Arvind Panagariya and Shruti Rajagopalan Talking Trade

Episode 5: India's Trade Policy (1940-1965)

SHRUTI RAJAGOPALAN: Welcome to the discussion series on free trade and liberalization as part of The 1991 Project at the Mercatus Center. I’m Shruti Rajagopalan. In this conversation series, I will be talking trade with Professor Arvind Panagariya, who’s the director of the Deepak and Neera Raj Center on Indian Economic Policies, and the Jagdish Bhagwati Professor of Indian Political Economy at Columbia University.

In the past, he has served as the first vice chairman of the NITI Aayog in the government of India, and as chief economist of the Asian Development Bank. He’s the author of a number of books, but today’s conversation will primarily focus around Indian trade policy with some insights from his recent book, “Free Trade and Prosperity.”

We’ve covered some very basic insights on what kind of trade models exist, what they inform us about the world and economic policy, more generally, what we can learn in terms of insights for developing countries and how developing countries can prosper. And if there are any valid arguments, against trade and in favor of protectionist policies.

Socialism and the Indian Nationalist Movement

Now I want to zoom in a little bit more on India specifically. I know we’ve talked about some Indian examples, but I really want to dig into Indian trade policy. I want to start rather at the beginning. One of the things that I have observed when I read about the postcolonial period in India—in fact, I would start maybe even pre-independence in the late 1930s and early 1940s—it was very clear that socialism as an ideology and also socialist planning as an economic policy framework was gaining a lot of momentum and prominence. This we can see throughout the Indian nationalist movement, but in particular the Congress Socialist Party was brought to prominence in 1934. By 1938, in just a matter of four years, the then Congress President Subhas Chandra Bose created the National Planning Committee.

This was the committee that was tasked with forming an economic plan for India. We know now that this committee met so frequently that its secretary, KT Shah, produced about 20 volumes of papers. This was simultaneously also going on with the war effort. A lot of the socialist price controls, quantity controls that were left as a legacy in India, they really started with the scarcity problems in World War II. Those war controls were a new kind of socialist planning that was taking place in India at the time. This was really the precursor to the new Indian government under the leadership of Nehru. To me, it seems like Nehru, along with most of the nationalist leaders in the ’40s conflated British mercantilism with a different economic system, which is free trade and capitalism. The Indian nationalist movement had always blamed British rule for the impoverishment of India.

This starts with Dadabhai Naoroji talking about the extractive policies of the British, but the conflation that took place in the 1940s in the Indian nationalist movement was that the impoverishment of India was now blamed on British capitalism as opposed to extractive mercantilism.

Now, my big question to you is, what were the consequences of this kind of conflation? What did it mean for the economic thinking at the time and the economic policy that was being hatched under a new government, which was in this case led by Nehru, while writing the constitution and while being in transition from a colonial state to an independent one?

ARVIND PANAGARIYA: Shruti, this is a very good starting point. Let me pick up where you have brought me already. As far as Nehru is concerned, and his own view of Great Britain, in some ways, at least, particularly just around the time that the National Planning Committee is appointed, he actually sees capitalism as the fundamental evil. The way he sees, even what you’re calling the mercantilist policies, is a necessary outcome of capitalism.

It’s not just mercantilism. He associates capitalism with the emergence of imperialism. He says that capitalism creates these factories, and these factories generate a lot of output. You need market for output. Where are you going to get that? You get them in the colonies. Then the factories also need raw materials. Where are you going to get raw materials? You need raw materials from the colonies.

He had this very direct association of capitalism with imperialism. Around this time, certainly, Nehru believed that the only way to combat this imperialism was to combat capitalism and therefore socialism was the way to go. Of course, within the Congress there was a lot of consensus. Subhas Chandra Bose himself actually was very much aligned to the same view. Subhas Chandra Bose was very much a strong socialist in this aspect. Both of them really also believed that industrialization was very important. The mandate actually to the Planning Committee was to think in terms of how India was going to industrialize. What will be the plan for industrialization?

And then you also rightly pointed out that the committee really did a lot of hard work. And at the end actually the committee’s work ended abruptly only because Nehru got picked up by the British and put into jail. Then he wanted to complete the final volume of the work and the British would not let him do that. Anyway that’s the history.

I’ll really come to what happens after independence. And here, before we get to trade policy, we need to lay down a bit of background of the overall domestic economic policy framework because that in a way drives the trade policy as well. As we’ll see, if you look at the 1950s, there’s no active trade policy happening at the time, but we’ll come to that.

First, what was the basic framework? Nehru’s basic framework was that imperialism necessarily followed from capitalism, and this was done through international trade. Therefore international trade was itself actually to be kept at a distance. Therefore following the idea of self-sufficiency. He writes in “The Discovery of India” that, in the context of the self-sufficiency objective we don’t want to be the victims of imperialism, nor do we want to develop similar tendencies ourselves. Therefore, while we are not against trade, we want to minimize that.

Self-sufficiency became a very important centerpiece of the entire policy framework that got adopted. Mahalanobis, of course, had started interacting with Nehru beginning in 1940. It was not a continuous interaction because Nehru spent the last part of the 1940s in jail prior to independence. Nevertheless, they had begun to understand each other, and so later on Nehru appointed Mahalanobis as the statistical adviser to the cabinet. Then Mahalanobis became central. Basically, academically, we think of the basic planning framework as coming from the Mahalanobis’ model, which at some level is correct, but it really is a rationalization of what Nehru thought.

Mahalanobis was completely aligned to Nehru’s view and he interacted quite closely with Nehru while he was preparing the plan frame and the draft plan frame as the document is now known. Here self-sufficiency is essential, but then there are different ways. Even Nehru knew and Mahalanobis knew that you can’t become self-sufficient overnight.

They knew that it’ll take a little while. There are multiple paths to achieving self-sufficiency. The very closely associated big mistake that also happens around this time, which to me, continues to haunt us till today—it’s not a problem which we were able to solve, because the sclerosis is so deep—was the focus on the heavy industries. Nehru felt that unless we learn how to do heavy industries—learn to make machines, learn to make steel—we would not be self-sufficient.

And he talks about machines that make machines. Not just machines that would make parts of bicycles, automobiles, or boilers or air conditioners, what have you, but machines that also will make the machines that make these parts, and so forth. That was the conception. That I think was really, practically, I should say, fatal, and showed that success was not going to happen in any near future, for the simple reason that you started off with very limited capital.

It was a poor country, very small GDP and the savings rate was about 7% around the time second Five Year Plan was being written. Savings were very small. If you’re going to put that into making steel and making machines that make machines, that sort of investment, very highly capital intensive, then you knew that most of the capital will basically get absorbed there. They saw that. They knew that. They said, “What is going to happen to the consumers?” Well, consumer goods will be produced by the small village industries. At that time the Gandhian view of promoting the village industries, cottage industries, household industries—it’s called the hand industries, meaning that’s the labor. They refer to these industries as hand industries in many of the documents, contemporarily written during the second plan formulation. They said, “Well, consumer goods we leave for the hand industries.”

In a way you see that’s the setup. Now you know what is going to happen as a result of this. First of all, the heavy industry is never going to achieve the kind of scale because your capital is limited and you’re trying to diversify very rapidly. It’s not that you are going to go for a big scale. Diversification was not just in terms of product, but also in terms of geographical diversification.

Rather than put a very large-scale steel mill, you are going to put up three of them so that you can put them in three different places. You don’t get scale there and then you do cottage industry for consumer goods, goods in which you actually have comparative advantage. Well, you can’t get scale there. Then to mobilize resources, the government also used the instrument of printing money. That, of course, also meant that inflation happened, and the exchange rate—now, this is the big factor, which nobody seems to see or bother with at the time—I think this all reflects the prevailing thinking at the time. It’s not as though there are any disagreements on this. Most people are agreeing, and there’s a whole a lot of agreement actually on what was being done at the time, including this famous panel of economists which had 20 economists selected from universities in eight different states.

They were all there and largely, except B.R. Shenoy making it sort of a dissent note. From the Bombay school, C.N. Vakil and P.R. Brahmananda writing something to the contrary, although still not dissenting formally, but the rest of the panel actually is in agreement and all. It’s not as though what was being done was contested at the time by almost anybody. The fact of the matter is that if your nominal exchange rate is fixed, inflation is higher, then you know that domestic prices are way more lucrative on everything than the foreign prices are. Exports will suffer, you know that. Also, imports will want to come in because imports are a lot cheaper with a fixed nominal exchange rate, and the domestic price is rising.

Now, on top of that, what you are doing is you haven’t got really a serious scale of production either in the heavy industries or in the consumer light industries. Your costs of production, therefore, are high everywhere, and because the exchange rate is fixed, they are high in rupee terms in almost everything.

You see this transformation that happens in most developing countries, where they become exporters of labor-intensive products, just didn’t happen in India. That is the background to the whole system.

Impact on Human Capital Formation

RAJAGOPALAN: Before I get into the mechanics of the trade policy, I will actually highlight two or three more unintended consequences of going in the direction of heavy industry. One of the unintended consequences was to actually have these heavy industries perform and hire from within India, you needed to produce scientists, engineers, applied work to set up these industries and run these industries, which meant that a lot of the government focus in education went toward higher education.

It went toward necessarily setting up IITs and engineering colleges and things like that. The vision was, this is the modern way to go because it’s science at its highest level, but we know that in a country a fraction is going to be engineers. So if your education policy is entirely designed as an input for heavy industry, you are in trouble already. You become very good at producing engineers and not very good at producing other kinds of human capital. I think that was one unintended consequence.

The other partially unintended, partially intended is because the government is going to invest in heavy industry, and they want to acquire a certain scale, when it comes to what they’re calling hand industries or cottage industry, the second fatal blow is the small-scale industry reservation list. This is basically a list of sectors or industries which are supposed to remain small. They cannot exceed an investment of more than a certain amount of money.

That means that anyone who wants to be an entrepreneur and eventually achieve scale—that is, if you want to be in the garment business and you want to supply garments to Zara across the world or something like that—you are necessarily not going to be doing that in a labor-intensive way because you’re going to fall in the category of one of those industries, whether it’s making shoes or whether it’s making handicrafts. There is this really complicated relationship that the government seems to have with scale, where scale is thought of as one of the achievable goals and not as an output of a really successful or really productive enterprise in the first place.

PANAGARIYA: Absolutely. No. Long-term effects really go a lot deeper, not only what you have just mentioned. Just think of what you said about cottage industries and hand industries. A lot of the low-level skills are developed precisely in these industries. This is where the skill formation begins. But once you say there’s a hand industry, no capital is allowed, other than the household capital—you get your needles and threads, and so forth, charkha and so forth—the industrial skills will simply not be developed. On the one hand, you’re developing these engineers and very high-level technical expertise. On the other, in terms of low-level skills from which a vast population begins to rise up, that’s not happening.

The impact today remains that our workforce is the least-skilled workforce today after near 75 years of independence. And the impact that this leaves, because you say there is also this inheritance in terms of thinking. The socialist thinking doesn’t end with Nehru. It’s inherited. All the major actors: politicians, journalists, intellectuals, bureaucracy, in every one of these influential classes of people, socialism has its inheritance. This is where—there’s a book I’m working on right now where I’m going to bring all this—but this is where democracy and socialism is a cocktail that is lethal. In contrast, remember that China had more or less the same model, but because it was authoritarian, Deng Xiaoping could come along and tell everybody, “Okay, old game is over. New game is beginning.”

In a democracy that doesn’t happen. Even think 1991, when Narasimha Rao begins to make changes, he never says I’m changing. He says it’s a continuation. If you read the speech by Manmohan Singh, in some ways, it’s a fantastic speech, but in other ways, he is also saying we are connected to what Rajiv Gandhi did, we are connected to what Nehru did. There is that connection drawn because in democracy you have to move very slowly, gradually. Even you see the way this ideology left the impact comes along 2009 to ’14, UPA II. Socialist policies reassert themselves: Right to Education Act, very much a socialist act, and the Land Acquisition Act, very much a socialist act.

Remember who is running the finance ministry around this time. You got Pranab Mukherjee, pretty much a committed socialist. The impact of what Nehru did remains till a long time through all these inheritances that happened. It’s like you inherit ethics from your family, but the new IAS officers who come in, learn from the senior ones that are in existence. They then take their mantle and carry the work forward. You can see till today, journalists, intellectuals, bureaucrats, politicians, still. Long-term damage is significantly wider and deeper and long-lasting.

Trade Policy in the 1940s in British India

RAJAGOPALAN: In one sense self-sufficiency, as you discussed, is going in the direction of heavy industry, homegrown home-cultivated heavy industry. Another way that self-sufficiency eventually emerges in India is some kind of autarkic trade model. Before we get to the later years of autarky, can you tell us a little bit about the domestic trade policy in the ’40s and ’50s at this point? What was being thought through? What were the models being used? What were the ideas being debated?

PANAGARIYA: That’s a good way to begin the discussion on trade policy. Originally, of course, the British had imposed on India free trade policy, meaning that goods in India could enter without any customs duties, and whatever little customs duties that got imposed were to raise revenues. They’ll be 2.5%, 5%, something like that. It’s only in a real sense what we would call protective trade policy, which is different from the revenue raising.

Revenue is different because at that time, internal commodity taxation is harder. At the border it is easier to collect taxes, so for revenue purposes, you do that. A little bit of that was perhaps done earlier, but really, it’s in the 1920s that lobbying by the Indian industry, some bit of tariffs got introduced in the 1920s. These were in iron and steel and textile. Those were the two major industries that had evolved in India other than textiles, of course. Some custom duties got introduced that remained in place, that were inherited.

Then came the war. During the Second World War is when you began to put in place the control system. Initially, in the 1940s, you started with some import controls on the consumer goods. This was as early as 1940. Then by 1942, this was extended to practically all goods. You put in these input controls, meaning licensing on imports, but there were no specific quantities that were fixed up for these. You just needed a license, which could be given to you if foreign exchange was available and so forth. During this period also they begin to involve the principle of essentiality. Now, later, it plays a very important role, of course, in the entire import policy regime, as we will see.

The principle of essentiality is involved during the period, although imports in the Sterling area were regulated mainly because of the shipping restrictions. Because anything that had to do with war had priority in terms of the usage of, availability of shipping capacity. Subject to shipping capacity availability, I think still products were allowed to be traded, imported and exported.

That’s a rough kind of regime that we inherit after independence. Toward the end of the British era, 1945-1946, the idea of open general licensing had been evolved already also. This also later on, in the 1980s plays a very important role in India’s early liberalization prior to the ’91 liberalization.

We got basic machinery, as you see, the import licensing, the principle of essentiality, open general licensing, this is all already evolved from the British period before we became independent. Some expansion of the open general licensing list was done in 1948, but at the same time, this was a period we had a very hyperactive joint secretary and finance minister, B.K. Nehru. He was very worried about the foreign exchange.

Temporarily he had introduced foreign exchange budgeting, but then B.K. Nehru got transferred to become the executive director of India at the International Monetary Fund. The minister then issued an order abolishing the budgeting. I mentioned this historical fact, which is quite important because later on B.K. Nehru returns and so does foreign exchange budgeting during his period. Once again, it’s his initiative that of course introduces the foreign exchange budgeting. We will come to that, but this is the very early history.

Now, the first planning period, 1950s, that is generally a liberal period as licensing existed, but licenses were issued with relative ease. And there were two major categories of licenses: one was the established importer and the other was the actual user licenses. All these things continue and become very, very important later on as the licensing regime tightens up. Now what happens is that in the 1950s because of India’s war effort, India had earned a lot of sterling balances from Great Britain. Now, there was some restrictions on how much you could draw these sterling balances every year. The British will not release the entire pot of the sterling balances at once, but every year they’ll release some.

That fact plus the fact that during the 1950s, the food situation luckily remained pretty reasonable and we didn’t have to import food on a large scale. Some imports had happened, but largely we were able to meet our needs during the 1950s. Both of those factors left a sufficient amount of foreign exchange to allow imports to remain relatively free.

This is a period during which you see that consumer goods imports are also coming in, according to the third Five Year Plan, which gives at least the aggregate data. It says during first Five Year Plan about 32% of total imports were consumer goods. They decline from 32% to 23% in the second plan, but by the end of the second plan, of course, the trade regime really gets much tighter and the share of the consumer goods and therefore the share of the established license holders declines very dramatically to 10% or below. That is the history.

Now, what changes their regime? Why does it become so restrictive as we will discuss? I think we will come to discuss it in great detail. I think for, particularly, the younger generation it is good to follow how Kafkaesque or Orwellian, this trade regime was in those years. We can come to discuss that in detail. Very quickly the origins of it: How did we end up with this kind of system?

Beginnings of the Kafkaesque Controls System

What happened is that sterling balances were gradually being depleted. You knew that this was a fixed pot ultimately, which the British were releasing in different tranches every year but they were going to run out. Now it also happens that B.K. Nehru returns in 1954, and he’s very upset that this foreign exchange budget is gone. He also writes these memos to the secretary at the time and the minister C.D. Deshmukh that there is a problem here. He gets no replies.

This is all from his autobiography. He gets no replies. Eventually C.D. Deshmukh resigns, T.T. Krishnamachari becomes the finance minister and he promotes B.K. Nehru to become the secretary of the department of economic affairs (DEA). Around 1957, 1958, that’s the year in which B.K. Nehru is alarmed that sterling balances—if we look at the numbers, actually, you can see that—in 1957, the foreign exchange reserve really declines quite dramatically.

That scares him as to what’s to come. He quickly, on his own authority as the secretary DEA, issues the order for the return of foreign exchange budgeting. Foreign exchange budgeting is nothing but foreign exchange control. It simply says that, anybody who needs foreign exchange now, any transaction that will require foreign exchange, they have to get the clearance of some authority, which to begin with was, of course, was nobody other than Mr. B.K. Nehru. He would begin to draw up this foreign exchange budget every six months. Then we see that a whole bureaucratic system has to be evolved because there are lots of claimants of foreign exchange and, how are you going to allocate them? How are you to give them? Also this obviously also begins to lead to the tightening of the import licensing regime as well. We can come to that.

One thing I want to say here, which is very, very important, is that it was very unfortunate at this time there was no discussion of what were the possible solutions? If some discussion had happened and if they had even considered the possibility of devaluation—at this time the economy was doing well, it was not growing 7%, 8%, 9% or anything, but it was decent, 4% growth had been achieved, which was decent for the time.

And food situation was generally comfortable. Inflation was not so completely out of hand. Generally it was good economic conditions. If a proper devaluation had been done, we would’ve seen some response, some favorable response. Manmohan Singh later actually when he writes his thesis in 1964, that famous book, “India’s Export Trends,” he actually at the time does say that what we should do is to devalue. You see then the devaluation happens in June ’66, when economic conditions are totally different. Back to back, two droughts happened.

Politically, it doesn’t generate the kind of response that was required, but ’57, ’58, if they had devalued, could’ve been a little different. Not dramatically different, I should say, because still the business of being in heavy industry and consumer goods being done in cottage or hand industries, that would have continued to haunt us, nevertheless. Still things could have been a little better.

RAJAGOPALAN: I completely agree with you. In fact, I wanted to delve into this 1958 as one of the important structural points in Indian economic history. In one sense, this is sort of the first post-independence balance-of-payments crisis that India is facing. Almost on the brink. That’s part one. But what is the really important lesson? One, of course, I completely agree with you that in 1966, the economic situation was worse and also the egos were quite different.

T.T. Krishnamachari just simply did not get along well with the American administration at the time. There was a lot of personal conflict involved in that devaluation, not succeeding other than the economic problems at hand. In fact, we have a lovely timeline of what happened during the 1966 devaluation and why it failed in our 1991 Project website.

In 1958, had we devalued, none of the control systems, whether it is talking about foreign exchange controls or talking about the later industrial licensing controls, which are a natural consequence of an autarkic system, none of that would’ve happened. And therefore none of that would’ve had to be rolled back either. In a sense, the 1958 devaluation, had it happened, would’ve been a rather clean and simple affair.

It’s not having to roll out this massive, as you mentioned, Kafkaesque system of controls, and then having to roll all of it back as we started doing in 1991. In some sense, we’ve still not managed to do it. It would’ve been a shift in priorities. What happens in 1958, given that we don’t devalue? One consequence is that the trade policies or trade priorities dramatically shift. Because the trade policy dramatically shifts, there is also a major shift in what is domestic production and consumption policy. Can you walk us through this? What are these trade priorities and what are the adverse impacts that follow? You already hinted that there were outside economists like Bhagwati and Desai who eventually criticize the system that followed, and even C.N. Vakil and Brahmananda. What is the system conceptually post ’58?

PANAGARIYA: We’ll come to that. But just ’58 itself, as I said, probably dramatic changes would not have happened as a result, because of the domestic regime being what it was. Having said that, suppose the rupee was devalued significantly. I think you would have required significant devaluation. If it was done, some export response would have happened. There is no doubt.

It would have happened, because the economy generally was otherwise on the upswing. You would have got some export response. That would have changed the mindset a bit. What I’m saying is that one-time devaluation probably would not have been enough to escape the regime that eventually came to rule on import protection. But if it would have also led to a more favorable view in the administration, in the government of devaluation, that, yes, devaluation is an instrument that can deliver exports and therefore, solve our foreign exchange problem, then I think, a second time around we would not have had the episode you’re describing that happened in 1966, of the egos, etc., that come in because egos are building on some fears that everybody else is expressing also that devaluation will be more inflationary. You know that old elasticity pessimism that prevailed. The failure of the ’60s devaluation became self-fulfilling, and that put God’s fear in us to devalue in the future.

RAJAGOPALAN: Absolutely.

PANAGARIYA: For a long time, till we come to 1980s, rupees 7.50 per dollar exchange rate remains. Remember that, in this intervening period, these very high rates of inflation that we suffered from, of course, continued to make the domestic products less and less competitive. And so, the exports continued to do poorly. It is more the psychological effect, I think, which might have helped if devaluation had been tried in 1958.

Anyway, that’s not what happens. At the end of the day, it’s just one secretary’s decision. You can’t find very much discussion of this anywhere except in—at least I haven’t found it—except in B.K. Nehru’s autobiography. He does that and that’s that. That, of course, then now begins to build this entire control regime. Now remember that already investment licensing was of course being done, but in the 1950s even investment licensing is relatively liberal because your foreign exchange situation is comfortable, because of the sterling balances.

Machinery that needs to be imported, can be imported and so it is not a big issue. Licenses were being issued. The only thing was that it was understood by the businessmen and the industry in Bombay that consumer goods industry licenses will not be issued so there is no point even in applying. Usually, they knew the chemical industry, engineering industry, you will get the license. You don’t hear much complaints about the licensing system not working or being clogged and so forth. That only starts in the 1960s, early to mid-1960s, and then a number of committees get appointed.

By the way, also the 1950s, nobody’s paying attention to exports. That we will discuss later on when we come to the export policy. The basic point to note here, currently at the present moment is that sterling balances have run out because exports are not doing well and nobody’s paying attention. Practically it’s a policy of benign neglect on the export front and we also suffer in an obscure place, but Vakil and Brahmananda say this. They say don’t let go of these consumer goods industries in which we have actually doubled our expertise over four to five decades. We have the expertise and they could serve as export industries.

They, in fact, make that pitch in their paper which was submitted to the Planning Commission as a part of the panel of economists’ discussions, but I don’t think anybody paid attention to it. And then if you look at the industrial structure, how it evolved, then apparently, you see this, that like cotton textiles, there is hardly any expansion that happens between 1955-56 and 1960-61, a five-year period.

The index of cotton textiles production rises from 128 to 133. It’s less than a 4% increase. Compared to that if you look at the general industrial index, that rose from 139 to 194. That’s about almost 40% increase. It’s the industries that are being allowed to expand, things like iron and steel, machinery, chemicals, these are the industries that are flourishing—flourishing by the standards of the day. Cotton textiles, it’s not allowed to expand and this is where we had the advantage. They could turn into export industries. Revenues would have been coming, but no, it was not allowed. It’s a pity in a way because India had a very large share, 10% to 11% in exports of cotton textiles around this time in the 1950s. That advantage is allowed to wither away.

Then alternative industries, they tried to get engineering goods and chemicals to become exporters. Some exports emerged, but these are small. That also begins to happen in 1960s, not in the ’50s. So in the ’50s the big exports are textiles, tea, what you’ll call primary products. At that time, we are actually either imposing export restrictions, meaning quantitative restrictions, no more than this, or we are even taxing. In some cases, export taxes are being levied. There’s no desire, there’s also skepticism that trying to export more of it will result in decline in prices.

Also shared by the economists, this elasticity pessimism that existed at the time. On the one hand, where elasticity was high—both price elasticity, as well as the income elasticity was high which is cotton textiles—there we let it decline for totally the wrong reasons, meaning we are trying to do only heavy industry. The capital has to be saved for the heavy industry, so cotton textiles get neglected. Where we were exporting rather than still trying to double up those industries, we let them decline also through these controls on exports and export taxes. Overall situation on the foreign exchange is bad and that’s why there’s the crisis and so forth. Now, of course, the import policy, how it looks—

RAJAGOPALAN: Before the import policy, to me, it seems like whatever we see later at an economy-wide scale in India, which is the problem of command-and-control policies, we see it as a microcosm with foreign exchange budgeting, under B.K. Nehru, the same kind of adverse consequences. What you basically have is, you have a bureaucrat who’s in control of all the resources, and it’s the job of the bureaucrat to pick winners and losers, as opposed to the discipline of a competitive market, picking winners and losers. The bureaucrat has already decided that the winner is heavy industry. It’s not going to be some of the consumer goods like garments and textiles that you were talking about.

Now you almost have a self-fulfilling prophecy, because all the capital is only going to go to heavy industry. You further have a situation where all these consumer goods manufacturers no longer get the investment they need, and they’re going to be less competitive, which means they are going to export less, which means you’re going to earn less foreign exchange. Which means that the demands of the bureaucrat who’s controlling foreign exchange in the first place become worse. Now you do this over three or four or five cycles, and you end up in a very dire situation by, let’s say, the mid-1960s. Is that a good way of thinking about what happened post foreign exchange budgeting?

PANAGARIYA: Yes. I think so. Absolutely. It’s interesting. There is a quote somewhere in B.K. Nehru’s autobiography—because you mentioned the fact of the bureaucrat making the decision. At that time, he was a junior. The first time when he did this in 1948 he doesn’t mention the date exactly, so one has to guess a little bit. But from reading in between lines, probably around 1940, or maybe ’47. He was the junior-most joint secretary in the ministry.

He issues the order that henceforth, and then very triumphantly writes in his autobiography, saying that every minister had to come to the junior-most joint secretary, Mr. B.K. Nehru, to get the clearance. Mr. B.K. Nehru had the power to now cut anybody’s foreign exchange demands to whatever he thought was appropriate. That, of course, as I said, was gutted after he went to IMF as executive director. But then when he came back it came back, but it was very much of a bureaucratic decision. It was very much a bureaucratic decision.

RAJAGOPALAN: As you say, India has in a sense, doubled down on its heavy industry policy. It has doubled down on disincentivizing small industries or hand industries and so on, so forth, but it has also doubled down on the role of the bureaucrat as the coordinating node for all economic activity in the country. These three things, these were bets that were made by Nehru in the late ’40s, and by the late ’50s, we’ve doubled down on all three bets.

Even though, at the end of the second plan, there is some minor criticism about what’s happening. How does this play out exactly in terms of the import and export system? In particular, I want to talk about the controls and tariff system. From what I understand, tariffs, even at this point in time, played a fairly small part in India’s trade policy. India’s trade policy was really about import and export controls at that time.

Can you walk us through this because this is an area not too many people are familiar with? It’s a little bit extraordinary once we hear about just how deep the control system went. There’s nothing like this that exists in India today, even though we are still a relatively restrictive trade regime. This is just something that you read in sci-fi novels or something like that.

PANAGARIYA: Even though it’s a bit tedious of a discussion, I think we ought to look at it in some detail. Today, very often there are casual remarks get made that, oh, we are returning to 1970s. No, no, we are not returning to 1970s, because anybody who makes that remarks just doesn’t know what 1970s and ’60s were. It is worthwhile from that perspective to flesh it out a bit.

As you said, yes, tariffs were not used as the predictive instrument. Nor they were used in a serious way as revenue instruments. Either way, you would have actually tried to take out all the quota rights that got created. Licenses created a lot of premium on the imported products. On average, the highest tariff—this is 1965-66 we have the data from Bhagwati and Desai—consumer goods were the highest, which is 100%.

Anyway, that didn’t matter much because licenses were so tough to get for consumer goods. Basically, by ’66, except for rare commodities, you would not get. These were not even permissible commodities. There were permissible commodities and there were non-permissible commodities, and consumer goods largely were non-permissible. Plant and machinery 35%, agricultural machinery 15%, basic industrial raw material 40%. They were not particularly high. Collection-wise also if you look at ’62, ’63 import revenues, tariff revenues as a percent of the dutiable goods. It’s not even a percentage of all imports but only goods that were subject to positive duty—25% or 26% in ’62/’63, it rises steadily to about 55% by ’65, ’66. This is really nothing compared to what we would call the import premium. I’ll give you some examples. You’ll have a good laugh at some of these numbers.

On some consumer goods, for example—Bhagwati and Desai have a very good documentation by the way. Anybody who is interested, should really read that book. It’s a hard work to read but it’s absolutely a gold mine of information. It’s not just trade policy. Trade policy is fleshed out in detail also but also industrial policy, politics, private versus public sector, everything. It’s a fantastic book. Anybody interested in that part of the history really should read that book, absolute landmark.

Here are some numbers: Pens were generally not allowed to be imported. It was very difficult. They provide three different types of pens. There’s Goldwing, Beverly and Hindoo, H-I-N-D-O-O. On Goldwing, this is the premium over the world price, CIF delivered price. What you are looking at is what is the domestic price, minus the CIF price from imported as a percentage of the CIF price.

By what percent the domestic price exceeds the CIF import price? For Goldwing, 380%, for Beverly, 291%. They are pencils, lead pencils. Taj Mahal lead pencil was the desired commodity in those days because the premium on that was 602%. You got writing paper. There’s some Conqueror writing paper, 610% premium. These are the final products but then there are also intermediate products.

The engineering goods like shock absorbers for Jeep. In fact, in this case, the numbers are giving you the percentage by which the domestic price exceeded the tariff inclusive price. Yes, so in this case, tariff inclusive even that’s taken out and on top of the tariff, this is the amount of profit you can make, proportionate tariff you can make if you got the license. Shock absorbers for Jeep, 146%. This is 1962. Shock absorbers, Land Master, 150%. These are incredibly high premiums that are there and that’s because tariff policy is not what is determining what your domestic price is. It is the import restriction which is so tight and the demand and the need for it is so intense that people are willing to pay that kind of price.

RAJAGOPALAN: Yes. One of the things is also paper in your list, if I can find printing paper Solex, the premium is 265. And it reminds me of the anecdote you told me about Bhagwati writing to his friends abroad.

PANAGARIYA: That’s true, it is a good one.

RAJAGOPALAN: Maybe you can tell us that anecdote again.

PANAGARIYA: Yes. Obviously, this paper being so expensive everybody would use the Indian paper, right?

RAJAGOPALAN: Yes.

PANAGARIYA: Bhagwati came from Cambridge and was very nationalist at the time. The whole family was; apparently one of his brothers was also a participant in the underground movement and all at the time. His teacher, Harry Johnson who’s a trade economist and of great repute actually because he had lived long, he died relatively young, somewhere around ’76, ’77. Probably Jagdish and Johnson would’ve been jointly awarded a Nobel prize if he had been alive. But anyway, he wrote to him saying, “Harry, I find it so repulsive”—or something, not quite those words—“it’s really disappointing that there is such a craze for foreign goods in India.” Harry, being also a very quick wit, wrote back saying, “Jagdish, if I go by the quality of the paper on which your letter was written, the craze for the foreign goods seems quite justified to me.”

RAJAGOPALAN: Just to connect it back to some of the previous discussions we’ve had in the last three episodes, this is classic, right? There is this huge premium for imported goods, which means there’s this huge demand and basically, you have this huge demand because you want to make sure that the goods are not imported and some domestic substitute is used. But because there is such a big premium, the domestic competitors don’t have to really compete, which means that their product quality ends up being relatively low. They’re not competing with the best paper abroad or the best pens abroad, or any of the shock absorbers, any of the examples that you gave. That bears out perfectly in this lovely anecdote of letters between two trade economists, which is everything we’ve learned about trade. It’s in this one table in Bhagwati and Desai, right? There is this premium on paper, and now this is where we’re going.

PANAGARIYA: And you’ll see as we go, obviously when you say that they’re not competing with the best in the world, they don’t need to because—

RAJAGOPALAN: They don’t need to.

PANAGARIYA: —it doesn’t matter. The way the import regime is going to evolve now or has evolved by mid-1960s is that if anything is produced at home, whatever the quality of it doesn’t matter, whatever the price at which you are going to get it doesn’t matter. Protection will be provided. If you say that I’m going to produce something, imports will not be permitted anyway, of it. They didn’t have to compete. Absolutely.

Anyway, what we can do is, for the listeners, try to walk through what exactly this import system looked like. All right. Now here, there are two parallel bureaucracies at work. One bureaucracy has to take care of the foreign exchange issue, how the foreign exchange is going to be allocated. There has to be a bureaucracy to do that. In parallel, there is another bureaucracy, which has to make decisions on what goods will be allowed to be imported, import licensing authority.

There is an import licensing bureaucracy and there is a foreign exchange bureaucracy. At some point, of course, the two have to come together. But what the two bureaucracies mean is that your first job, if you want to import something, your first job is to get an import license and then you have to get the foreign exchange. Getting the import license is necessary but not a sufficient condition that you’ll eventually be able to import, or when you will be able to import. Ultimately, foreign exchange will have to become available as well. You will have to wait a little longer. That’s the first broad point: That there are these two bureaucracies with which you have to deal.

First of all, there were three main kinds of authorities that had the power to issue licenses. These are not overlapping. These were charted out. Most of the licenses were issued by the chief controller of import and exports. There was a chief controller of imports and exports who issued most of the import licenses, except the ones that were issued by the other two authorities. Who are the two other authorities? The iron and steel controller.

You can see heavy industry and steel, Nehru’s favorite industry, that was always supreme. You had a separate iron and steel controller. Any licenses that had to do with the imports of iron and steel, iron and steel controller would issue those licenses. You had to deal with that.

Then the third one which is the development officer (tools). This is where some technical stuff goes on within the development wing of the ministry of commerce. Anything that had to do with technical stuff, what licenses that authority, the development officer in commerce ministry, issued was also stated, that this is their territory. That was the division. Most of the licenses therefore were issued by the chief controller of imports and exports, known by the acronym CCI&E. In those days, you never use the full form, chief controller of imports and exports—CCI&E.

What were the import licenses themselves like? There’s a full classification of different import licenses and these are terms we have already discussed earlier. There were the established importers. These were the importers who could import and then sell it to others, as opposed to the next category which was actual users. Actual user licenses were issued only to the actual users as it’s what it says. These are largely for raw material intermediate inputs. All the inputs that have to be imported would go as actual users and then there’s established importers.

Then they had a separate category called capital goods. Any capital goods to be imported which were also usually issued only to the actual users, no established importer will get licenses there, that was another very important category. If you’re starting a new enterprise and obviously, there’s interface there with the industrial licensing authority ultimately because the industrial licensing authority will not give you the industrial license unless you had the clearance first from the capital goods committee of the CCI&E.

That’s how it worked. The industrial licensing was connected also to this import licensing. It’s not just the import licensing and foreign exchange authority but also there’s a link to the industrial licenses. Then there were some others, like heavy electrical plant had a separate category for itself. These are electricity generation plants if you are going to make it. There were licenses for newcomers—established versus newcomers. I don’t think there were many in those days, but if somebody found a way, some connection or whatever, then there’s a newcomer’s license.

Then there was an export promotion. This was also done particularly in the ’60s they had started this. There were some export promotion licenses as well. Then there were miscellaneous categories. Really, the main ones are actual user for inputs and capital goods for capital machinery. Those were the licenses to be issued. How the system worked was that what we can do basically—Bhagwati and Desai they give an illustration that you look at how the actual user licenses were issued for these inputs. That’s the illustration they gave you.

First, the importer had to meet two basic conditions. If you’re an importer, first thing you need to do is get clearances for two conditions. One is essentiality that we have already seen before, that was introduced in the Second World War, but now it becomes very critical. Now the implication of essentiality condition is simply that, it gives bureaucrats some power. If the bureaucrat decides that this is not an essential import for whatever reason, then you’re done for.

Then the second condition that had to be offered, even if it was essential, it also had to be something that was domestically not available. There was a domestic nonavailability condition. That condition was regardless of cost or quality. It doesn’t matter how much it is going to cost to get from a domestic source, it doesn’t matter what quality product you are going to get.

I remember Anne Kruger has this example: One time India’s tea exports were suffering to Germany. They were suffering, they were losing out to the competitors because the tea bags, they had to use local paper and that quality of the paper was so poor that their exports were getting rejected. But the government of India would not allow imports, because they were domestically available, they failed the condition of domestic nonavailability. Anybody who comes in and says yes, I can provide it, doesn’t matter how good or how bad the quality didn’t matter, price didn’t matter.

For both reasons you could be driven out of your export markets. If quality is poor, you’ll get driven out. If the cost is very high domestically, then also you’ll be driven out, but that was a condition. Then who was the authority to give these certifications? That’s where there is a sponsoring agency that comes into play. You have to have some, so they’ll be designated for different sector imports. They’ll be different ministries or different directorates who would be authorized to be the sponsoring agencies, who would normally give the essentiality certification. Many times this sponsoring authority will also give the domestic nonavailability certification, although the two agencies were not always the same. Sometimes your essentiality certification maybe from one authority and your nonavailability may come from another authority, but these were designated so you have to go and get those.

Now actual user licenses for input imports, how did it work? The actual user licenses themselves then get divided into several groups. For example, they get divided into small-scale sectors. There are some licenses, which are the small-scale sectors, actual users. Then there is second, which is organized sector schedule industries that are assigned to the directorate general of technical development in the ministry of commerce. There is the small-scale sector, then the large-scale sector is divided into two. One is the set of industries, and these are more technically sophisticated industries, for which you have the directorate, organized sectors, scheduled industries assigned to the directorate general of technical development. Then you got the other organized sector schedule industries or whatever you call the other large-scale industries. Small and then large, and large divided into these two. The directorate general of technical development certified the importer for both essentiality and domestic nonavailability condition for industries that were assigned to that. The directorate was assigned a number of industries and they would give both the essentiality certification and nonavailability certification.

For small scale, they were the state directors of industries who gave the same clearances for small-scale importers, entrepreneurs. Then for the remaining schedule industries, there were a number of different agencies, depending on the type of import. There was the central silk board that will certify the essentiality and nonavailability for the silk industry. There was a coal commissioner who would do it for collieries, there was the textile commissioner who would do it for textiles, like that. There were these different designated agencies.

RAJAGOPALAN: Yes, but this is a natural consequence of the original problem, right? If you don’t have a tariff system and you instead opt for a control system, as part of your trade policy, then you say, okay, now we need some rational mechanism by which we can allocate, which is not the market rational mechanism. We need to substitute it with something, and then they come up with this essentiality and nonavailability, but both essentiality and nonavailability completely depend on the sector in question. Now, you’ve created a situation where you need about seven different bureaucracies, the ones that you’ve mentioned.

Because a random person sitting in the commerce ministry may not know much about silk or textile or tea, or the DGTD, which is for chemical fertilizer or something like that, which means now you need to house these new bureaucracies, you need to hire chemical engineers who will become engineers-turned-bureaucrats, who then have to go through a particular protocol and say, this is essential or not, or this can be produced at home or not. The whole system in a way creates itself, right? It’s not like someone messed up and made a hack job of it. It’s, if you start with import controls, this is the only logical place you will end up, and there’s nowhere else to go really. In fact, I’m surprised it was this limited. I would’ve imagined even further proliferation, which probably would’ve happened if you had gone past.

PANAGARIYA: Don’t underestimate by the list here because this list is partial because all the ministries will chip in and later on, as it evolves, there were groups of ministers created. And by the way, I don’t think they’re hiring engineers to do this, except maybe in DGTD, maybe there were some. But largely these are operations run by the IAS bureaucrats, because remember that there are big rents associated with these decisions, big rents associated. So at every single point you’re creating rents and therefore potential for bribes. And this is why also the files, the movement of files, the file begins with the lowest level officer within any ministry, for anything. The essentiality or nonavailability, the file will start at the bottom and you have to put some weight on the file before it moves.

RAJAGOPALAN: Absolutely.

PANAGARIYA: Meaning you have to bribe the fellow.

RAJAGOPALAN: I remember T.N. Srinivasan had said somewhere that you have all these different controls, right? You have capital controls and you have import controls, you have industrial licensing controls and price and quantity controls. Then he said, all the controls taken together were far more restrictive than each of them individually. So for instance, if you get the industrial license, it doesn’t automatically imply that you have a capital goods import license. Then you have to go and stand in front of a different bureaucracy altogether, and it’s only when you get all the licenses, can you even start. That’s the starting point for production for a domestic entrepreneur. There is something really quite crazy going on in the way the Indian economy started running, starting in the ’60s and then goes on for—

PANAGARIYA: Yes. Not only multiple points, but they also interact you see because once foreign exchange became limited, then if you needed machinery, for example, previously in the 1950s, it was enough to give the broad category within which the machinery import would fall. Meaning broad category of the industrial classification. Now once this happened, you have to give a very detailed description of the machinery, of your raw materials. Everything had to be very specific, very detailed description because it had to be then assessed by the essentiality authority. Otherwise, how do you even assess? You have to give very detailed specifications. Even that sort of thing crept in. Yes, sum of the restrictions actually amount to a hell of a lot more than the individual restrictions taken in isolation. Absolutely.

RAJAGOPALAN: Now, this licensing, this is just the import licensing part of the story, right? There is also an entire system of controls related to foreign exchange for instance?

PANAGARIYA: Absolutely, yes. Then there is a separate bureaucracy that runs on how the foreign exchange is to be allocated. Eventually, by 1965, it existed. It started at the top with the foreign exchange budget branch in the DEA (Department of Economic Affairs) in the finance ministry. They had a whole separate foreign exchange budget branch.

What they would do is first, they will estimate what the foreign exchange availability from exports and other sources is going to be over the next six months or a year. There used to be something called the Red Book that came out of the commerce ministry every six months or sometimes every year. The Red Book spelled out in great detail what is allowed and what’s disallowed, what is permissible, what’s not permissible, in what quantity, from where. It is an incredible documentation. That’s how it started there. What happened then?

Firstly, what they would do is there were some priority items, which they would take out at the source within the finance ministry itself. Any debt service charges, debt payments, any interest in principle that had to be paid back on India’s foreign debt, that was deducted first. Embassy expenditures were deducted first. Anything that’s related to food, fertilizer and petroleum oil and lubricants (POL) defense expenditures, that also got taken out. All this got taken out. Then what is left over is what is available for the allocation to other importers.

Now, we come to the foreign exchange, which is now to be divided. We start with three categories here, which is at the level of the finance ministry, the DEA this so-called foreign exchange budget branch of the DEA. There will be one allocation or a number of allocations for public-sector undertakings. What would happen is that the finance ministry itself, DEA, would allocate each public-sector undertaking for a certain amount of foreign exchange, both for inputs and for capital imports. These are for public-sector undertakings or public-sector enterprises, and it will then assign that foreign exchange to the ministry that is relevant.

If that particular enterprise belongs to heavy industries, then it will go to heavy industries; if it belongs to textile industry, then goes to textile ministry, like that. That’s the allocation. Now, it’s up to the ministry. Because remember now, the allocation problem, both for license as well as for foreign exchange, particularly foreign exchange, is not just at the level of the industry, then it has to be to the level of the enterprise. Which enterprises are going to get, which enterprises are not going to get. There is also that allocation which we have to deal with.

Now, first off the public-sector enterprises, for them goes to the relevant ministry, foreign exchange allocation is communicated. Then there is a bulk allocation for inputs and capital goods that went to the iron and steel controller. That is the favored child of the government of the day. There is iron and steel controller. Remember that iron and steel controller also issues the licenses. In this case, the foreign exchange decision as well as licensing decision and also the essentiality and nonavailability condition issuance, all that is in this iron and steel controller. The remainder of the foreign exchange was allocated to the economic adviser in the ministry of commerce. Largely this was for the private-sector enterprises who wanted to import inputs or machinery. For the bulk actually, once you took out the public-sector enterprises, you took out iron and steel, the bulk of the remaining foreign exchange now is for the private-sector people. That authority, at least the allocation is now sent out to the economic adviser in the ministry of commerce.

Now it’s up to the economic adviser in the ministry of commerce, to figure out the allocation across industries first and then from industries, it has to be figured out to the individual enterprises. You can see, it’s not a simple bureaucracy. I’ll give you some numbers. You will find it’s mind-boggling actually, once you begin to see the numbers that are involved here.

Each of these entities then got their allocation of foreign exchange. They had to, as I said, divide among the industries and enterprises. Now, how did the economic adviser allocate? Now, the economic adviser created a lot of the groups of entities to which it will then allocate the foreign exchange. There were some groups created by commodities. Examples Bhagwati and Desai gave like copra, iron and caustic soda, these are commodity groups. Then, there were groups of industries, such as bulk allocations to the directorate general of technical development. Remember, DGTD is the authority for many organized sector industries to issue the essentiality and nonavailability certification.

For that group of industries, the economic adviser in the ministry of commerce will make an allocation to the DGTD, the same authority. For a lot of these industries, iron and steel, it’s for both licenses as well as for foreign exchange allocation. Likewise, DGTD had the jurisdiction over both functions in a large number of industries, particularly the chemical and engineering industries. Then, by size of enterprises, the adviser will make another allocation, meaning small-scale, so for the small-scale sector, another bulk allocation gets made.

Then there were schemes such as export promotion schemes under which exporters were given some entitlement to import under an entitlement license. For that, there is a separate allocation made. These different categories are identified by the economic adviser, and there is this allocation done of the bulk allocation that the adviser receives. Now it has to be then further at the enterprise level, there has to be separate allocation. The adviser also has to decide about how much to allocate for the input guys, raw materials and intermediate inputs, how much for the capital goods. That allocation has to be done.

In most of these cases, there were different administrative agencies, such as the DGTD textile commissioner, etc. involved. It was not unusual for an enterprise to get foreign exchange from multiple agencies. If you need steel, then it’s the iron and steel controller. If you need nonferrous metals, you have to go to another agency. If you need capital goods imports, you have to deal with another agency. Any importer in principle could be dealing with multiple sources of foreign exchange. It’s not like, well, this is my total need and this is what—no, you have to have separate applications made for every one of these separate categories of imports. It was really a very, very elaborate system, but this is just a process. Now comes the question, how do you allocate?

RAJAGOPALAN: The question is not just how do you allocate, it can’t just be any random allocation. It is, is this allocation rational? What we mean by that is, is it the best use of scarce resources? Are resources going to their highest-valued use within this system, the way they would have done in a competitive market process? There is a standard for comparison. We’re not just saying, oh, you have 100 rupees and let’s make sure that the different sectors are all happy with the small share of the 100 rupees. The claim in the socialist system and this autarchic system is that it is an improvement upon the market system. That is something we mustn’t forget at the back of our mind. The job is not just that it has to be done but the claim is that it’s done better.

I want to go back to an earlier point that you mentioned, and I have a personal anecdote here where you said that at that time journalists and public intellectuals and everyone was socialist and there was no real criticism coming from any quarter.  My grandfather and his younger brother, my great-uncle, both were journalists. My great-uncle, in particular, at that time, for a long time, he was with Hindustan Times and then with The Hindu, he was based in New Delhi. He’s told me so many stories of how national newspapers—we’re talking about Hindustan Times or The Hindu or these really big papers—you have to go and stand in commerce ministry or iron and steel or any one of the departments that you’re talking about to get allocation for a printing machine, to get foreign exchange allocation for newsprint. Of course, we know the newsprint orders were used in a particularly malevolent way by Mrs. Gandhi.

It went on to the Bennett Coleman case and then the supreme court said, this is an actual infringement—the newsprint order which is essentially an import allocation policy, it’s a trade policy question—said that it’s an infringement on free speech in that particular supreme court case. You have a situation where if you need—R.K. Laxman has written in his biography—that if you needed to make a trip abroad as a journalist, you needed to get your allocation of dollars. How do you get that?

When we’re thinking about this and we say iron and steel, or we say paper, or we say coal, our natural tendency is to only think about a particular type of industry. We are thinking about, this rich, greedy capitalist standing in front of a really malevolent bureaucrat, but in fact, it seeps into everything. It seeps into schools, it seeps into hospitals, it seeps into newspapers.

Before you know it, especially in the case of newspapers and schools, you can’t have any opposition to the current dispensation and its economic regime because you are all waiting in line to get your allocation which can be taken away at any point by one arbitrary move of someone saying this doesn’t fulfill essentiality or something like that.

PANAGARIYA: No, absolutely. It’s a perfect system for extracting bribes.

RAJAGOPALAN: Abuse. Absolutely.

PANAGARIYA: Abuse and extracting bribes. The pity is that the cake is so small. Bribes that are being extracted are also small. Sometimes all you are doing is to treat the fellow to a cup of tea or something or samosa maybe. Because incomes are so low—I remember when we were growing up, we would complain that, oh, such and such he’s an irrigation engineer and he’s such a corrupt fellow and all. When we grew up, we found out that nobody became rich taking bribes because ultimately the cake was so small.

RAJAGOPALAN: It was more like a favor exchange system. The bribe for the bureaucrat was that the son-in-law will be given a job in the company that was requesting the foreign exchange or something like that. It really became a favor and crony economy in addition to a corrupt and discretionary economy. It really started enforcing these networks of you need to know who is who, and that’s how you get things done.

Even when you look at all these old 1970s movies like these Amol Palekar movies, it keeps popping up how you can’t get a job without sifarish, without someone calling from above. It really became like this favor exchange economy. It has implications even for human capital allocation, right?

PANAGARIYA: Yes, of course.

RAJAGOPALAN: You mess with this trade and capital control system, and eventually, all the downstream effects are that it infects everything. Just to take this further, in addition to what you said Bhagwati and Desai and of course, Arun Shourie’s excellent work—his doctoral dissertation on this foreign exchange allocation, it’s very readable—what are the economic effects beyond this immediate, corrupt political economy that has been created for foreign exchange?

PANAGARIYA: Let’s come to the effects. First, just the basic idea just to complete our discussion of how difficult the system was and the whole idea that ultimately, all right, this was the process. But how was the process implemented? What were the priorities? Precisely how did the bureaucrats decide? Bhagwati and Desai write this beautiful sentence.

As a result, there was no rational way. This is where Arun Shourie’s thesis also comes in because he precisely probes that particular question, how are you assigning the priorities?

Even some people tell him that, oh, yes, some particular industry, which is doing it, or some ministry doing it, say that, no, no, we have to establish priorities. We have high, medium and low priorities. Then, of course, Arun Shourie, goes and further probes those who are actually doing the allocation, are they using these priorities? But in fact, nobody’s using them. There is no use of the priorities.

Bhagwati and Desai they just say that,

Ultimately, when you can’t figure out a set of priorities, and the reason you can’t figure out the priorities is that the list of industries—and this is where the system gets really hairy—the list of industries over which you have to decide priorities is so long. Bhagwati and Desai in fact, go in just to impress upon the reader how difficult the problem is. They give a list of 123 industries. They’ve listed every single industry. Then they say that each of these industries is subdivided into another dozen, dozen and a half industries. For one or two, they even give the subindustries. Just think about 123: If each one has another 10, it’s 1230 industries.

How are you to decide who has priority over which? It’s just impossible. There’s no rational way for the bureaucracy to see the whole picture. Then also see what the industry license authority is doing. There’s no way. The Orwellian kind of characterization by Bhagwati and Desai is absolutely a very apt characterization. This is where then they say that ultimately they will say some notion of fairness. “They have got this much capacity, so we should allow that”. Or they will make these rules that, “this particular six months or this particular year foreign exchange is in short supply, so we’ll give everybody, let’s say, 60% of the capacity”. Why everybody 60% if they’re not all equally productive or their products are not all equally desirable and so forth? Everybody gets it because that’s fair. “Or last year, how much did we allocate?”

RAJAGOPALAN: That was the typical method.

PANAGARIYA: Yes. It’s not being decided based on either efficiency or desirability of the particular product, where excess capacity is less valuable, where excess capacity is more valuable. None of that is playing. It’s basically these decisions.

Shourie, for example, there’s a very good quote which appears from his—you’re right, his thesis was written in 1966 at Syracuse University. Arun Shourie as quoted in Bhagwati and Desai saying that:

RAJAGOPALAN: One part of it is that it’s very complicated and there is no criteria. The other part of it is that whole Mises-Hayek impossibility of socialist calculation. It’s not just that it is difficult to do, it’s that it simply can’t be done. The nature of the problem that they are trying to solve, which is to substitute rational allocation through market forces with a bureaucratic allocation, you’re simply not going to be able to calculate your way out of it. Because now you’ve said that prices and profit and loss are irrelevant to your allocation.

PANAGARIYA: Yes, exactly.

RAJAGOPALAN: If you have price controls and you don’t allow for profits, all that is happening through the industrial licenses and control system and price and quantity controls, which already exist in the market. Once you don’t rely on prices and profits, what is the rational basis for allocation? There simply isn’t one. Then you have to replace it with something.

In some sense, some of the more honest bureaucrats, they did their best, they pored over the 123 categories, and said, a little bit upar neeche from last year’s allocation seems about fair. You’re tinkering. Some of the less honest bureaucrats are just going to make something up and give it to the people that they favor. Everyone can now indulge in their biases.

Still, the problem I don’t think is with the people involved. I think the problem is just the system. They place you and me in the system and all our collective economics knowledge is going to collapse, right?

PANAGARIYA: No, no, absolutely. There is no doubt that it couldn’t be done. It just couldn’t be done. When ultimately it got to the firm level, Panchmukhi, the old trade economist, he had this wonderful study that he got some firm-level import data. Then tried to correlate it to profitability. In many cases, he found the correlation to be negative. It’s the guys who are least profitable who were managing to get the foreign exchange. The ones who were profitable were getting much lower allocation, which is not surprising. It could go any way, maybe there would be no correlation also.

That was how it was, it was basically a problem which could not be solved. Therefore, you had to seek ad hoc solutions. For the bureaucrat, what is most worrisome is that somebody will raise the question. You have to be there, you have to have your criteria, which is transparent, at least you can answer. You say, whatever I did last year is what I did this year. That is defensible.

Apparently, during the China war, because foreign exchange was required for defense-related imports, all the regular imports had to be cut. They did a largely proportionate cut across all industries. That tells you that they were using the rule of thumb. That’s evidence that Arun Shourie cites that they were using basically the rules of thumb.

RAJAGOPALAN: I have to say, there are two things I’ve read by Arun Shourie, which I recommend everyone reads. This dissertation, the one he wrote in 1966, and a later book that he wrote called “Governance” which is about his experiences as disinvestment minister. The lovely thing about Shourie is he does exactly what you have been doing in the last hour. Not just saying we had this import control policy or something, but actually walking through the details and weeds of, who were the people involved, who were the bureaucrats involved, how did a file move from here to there?

RAJAGOPALAN: Thank you so much, Arvind.