. There are already growing concerns about increasing concentration in several sectors of the economy, though these are for now more focused in non-tradable areas such as telecom and airports. An inward turn because of protectionism could lead to further concentration of economic power in India. As in the 1960s, one possible response is restrictions on size, through some form of regulation, which has implications for economic efficiency as well as competitiveness.

Niranjan Rajadhyaksha is a member of the academic board of the Meghnad Desai Academy of Economics