Budgets, risk, and Knightian uncertainty

Budget season for a certain type of economist is a time for letting the im­agination run riot. So two bad ideas are being propagated so vigorously that, as so many times in the past, good pe­ople are considering adopting these bad ideas.

One bad idea is the creation of a “bad” bank. The other is the reincarnation of a development finance institution (DFI).

A “bad” bank is a financial institution that takes over the bad loans of other banks so that their balance sheets start smelling of roses. It’s the way Indian streets are swept — by moving the dirt from one side to the corner. Then someone else cleans it — in exactly the same way.

A DFI lends money to high-risk, long-gestation projects in the fond hope that it will get its money back. India had two till their financial condition forced the government to shut them down during 1999-2001.

There is a reason why these bad ideas are in play once again. It is the persistent con­fu­sion in India between risk and uncertainty.

As a result, although India has huge economic potential, it has not realised it. Many explanations have been put forth for this poor performance.

So here’s one more. It’s unlikely to make any difference. But it’s worth a try.

Risk …

Indian governments have tried, as everyone does privately also, to minimise risk as far as possible and even eliminate it. This is a perfectly legitimate objective.

Thus the entire policy and regulatory effort has devoted itself to eliminating or re­d­­ucing risk for all economic agents. It’s something — and the only thing perhaps — at which the bureaucracy is very good.

And to their credit, it must be said they have been mostly successful. Failures have happened because of corruption, not lack of effort to eliminate risk.

But this success has come at a price. In fact, many would argue that it is this very success that has held down the economy.

Economists have written extensively about risk and its mitigation. There are good ways of doing it and bad ways too. By and large Indian governments have chosen the bad ways.

Planning was a bad way. Price regulation was a bad way. Industrial licensing, abolished after it had done massive harm, was a bad way. Government-directed credit was a bad way.

Indeed, a government owned central bank was a bad way, too. The RBI was private till 1949.

The point is this. De-risking is fine except that it also means low returns.

That has translated into the persistence of low rates of GDP growth. It’s like driving slowly and arriving at the bus stop — and missing the bus.

… and uncertainty

Uncertainty is the Siamese twin of risk. It looks the same but, at the same time, is completely different.

This is because while risk can be managed, uncertainty, by its very definition, cannot. For example, there is risk when you drive and you can manage that risk by driving slowly and following all the rules.

But there is uncertainty, too. What do you do if someone suddenly runs across your car? That’s what uncertainty is and it can’t be managed.

The man who made the distinction first 98 years ago was an American economist called Frank Knight. His teaching is called “Knightian Uncertainty” and it should be­c­ome a compulsory course for policymakers.

I say this because even as bureaucrats carry out political orders to reduce risk, they end up increasing uncertainty. The reverse is not true because uncertainty is sui generis.

That is why no one in India knows when there will be a sudden and unexpected change in policy. And our Budgets provide a wholesale opportunity for announcing such changes.

It’s scattershot stuff and it is “Knightian Uncertainty” at its worst because it basically says that in human affairs at any given time there is a limit on knowledge. The resulting ignorance of consequences increases uncertainty across the board.

Nothing illustrates this better than the revenue-maximising efforts of Budgets. The government thinks the more money it has, the more it can help growth to be faster. But this very effort ends up slowing growth because it raises the risk for investment by increasing uncertainty.

That’s why I have often wondered whether we would not be better off if the Finance Bill was presented once in five years only. Each year the Bill has 75-100 changes to the previous one. Not having any for five years would be like being on a turnpike, which is a straight road without intersections and bumps.