The visible hand

Strong ideological divisions have often prevented honest and useful discussions on many aspects of public policy. One such example in India has been labour markets. Labour employed in the organised sector have prevented making the labour market flexible by opposing policy changes that would make it easier to sack workers. India's labour force, 400 million strong, stands to gain if labour mobility increases. But the 30 million in the organised sector may stand to lose from a more flexible labour market. Yet, a position that argues in favour of an exit policy for industry and a change in labour laws is viewed as anti-labour.

In the same vein, to point out that capitalism and free-markets have often been abused by capitalists themselves is, in an ideologically divided world, perceived to be anti-capitalism. While a large number of 'free market' economists would be happy to talk about how UN-free labour markets support incumbents in the labour market, few seek to analyse how financial markets that are not free support the rich and powerful in these markets. Such arguments are often viewed as a critique of free markets. To ask for active government interference in markets, in order to make markets work, is viewed as contradictory.

Raghuram Rajan and Luigi Zingales have successfully crossed this line in a recent book called Saving Capitalism from the Capitalists. They argue that markets need rules to function and flourish. The absence of rules on the one hand, or rules that stifle competition on the other, lead to opportunities for misuse of markets. In many countries, dominant business elites have created rules that prevent markets from becoming truly free. India's recent experience in telecom policy, where big business houses have competed to influence policy, is an example of these concerns.

The free market is a powerful tool for obtaining efficiency and a meritocracy. But by creating competition, free markets undermine the power of those capitalists who are already present in the market.

Free markets are often understood to be markets that are left free to operate without interference from the government. But is a market that is open only to those who are already present in it, and which prevents access to those outside it, truly free and competitive? There is, argue Rajan and Zingales, a role for a government to carefully examine closed clubs, and undertake actions to force club markets to open up to wider participation and competition. The authors ask how government can be made to set rules in the interests of the people.

India's story on the equity market is a striking illustration of this problem. The equity market was once run by a club in south Bombay, the Bombay Stock Exchange. The BSE controlled access to club membership, and the BSE made the rules about how trading took place. This was not an open, competitive market. A simplistic `free market economics' view on policy would have argued that the BSE is a private club and should be left alone to run the equity market.

In retrospect, SEBI and the Ministry of Finance very wisely chose not to leave the BSE to its own devices. They pushed for a highly unusual idea, that of a quasi public-sector stock exchange, the National Stock Exchange. This led to a revolution in India's equity market. It has given a transparent and open market, with participation from across the country. It has modernised technology, and eliminated the rents of club members.

A similar story is faced on India's debt market also. The debt market is a cosy club which runs on telephone calls in south Bombay. The open question for policy is how we can move away from this club into an open, transparent market with wide participation by other economic agents, from all over India. A simplistic policy position which advocates leaving this market to incumbent club members would not give us the benefits of a genuine market.

Moreover, if the market works in public interest, it can lead to a better distribution of wealth, one that is not concentrated with a few established families. Most economists have argued that free markets lead to more efficiency and higher growth. But few have focused on how free markets help in obtaining better distribution. Indeed, since markets are governed by rules made by the rich and politically powerful, they are often seen as instruments to make the rich richer.

However, argue Rajan and Zingales, free markets, particularly well developed financial markets have not just created wealth but also distributed it better. Markets expand opportunities for those individuals and firms who are not part of the established wealthy. Countries with better developed financial systems have a higher frequency of self-made billionaires per million inhabitants! An increase in the size of the equity market in France (50 per cent of GDP in 1996) to the level in the US (140 per cent of GDP) would be associated with an increase in the frequency of self-made billionaires in France from 0.07 per million to approximately 0.30. The difference between America's 0.28 billionaire per million and France's number of billionaires is entirely explained by the difference in the openness of finance.

However, the authors argue that economic institutions neither arise nor flourish if there is no political will to back them. In terms of political economy, it was unusual for SEBI and the MoF to make war with BSE members; it will be difficult for RBI and MoF to take on existing club members in the debt market. There is thus a need to create conditions such that the the incentive to oppose change is reduced. The objective is to ensure that incumbents have largely the same interests as everyone else.

Since inefficient owners tend to oppose rules that promote competition, the authors propose policies that would promote productive assets going into efficient hands. This can be done by changing the structure of taxes, opening up borders to increase competition for domestic producers and creating safety nets for individuals rather than firms. Most importantly the force of awareness is one of the strongest forces in a democracy. A better awareness and understanding of how governments can help support public interest as opposed to private interests by better rules and regulation can create a strong force to support change.

Economists believe that free markets are great, but government sometimes needs to intervene to make markets free. Withdrawal of the government from the market can sometimes only help the privileged few. The middle ground between an absence of rules and the presence of suffocating rules is narrow and delicate. If the public is aware of its interests, then democratic forces can make it happen.

The author is at ICRIER. These are her personal views.

Ila Patnaik

Ila Patnaik
ila at icrier dot res dot in