This problem had been encountered before. Bolsheviks dethroned the Czar in 1917 and assumed power in Russia. They too wanted to make the Soviet Union rich. A solution was suggested by Evgenii Alexeyevich Preobrazhensky and Grigory Alexandrovich Fel’dman in the 1920s. The Soviet Union did not have much industry; so agriculture, its dominant sector, should be taxed and exploited to extract a surplus for industrialization, which is what they suggested. A similar solution was suggested to Jawaharlal Nehru in the 1950s when he called in Prasanta Mahalanobis to help with planning: consumption had to be taxed or curbed to create savings for industrial investment. It was consistent with a hypothesis floated by Hans Singer and by Raúl Prebisch in 1950, that the prices of primary commodities declined relative to the prices of industrial goods, and that industrial countries consequently got rich at the cost of primary commodity producers. The lesson drawn was that to get rich, poor countries should industrialize.
Then came W Arthur Lewis’s pioneering 1954 article in Manchester School on Economic Growth with Unlimited Supplies of Labour. What he had in mind were countries like India, Egypt and West Indies which had little capital and natural resources and where marginal productivity of labour was zero or close to it.
There were workers who added nothing to production; they managed to get enough to subsist either because they were members of families that supported them or because they were dependents of rich people who let them hang around and fed them. That did not mean that they themselves produced nothing; but if they left whatever they were currently doing, such as work on farms, carrying someone’s bag, doing some part-time gardening etc, the rest of the workers in those jobs would work a bit harder; the work would get done. If they were employed in some other jobs where they produced more than subsistence wage, total wages and output would go up. Apart from men willing to take a job at subsistence wage, there were also lots of housebound women who would take jobs if they could get them.
If a capitalist sector emerges in such a subsistence economy, it can draw workers at subsistence wage; as long as this wage is lower than marginal product of labour, the capitalist sector will make profits, reinvest them, and expand. The expansion can continue until the labour surplus is exhausted. Suppose a backward economy has two sectors: a subsistence sector, and a commercial sector which produces something for export to industrial countries. Wages in both sectors will be equal to the subsistence wage; if productivity increases in the export sector, its prices will fall, and the benefit will go to the importer in industrial country. So free trade in such circumstances benefits the industrial country. On the other hand, building up an import-substituting capitalist sector will benefit the subsistence economy by creating a domestic market for it and employing its superfluous workers. Hence Lewis was of the view that industrial protection to the capitalist sector was justified as long as it drew workers out of the subsistence sector into more productive employment.
No one pointed this out then, but actually, this argument was not for protection, but for giving a wage subsidy equal to minimum subsistence to workers in the capitalist sector, so that it could draw them away from the subsistence sector. But subsidies had to be financed, whereas taxes earned money for the state, so taxes were easier. Lewis also pointed out that the backward country’s government could print money as long as it led to expansion of the productive sector, and not to inflation. Expansionary monetary policy was not yet respectable then; it became respectable only when recessions multiplied in industrial countries, after the oil crisis of 1973.
There was another argument for protection that Lewis did not make – that it improved the balance of payments. This argument appealed to India, which had a chronic payments problem after independence. What no one pointed out was that protection did not improve the balance of payments in the long run; it raised the domestic price level relatively to international prices, and made the payments problem worse. That did not matter in the 1920s and 1930s when all countries had high tariffs; but when industrial countries collectively brought down their import duties after the War, countries that were wedded to high levels of protection got addicted to payments crises.
Japan ran enormous payments surpluses in the 1980s which it did not know what to do with; when financial institutions of the Indian government went to Japanese financiers, they showered big loans on them – until 1989. Then even they saw that India was bankrupt, and stopped being generous. Bimal Jalan, then finance secretary, had sleepless nights looking for new lenders. Then, luckily for him, the government fell, and responsibility for the crisis could be placed on “political instability”.
The excuse stopped working in 1991; by then, Yashwant Sinha, the finance minister, had exhausted every kind of emergency loan he could get. The International Monetary Fund, the world’s lender of last resort, told him that his sojourn in the last resort had come to an end; it asked him to devalue, reduce protection, and bring down his fiscal deficit. He did not; whether it was he who was responsible, or Rajiv Gandhi who was supporting Chandra Shekhar’s minority government, is not clear. Anyway, Chandra Shekhar fell, and Rajiv Gandhi was assassinated by Thenmozhi Rajarathnam of Liberation Tigers of Tamil Eelam in 1991. She and six of her collaborators were caught, tried and sentenced to life in prison. Narasimha Rao became prime minister, he brought in Manmohan Singh as finance minister, and he called me in briefly to advise him.
I found him extremely averse to my advice to dismantle import duties; his argument was that he could not afford the loss of revenue. In a compromise, he began to reduce the maximum tariff; from 350 per cent, he brought it down to 110 per cent in the first year, 85 per cent the next year and so on. But the average duties stayed high in his time; it was only after his fall in 1996 that they began to come down. Manmohan Singh was a good economist once; maybe he was a follower of Arthur Lewis.