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India's role in Keynes' economic theory

March 11, 2004

Any Indian disciple of Keynes would like to think that some of his revolutionary ideas developed because of his awareness of the Indian economy as it operated in the twenties and thirties; but on the occasions when I have put this proposition to Keynes's distinguished biographer Robert Skidelsky, his response has always been that there is no clear evidence that Keynes had India at the centre of his attention at the time when he was writing 'The General Theory'.

Skidelsky is too fine a scholar to disagree with; nevertheless one may have at least an arguable case to speculate that the inspiration for some of the more radical generalisations in the 'General Theory' may have come as a consequence of observing the Indian economy.

The fundamental difference between Keynes and the classicists turned on their different treatments of savings and investment. The classical argument as reflected in Adam Smith ran as follows:

"Capitals are increased by parsimony and diminished by prodigality… Whatever a person saves from his revenue he adds to his capital and either employs it himself... or enables some other person to do so by lending it to him for an interest that is for a share of profits...

What is annually saved is as regularly consumed as what is annually spent and nearly in the same time too but is consumed by a different set of people." (Adam Smith 'The Wealth of Nations' (Volume 1, page 320).

Now this did not happen in India at the turn of the last century with its undeveloped banking system. The majority who hoarded their savings did not employ them themselves nor did they enable other persons to employ them by lending for a share of profits. Keynes like many other Indian economists observed this Indian habit of a propensity to hoard cash.

On the other hand, at the time of the publication of 'The General Theory' those of his critics who had not studied Indian markets, like his reviewer, Jacob Viner not surprisingly accused him of placing "a grossly exaggerated importance" upon "the desire for cash for hoarding purposes" (Viner 'Quarterly Journal of Economics' 1936-37, page 56).

Keynes considered Viner's analysis the most important of the four comments on the General Theory published in the QJE. In the only defence (QJE, February 1937) he ever published of 'The General Theory', Keynes readily conceded to some of Viner's criticisms.

He admitted that his definitions of unemployment were obscure and needed clarification, but on savers' propensity to hoard and the impact of this on interest rates he did not capitulate at all. Indeed the propensity to hoard was central to Keynes's revolution particularly to the invention of the liquidity preference concept.

The connection of liquidity preference Keynes associated with India is best introduced here. His sole reference to India in the 'General Theory' is the following passage on page 337:

"The history of India at all times has provided an example of a country impoverished (Italics mine) by a preference for liquidity amounting to so strong a passion that even an enormous and chronic influx of the precious metals has been insufficient to bring down the rate of interest to a level which was compatible with the growth of real wealth."

From a theoretical point of view it has always seemed to me unfortunate that Keynes linked liquidity or in other words a propensity to hoard with a passion for precious metals. This implied that Indians had a peculiar quirk.

A better explanation for India's failure to ensure that the surplus created by savers was not utilised by other persons, as Adam Smith had assumed, may have been an absence of adequate borrowing and lending facilities.

Thus according to India's Director of Statistics, Findlay Shirras, it was the lack of banking systems and poor communications that allowed, "our resources to be dissipated (by hoarding) in this appalling manner" (Shirras 'Indian Finance and Banking 1919').

The notion that highly organised markets could also suffer from a propensity to hoard did not occur to orthodox economists. It was thought that the rate of interest would adjust so that all income would either be consumed or loaned in a system with developed banking facilities.

Keynes therefore needed to explain how hoarding worked even in a society with a well developed banking system. In disputing the classical argument Keynes had to find a different explanation than a taste for precious metals to demonstrate the effect of hoarding.

Keynes concluded that hoarding or liquidity preference in developed markets expressed itself not through hoarding cash but through a reduction in the price for securities and bonds. That is, savers were able to display their desire for cash by letting "securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms. A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity preference." (Keynes, QJE 1937, Italics authors).

This proposition of a higher interest rate was diametrically opposite to the classical view that extra cash must lower interest rates. It was only by appreciating the true character of liquidity preference -- and how better than thinking of Indian psychology -- that Keynes revolutionised economic theory.

Later in the QJE article Keynes elaborated on the propensity for cash by stating "partly on reasonable and partly on instinctive grounds our desire to hold money as a store of wealth is a barometer of the degree of our distrust of our own calculations and conventions concerning the future. (Italics mine)… The possession of actual money lulls our disquietude and the premium which we require to make us part with money is the measure of the degree of our disquietude."

Now this way of describing hoardings in a developed economy may well seem very different from Shirras's account about India, but behind the sophistication of Keynes and the simplicity of Shirras lies the same underlying rationale.

Both authors recognise that an unwillingness to part with or to seek cash stems from distrust. In India it was "the cultivator's lack of trust" in having money at the right time and in developed markets it was distrust of the future.

Keynes summed up his main grounds for departure from orthodox theory by saying that "it assumes that we have knowledge of the future of a kind quite different from that we actually possess". But it would seem, at least from a cursory examination, that it is not just uncertainty of the future but also distrust of princes that enhances the propensity to hoard cash.

Arbitrary behaviour by governments could also create a preference for hoarding cash beyond that anticipated by the mechanical system expounded by classicists.

It has often been argued that Keynes's Theory is not really 'General' but merely an explanation of a particularly dramatic economic event, namely 'The Great Depression'.

But it seems to me that if you take account of continuous Indian behaviour in years of booms and slumps the generality of Keynes's Theory is rather more obvious. Not only in the diagnosis of the causes of economic difficulties but also its cures.

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