 Welcome to the discussion series on free trade and liberalization as part of the 1991 project at the Mercator Center. I'm Shruti Rajagopalan and in this conversation series I will be talking trade with Professor Arvind Panagaria who is the director of the Deepak and Neera Raj Centre 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 Ayog in Government of India and as chief economist of the Asian Development Bank. He's the author of a number of books but for today's conversation in particular we will focus on his recent book Free Trade and Prosperity. Welcome Arvind. Hi Shruti, very pleased to be back with you. Thank you for joining us for episode 3 and Talking Trade and Reforms. I wanted to talk today about a few aspects of protectionism as a continuation of our conversation last time. So in the last episode you detailed the various reasons why the infant industry arguments against free trade are misguided. Today I want to go over some of the other common arguments against free trade and for protectionism especially in developing countries and I would request you to perhaps expand on each of them and tell us if these have any merit, whether it's a question of information externalities or diversification or coordination questions, capital market problems, import substitutions, the bias against imports and the bias towards exports. These are just themes that have popped up over and over again starting in the 60s and 70s in India but these themes and arguments are very much alive today and they're always brought forward in some kind of new packaging to serve up protectionist policies. So I think it would be very, very helpful if we could go through each of these arguments and we could get your take on them. Wonderful Shruti. So let's begin with the diversification and information externalities. The diversification argument has itself come into different forms. First there was the early diversification argument that was used particularly in the Indian context that we wanted a diversified structure of industry and as a part of that we went in and because the constituency for open markets was almost non-existent India almost went to the extreme of offering what one might call protection on demand and sometimes in the earlier literature particularly Max Corden I think used this term made to measure protection something of that sort I forget. So the point was that if anybody said that here is a product that the country is importing but I want to produce it at home and we said okay we will simply private the import of the product. So this is pretty much anybody who is willing to produce the same product that's being imported would get protection. Another way we did it was that under investment licensing we would say that well we will give you the license so think of it that suppose these are tube lights somebody says I'll produce tube lights but of course you and I will have to import the parts. Well all right we will allow you for four years to import the parts and issue you the license for X number of tube lights to be produced but within four years you have to indigenize the product meaning so the diversification here meant not only producing assembling the tube light but also ultimately source the components that are assembled locally and that could mean either you yourself kind of manufacture these or seek some local manufacturer for these and so that was the diversification. So that's one form in which it played out. Now and that eventually fell out of favor at least even within India after 1991 reforms and so forth but now there has been a resurrection of the argument in a very different kind of form so there is some development research that came through so there's this paper by Imps and Regziard and they find that the rising per capita incomes are accompanied by increased diversification within sectors so if industry grows even if it remains a constant proportion of the GDP what happens if per capita incomes are rising is that within industry each product kind of becomes more and more diversified different varieties of the product come in. So there is new products being discovered which become a part of the of the basket so some sort of innovation seems to accompany either in process or in product so what has happened is that some economists most notably I think you know Danny Roderick has tried to capitalize on that kind of diversification being a part of rising per capita income is a part of rising growth rates so he says that you know product diversification itself requires the discovery of new products variants of existing products and processes that allow the available products to be produced at lower cost of production so he says then that these discoveries do not lend themselves to patenting you know if you could patent them then of course there is no externality problem and this is something we discussed earlier if you recall in the context of the infant industry argument for protection and so he says well look you know because they cannot always be patented meaning that there's a danger that they will spill over and then we'll have that problem that then nobody would invest in this discovery of new products I mean that's the problem we encountered earlier so he says there's a free rider problem here other firms can copy them without having to incur any of the costs of discovery so therefore no firm would want to undertake the discovery and that of course then paves the way for government to step into to take some action so then Roderick says look you know the first best policy is a subsidy on investment in new non-traditional industries but that requires close monitoring which is not practical so then he goes on and this is something you know I'm just giving you as a quote really that this is how he then builds it up says that in Hausman and Roderick this was a 2003 paper we recommend generically a carrot and stick strategy since self-discovery requires rents to be provided to entrepreneurs one side of the policy has to take the form of a carrot this can be a subsidy of some kind trade protection or the provision of venture capital note that the logic of the problem requires that the rents be provided only to the initial investor nor not to copycats to ensure that mistakes are not perpetuated and bad projects are phased out these rents must in turn be subject either to performance requirements for example a requirement to export or to close monitoring of the use of the uses to which they are put now that's the argument right so what he is saying is that well look you know you can't patent them and so you have to incentivize these innovations and how do I incentivize innovation well then there is a carrot and stick kind of strategy that what you need to do is ensure that anybody who makes a discovery gets the rent at least for a while that accrues to it so that can be some sort of subsidy or then use this could also be trade protection or the venture capital first of all if it's venture capital the government doesn't need to intervene I mean venture capital is a phenomenon that should come endogenously so why is that intervention even required really I mean if you allow room for venture capital you come through if the market sees that yeah there are some entrepreneurs out there who can innovate right I mean that's the whole idea of the startups etc being financed by venture capitalists protection now he's also put throws in their trade protection could be the carrot and we saw if you recall in the context of infinite industry argument that trade protection really does not solve that problem so I don't see how you know if it fails in the infinite industry context then how will it not fail here when it comes to product innovation right any kind of innovation that costs money and then can be free written by somebody else firms are not going to innovate they will continue to produce the existing products take advantage of the protection basically yes subsidy can do something but I come to that issue also in a minute but then he goes on to say about the stick you know it says that to ensure the mistakes are not perpetuated and bad projects are phased out these rents must in turn be subject to some sort of performance requirements or exporting or close monitoring of the users to which these things are put but I mean look you know first these days that well the first best policy is subsidy or investment in your non-traditional industries but this requires close monitoring which is not practical well if you can't monitor that how can you then say simultaneously that you will monitor close monitoring to which you are putting the subsidies and so forth I mean so it's arguing both ways first saying that oh first best cannot be achieved because there's monitoring problem but then I can do all sorts of other monitoring which is the stick part of his argument so there is an inherent kind of there's an inherent contradiction contradiction exactly right yeah yeah so also you know going further there is even leaving these facts aside there are at least three other problems with this argument you know which well one I've already noted which is that trade protection doesn't solve the externality problem so throwing in trade protection as one of the kind of carrots is patently wrong and he doesn't elaborate you know how will you solve it and that's what is my own analysis is concerned because the problem arises in the infant industry case also and it is very much the infant industry case I mean in a way this whole diversification business is a side show for his argument anytime there is an externality of course there is a case for intervention so I don't see why you know he has to bring in all this diversification issue here if there are products to be innovated processes to be innovated regardless of whether or not there is a diversification issue there is a case for intervention question is is there a case for trade intervention and answer there is is there is no now also the success stories that you know Roderick and Hausman if you go back the work that he refers to to bolster the argument these are cut flowers in Columbia soccer balls in Pakistan and hats in Bangladesh the reality is that none of these were actually successes made by the government these were all market successes you know the government can come in later on after they have actually succeeded I mean it really reminds me of something that my friend you know the famous Japanese economist Tatsu Ahata used to tell me we were together at the World Bank at the time and he used to say that you know in Japan the Mithi the Ministry of Industry and Trade in those days in the 60s and so forth they would simply see what sectors are succeeding and then they will give them the subsidy so it will look like they were creating the miracle but you know this was happening anyway and so you know this is a very similar story here cut flowers in Columbia soccer balls in Pakistan and hats in Bangladesh these are not successes created actually by the government you know so these happened much more kind of generically in the countries themselves you just said that every externality may need some intervention but it does not need trade intervention but I would actually go one step further and say every externality doesn't necessarily merit an intervention there are some externalities which are inframarginal they don't affect the optimal production or allocation of the good in question sometimes externalities get resolved through vertical integration there are kinds of arguments that themselves has made sometimes there is a quotient solution to externalities especially in innovation markets if there are tradable property rights the inframarginal externality of course Buchanan and Stubblebine have laid that out so every time people see externality and therefore it needs to have a Pigouvian resolution which now spills over as trade protectionism and interacts with the other side international political economy it's not so clear to me that the argument is convincing I think the standard has to be higher absolutely in fact now you could actually go even yet another step and argue that to think that the governments in these countries are capable enough to actually pinpoint the externalities and actually implement the solutions even very simple solutions and to think that this will not create perverse incentives on the part of the lobbyists is to assume a lot I mean the governments have actually created often more problems in trying to supposedly trying to correct the externalities than they have solved I remember both my friend and mentor Larry Westfall who was one of the very early economists to study South Korea when he ultimately eventually wrote a kind of more retrospective piece in the general economic perspectives he was very wise man he believed in Larry does believe in and certainly in that in those days I don't know his current thinking at the time believed in the infant industry protection and all but he was very careful to say that look you know this requires a very very capable government and that is not the case in most developing countries so it's only in very rare cases such as those of South Korea and Taiwan that you had capable governments to draw lessons from their experience and you think that you can replicate in many of the African countries or even in South Asia is to assume a lot and you know even when you have capable governments there is a question of what is one's model of innovation right and is it a process of trial and error and a sort of bottom up feedback mechanism through which innovation arises this is through consumer feedback this is because of competition you know other margins through which the innovation is being propelled or is the innovation a result of a small group of experts and their ability to identify winners and losers right so very often they conflate venture capitalists with governments venture capitalists are a small group of elite people who have the ability to pick winners and losers but they're also the residual claimants of their choices that model can't automatically be superimposed on the government and now we say there's an externality so we're willing to let go of the bottom up trial and error process of innovation and now the government can pick winners and losers as well as a venture capitalist or someone else can and I think that's another really big conflation but that's a conflation of frameworks you know it's not about a particular case or a particular country it's more a sort of like a mental model of how one thinks innovation takes place in an economy and on that you know we have very little limited understanding so and generally what seems to work is you know broader kind of policy on this you know kind of model that the United States has pursued generally you know that very good higher education incentivizing research at the universities and then sort of interactions between the universities and the industry I mean at the end of the day that seems to work a lot better than any specific kind of intervention that you do by incentivizing specific entrepreneurs and so forth you know you can sometimes pick up certain areas where R&D is required you know I mean 3D printing kind of things or something you know but you know even there actually successes when you pinpoint these things are much harder the broader kind of framework if you take you get better successes yeah and you know at the end of the day the the view of frictions for factors of production to get together in different combinations the greater innovation one will get in the economy right so even broader principles like free movement of goods free movement of people free movement of capital these are the big important sort of you know at the framework level these are the necessary ingredients so that then you can launch a thousand combinations of different things and some kind of innovation takes place but this kind of pinpointed intervention here and there to solve one externality that problem you know diversification capital market in perfection it actually it's a it undermines the larger framework which will allow more combinations right it's increasing frictions in the economy so in one sense this kind of intervention if you think if you take a very big picture view of growth and innovation something like what paul romer talks about in you know the endogenous growth theories this is actually a problem for innovation in the larger scheme of things yeah that's what you're saying reminds me of you know the story that shanta devarajan used to tell us you know very early in the very early days you know these are the days the people started just beginning to come in the united states and so he traveled to South Korea and the custom guys sort of stopped him and then they opened the laptop starting pictures and everything you know so he thought what was wrong you know so apparently later he understood that this was a new product and they had no idea and so therefore they wanted to you know some sort of reverse engineering or something there's some interest because of that what I'm sort of hinting towards is that trade if it moves freely you know diversity there's a lot of diffusion of technology through trade right because technology is embodied in the machines their products also which have technology which you can then reverse engineer you know if trade is happening but I mean I remember in India not even allowing these imports to happen so the innovators or entrepreneurs had never even had a chance to see the product and then to reverse engineer it was on the other end you know things like medicines did move and those got reverse engineered because of the very weak patent law and so a fantastic generic industry emerged so it was not so much you know any specific intervention that the government had done simply a law which allowed you to sort of copy the patented medicines in those days create the generics but it was through trade that the first medicines would come in right you know so this happens even at a personal level right like because I have traveled and I have lived outside India and I've lived in New York City and Washington DC which are sort of you know food capitals within the United States I am now more likely to cook Italian food or Korean food or Thai food at home because I have tasted it in a restaurant I know what it tastes like I have been to stores where I can get the ingredients my grandmother who never set foot outside the country and nor did she eat at restaurants was a fantastic cook she has never made spaghetti or she has never made kimchi or anything so even at a personal level we experience this on a daily basis but we sort of forget about it when we think about it in economic models or anything else the idea that exposure and diffusion of you know trade and diffusion of ideas and technology takes place when there's free movement of goods and people that's sort of like basic insight that each one of us has absolutely I think those are fantastic examples and food one is great actually because I'm slightly I've been generation slightly before yours and so my mother on traditional food was absolutely fantastic but even if it was Punjabi Bengali food she was that was a generation that didn't sort of travel very much and all so even within India because of the lack of movement or very restricted movement people didn't know so you know but within our lifetimes those barriers have broken because of the movement of people and information and so forth so that's one of the reasons I want to go through the you know nuts and bolts of these arguments now moving on to the next one is the question of capital market imperfections and this is basically the argument that interventions through protective tariffs or subsidies or some kinds of benefits to domestic producers they're justified in order to correct the distortions in the capital market right so if there were absolutely perfect and free and open capital markets we wouldn't need this but given the imperfection of capital markets we need to solve that distortion with an additional intervention in this case protectionism can you walk us through this argument and to my knowledge virtually the economy has perfect capital markets but many economies have high degrees of free trade so also some sense of how different countries solve the problem of imperfect capital markets without protectionism good way to phrase it so let's start you know first of all I want to go back to the infinity argument right you remember that one of the things there is that if learning really is internal and the industry is socially desirable then the market will ensure that it will happen and the way it will happen is that I incur losses today but my profits tomorrow more than offset the losses so I can cover my losses by borrowing from the banks I go to the capital markets to cover my losses today and tomorrow when I make profits that more than offset today's losses I can pay back the loan to the creditors and that's how it works now so first of all the capital market imperfections argument is resurrected I mean it's sort of brought in right in the context of trying to resurrect the infant industry argument oh but you know the capital markets are imperfect and so the bankers might not see it correctly they might think that you know there is no learning or tomorrow your cost will not fall enough etc etc and therefore there is an argument for infant industry protection right so first that clarification is essential as a starting point it's not you know not an imperfection in capital markets is not is not an argument for infant industry protection because the capital even if there is no learning involved if capital markets are imperfect then the problem can arise almost anywhere so anything that let's say requires heavy investment very capital intensive industry and has a long dissertation period so you know you will make investment it will take three years before output begins to happen well for three years no output is going to happen for three years I'm going to make losses even though there is no learning involved here it's simply the fact that you know it takes that long to set up the entire factory so it's not a learning issue at all so the capital market imperfection issue is quite independent of the infant industry one should not conflict infant industry argument with capital market imperfections so what we assume there when we discuss the infant industry argument saying that you can go and borrow from the capital markets is just the right way to approach the infant industry argument you know so now come to the capital market imperfections themselves right certainly you know in trade in international trade there is a good body of there is quite a body of literature where this is cited as a possible argument for protection and in principle if somehow the the mark means if somehow the bankers are kind of underestimating the return to industry right then when any but he wants to go borrow from the bankers they would underline to the industry and that would you know leave the industrial production suboptimal now forget even that actually it is even for any other reason let's say right if for any other reason the industrial output happens to be below optimal they may be for other market failures and so forth right and even then you could say that look you know the first best will be to subsidize the output itself but as a second best you could subsidize capital and that is how lot of the trade literature kind of made the argument that you know the first best intervention is credit subsidy to the extent of underestimation I mean you know so even if we actually locate the distortion in the capital markets then of course the first best thing is some sort of credit subsidy the second best intervention would be a production subsidy in this I'm sort of reverse depending on where the distortion is on the production side so that the industrial output is suboptimal then you subsidize the output but as a second best you can subsidize capital in industry use of capital in industry if on the contrary the distortion is directly in the capital markets then the first best is really its capital market subsidy is what we would say and the subsidy on output is the second best way to solve it now the problem is this okay so in principle let me grant it that you know conceptually you can make that argument but what is the you know when it comes to practicing that kind of argument what is the problem the first one was you know very nicely pointed out by Anne Kruger so she said look you know this is again you're thinking in terms of this two product model one is agriculture the other is industry and somehow the market you know somehow this within this framework because I see that because of this old export pessimism that at other times we have talked about right that if I rely on agricultural exports it's a non-starter for me because demand is relatively inelastic both price and price so demand is subject to low price price elasticity as well as low income elasticity so in any case because of low income elasticity as industrial economies become richer demand will continuously shift in favor of manufacturers and against primary products and therefore my terms of trade as the exporter of primary products will continue to deteriorate so it's not a winning strategy likewise even if I increase productivity in my primary products and want to export more then my own exports will lead to a massive decline in the price because the demand is also price demand for agricultural and primary products is also price inelastic and the price inelasticity would mean my attempts to sell more will result in a massive decline in price and therefore fall in the revenues that I am able to get so its primary products are non-starter I got to work on industry and so how do I do the industry right so I find some ways you know so we can have capital and you might say that reason industry is suboptimal is that my capital markets are not working and so industry is not getting fair share of credit so let's you know subsidize the industry now this recast the problem in three goods where you got two industrial goods one is an export good and one is an import good now if you start subsidizing the import good capital use of capital in the import good it's entirely possible that your competitive advantage was actually there in the export good and that was the underproduced good but once you do this you will actually pull capital out of the export good into the import good or import competing good that will be the wrong thing to do by assumption I'm saying well you know my underproduced good may have been actually the export good so it's not so straight forward but the biggest problem I think in my view on this capital market intervention kind of thing was pointed out by Ronald Mackenna and very rightly so you know he was he came from the finance angle right you know he was an expert on financial markets very one of the very early experts in the on that subject so Mackenna's point was that look when you're in a developing country this kind of sectoral intervention I mean in the end this is sectoral intervention that you work for even if you're trying to work let's say on the export sector and want to say that well not enough capital is going to the export sector you are talking about subsidizing capital the use of capital in the entire export sector but he's saying that look the developing country problems are actually very different you cannot go with these kinds of subsidies at the entire sector level what happens is that every sector whether it is agriculture including is that even agriculture but other industries even services they all have because these are very fragmented they all have entrepreneurs with very high returns and entrepreneurs with very very low productivity and so they are not your high return activities are not like concentrated in a particular sector so that you could give the subsidy to the sector you really have these high and low productivity activities going on simultaneously in the same sector and so really there is no easy shortcut actually to developing the financial markets he says look ultimately this is all about development of the financial markets and work on that otherwise you are going to make mistake because if you say I'm going to give capital to industry as a whole then and by the way good example of all this is there in the Indian context which is the priority sector lending which is terrible what are we doing we are doing exactly what Ron Mackinnon says that look the MSMEs are not getting enough agriculture is not getting enough exporters are not getting enough farmers are not getting enough so allocate a significant part of your credit to these sectors but each of these sectors as you know high return producers and low return producers and those actually who are low priority right so these are priority sectors they are non-priority sectors but many non-priority sectors actually do have a lot of very high activity entrepreneurs so your job is actually to really find this identify the high return entrepreneurs or high return activities which are spread throughout the economy and give credit to them and that requires development of the financial markets and if you think that you know you can really solve the problem by giving credit at the sectoral level then that's what you would think and not develop your financial markets properly and that has happened in India right and it's a giant trend seeking exercise with additional problems right you give loans to priority sectors and candidates that are low productivity and because of political bargains and you know political connections and before you know it NPAs and you have a banking crisis that is on the brink you know because of this kind of priority sector well certainly there's a contributor there is also this reckless lending that happened so I don't know pin the entire problem of NPAs on the priority sector lending but it certainly has contributed certainly has contributed and even if it doesn't contribute even if things are normal and all and banks are able to kind of cross subsidize and manage the point is that you are neglecting certain very high productivity activities because you have to allocate a part of the credit a significant part of the credit to these priority sector lending activities and you don't even know right I mean at what level do you want to maintain MSME sectors that should be an endogenous matter you don't want to kind of you know artificial credit subsidies keep alive small little firms I mean big problem is actually you know these very small enterprises and if you then also try to reinforce that through the credit subsidies and all then you are only perpetuating a structure which is the wrong structure it also industrial structure itself actually becomes hostage to the that kind of lending right because you know you get these are my priority sectors with no clear I mean with no clear justification why these are the priority sectors then you are perpetuating a particular structure of the economy and the whole development process is about actually you know the structural change right I mean at the end of the day you want the share of agriculture particularly in employment to fall and share in services to rise and this does the opposite right it keeps that perpetuated no there is an additional pattern I am observing now that you are walking us through multiple arguments it seems to me like the problem is usually not a trade related problem right they are using trade interventions and protectionism to always solve a problem which is somewhere else in the economy and they are not able to solve it or it is a much harder fix right it is much easier to enact a credit subsidy for this sector or that exporter as opposed to the decades it takes to have financial sector penetration ease you know sort of friction less really low friction lending good identification that kind of infrastructure takes a really long time to build and so all the models basically assume that that can't be done and try to put a band-aid on it using a trade protectionism model when actually the problem has nothing to do with trade that's what it seems to me like is that an ungenerous interpretation of all the models you are walking us well I mean lot of truth to that lot of truth to that it's an easy fix because even subsidy which would do less harm meaning production subsidy which certainly will do less harm than trade protection because trade protection is a combination of output subsidy and consumption tax so protection is not only kind of giving subsidy to the production but it's also taxing the consumer of the product which is subject to the tariff so it's worse but you know even so it will do less harm to do output subsidy but output subsidy is hard to maintain because politically it is people see through it that you are taking out of my pocket and giving it to somebody else but trade protection is very easy because you think that you are imposing it on the foreigners nobody sees that my own consumers actually are paying most of this tariff revenue that you are collecting you just give the impression that it is the foreigners we are collecting it from them so they are the target so politically it's they are very easy target actually you know and the thing about trade taxes or tariffs is that they generate revenues so the finance ministry generally is very happy that you know I'm getting these revenues and so they see this as a good fix but the bigger damage that happens of course is that in the end that delays your development of the financial markets if you take the view that oh you know financial markets will always remain imperfect and therefore I have to solve these problems through these alternative measures you are delaying the development of the financial markets fair enough that you know financial markets maybe even in America or Europe they are imperfect but they are far far less imperfect you know they deliver a lot of better outcomes than in most of the countries ultimately the financial markets and so there is an argument that look in don't delay or development of the financial markets by substituting all these other interventions and especially the trade intervention which really is ultimately not fixing the problem at all it's neither fixing the problem and at the same time it is delaying the development of your financial markets you know to take an example which has nothing to do with foreign trade or financial markets but will illustrate the point you know think about farmers in India for a very long time a very big problem with farmers is that their markets are very local and because we don't have good cold storage good infrastructure large agricultural markets access you know transportation infrastructure access to large agricultural markets farmers don't get a great price for their produce they get very low price and therefore they need all kinds of subsidies we need to give them free electricity we need to give them fertilizers we need to give them all these other loan subsidies or loan waivers were still but what really needs to happen for the farmer is you need to build the roads you need to build the infrastructure for the agricultural market you need to build the dispute resolution system you need to create a proper system so that you know spot contracts and futures contracts can actually be enforced those are the things that are going to improve the prices that you know farmers get but it's very difficult to build roads it's difficult to bring in a new dispute resolution system or create a large marketplace so what we instead do is you know we give them loan waivers subsidized personalizer or free electricity or MSP or something like that but what they really need is the road in fact there's some great literature showing that the moment there is increase in road penetration and railway penetration basically access to transport productivity starts increasing and this is an age old insight we see good evidence for this in India but to me the trade intervention argument because of imperfect capital markets though that's a completely different part of the economy it seems very similar to this kind of logic right except now we're talking about foreigners so it's really a matter of infrastructure development on this my question is how do countries that have open and free trade how do they deal with imperfect capital markets they must also have this problem to some extent right but look you know certainly they in the countries still the capital markets are much better developed and so at least something like Korea I mean this was not an advanced country when it opened up its trade it must have had not perfect financial sector and capital markets so how did a country like Korea deal with this problem without protectionism I guess that's my question like is there a way or a model or examples of developing countries that might have dealt with this so there was certainly some credit subsidies in Korea but that I don't think was a dominant instrument which so some interventions happened and this is where this whole business on targeting and industrial targeting etc comes in but that's not the dominant story at the end of the day to me seems the Korean story is really very much you know taking advantage of all the global markets with very early on by the way you know 1960 onwards because Korea really you know devalued big time the domestic currency which very quickly kind of generated response of the manufacturing exports you know 1960 to 1964 manufacturing exports are expanding at the rate of something like 50-60% a year it's a very slow base I mean I admitted it's coming from very low base so it looks a little exaggerated but the point is that the structure of the exports dramatically changes from agricultural to manufacturers manufacturers initially being 20-30% in 1960 by 1964 they're easily they've crossed more than 50 or more than half of the exports become manufacturers yet I think convinced the leadership that you know this export business could deliver and so by 1965 Park Jung he was very much onto the ballgame on this you know and so he very much started having monthly meetings or bi-monthly once in two months or something you know you'll meet all the export interests figure out what the bottlenecks are and it was relatively you know that Korea is number one small but at that time income levels being what they were economically it was even smaller so it was not very hard to find out who are the big exporters and they didn't have the small-scale industry business so you know the exporters you really are larger it's a larger firms which export so it was easy to kind of collect and find out from them you know what the bottlenecks were and all so that is how I understand the Korean story exactly whether they tried to I mean certain credit subsidies existed as I said but I don't think that was a big part of the story but also their side of the story is they are growing their engagement with the global economy and simultaneously strengthening their financial sector that's the story so this happens yeah you know they didn't scuttle it by you know nationalizing the banking sector for example so but also you know there is capability of government issue these were you know capable governments consulting the experts and all as well alongside but largely you know making good common sensical decisions in the China story you know where there is much more presence of the public sector is similar one at least in the sense of you know capability I mean consulting really was a capable leader so again this leadership issue of course does play a very critical role at least in my thinking it does so basically the state also making a credible commitment that they'll pursue free trade and focus on removing infrastructural bottlenecks as opposed to pandering to you know specific interest groups and lobbies and things like that definitely I think you know that seems to be a part of the story somewhere right because it's quite easy to give in to the interests of exporters not all exporters ask for better capital markets usually they just ask for a very specific subsidy for their particular good so I find that quite fascinating yeah no either that would also but alongside for them the ability to import the inputs is very important yeah I mean those are the bottlenecks I think you know that Park Chung-hee the president of Korea in those days tried to remove you know are they getting their inputs in time are they getting these beauty free even though they had tariffs they did ensure that the exporters really didn't have to pay those tariffs or were reimbursed rather quickly and often they would actually reimburse them a bit more than what they paid so they may have been some sort of element of subsidy but since they also had some import protection that small subsidy was only neutralization of the import tariffs that exist in the first phase so that's how and then let the financial financial markets evolve and develop alongside but in India what we have done is to nationalize the banks and so that has really innovation has been very limited much of innovation only began happening after 91 when we began to allow private banks again in a big way foreign collaborations foreign banks to come in as well so that's when some innovation began and then of course information technology came through also but even then you can see that the private banks were way ahead of the public sector banks we are treating public sector banks like any other public sector enterprise as basically a jobs program for the middle class that is formal and unionized that's what the Indian government banking sector has become it's become a jobs program for the elite as opposed to its actual job which is to make greater financial resources and penetration available so this is I think one of the original sins of Indian socialism and of course Mrs Gandhi nationalizing banks in a really big way in 69 and also you see the problem is that the leadership of the public sector banks is always under the fear of vigilance they never innovate exactly so it impedes the innovation you don't get promoted and get big bonuses for the good bets you make and you get pulled up and punished and taken to the CVC and CVI for even one bad bet and 0% bad loans or error is bad for any bank it means it's not making appropriate number of bets but now we are on the other side we just have very very high number of non performing assets so but your point is well taken that this is not the capital markets and financial a weak financial sector it's not clear that the obvious solution is protectionism it could be some other intervention or state capacity development in those areas but a protectionist approach is clearly not the way forward I mean the big thing you need is the expertise to evaluate projects the bankers have to have the ability to evaluate the projects properly that's what you need because ultimately you want to invest in high productivity projects and if you don't have that ability then or otherwise you impede that ability even if you have the ability and the decisions are political through this crony kind of landing that's also endogenous to the ownership the ability to pick good projects that comes out very clearly because private sector banks don't have that kind of NPA problem they did not take a rupee of the taxpayer money to clean up their NPS they did their own cleanup whereas in the public sector NPS have been massive and they had to be cleaned up through taxpayer money and when all the big scams like Vijay Malia and Neerav Modi and these sorts of things happen I don't remember which private sector bank it was I think it was HDFC and they were asked did they approach you for a loan and they said yes and we offered them a cup of tea and said thank you and that's basically it so it's not like an additional some kind of special superpower that the private banks have which the public sector employees don't have you put the same employees in a different bank and they will perform just so much better in picking winners and losers so I think the ownership is what is driving very much so yeah I mean absolutely I mean if not that you know these scandals don't happen in private sector banks you know we did have some bit of in ICICI and all but you see the far less the scale is very few scale is I mean ultimately look it goes back to the commercial pressure you know the private banks have the commercial pressure and public sector banks don't yeah they are fully subsidized basically I mean that's one big factor of course but then there are also these other issues of constraints of vigilance kind of things which constrain the ability of the leadership even good leadership really can go only so far in these banks because of the vigilance problems. No and also you know a lot of the fiscal spending is now done through the banking system this is of course Viral Acharya, Ujit Patel they've talked about how you know very high fiscal spending and what they call the theory of fiscal dominance is now entering the banking sector creating these spillover problems and entering monetary policy so that's one side but the other is also just plain simple political pressure right this is to some extent missing or reduced in private banks you don't have political leaders putting pressure on bureaucrats or the boards of you know Punjab National Bank or SBI or something like that and saying that you need to give so and so alone for this project and typically it's because that person lent them money for the election campaign or you know some other quid pro quo that has taken place on some other side you know of the economy so you just see less of this so it's not to say that the private banks are perfect and they can completely develop the financial capacity of a nation like India with no other inputs necessary it's just that we have a massive public sector system which has just failed to deliver right so to go back to the arguments for protectionism one argument this was you know it would keep coming up for developing countries again and again I mean it started with the Asian countries today people are saying the same thing about many African countries this idea that open trade is bad for employment domestically right this is again an argument that doesn't go away in India of course we have a particular kind of demographic structure and we have had what many people have called jobless growth right we haven't seen that you know massive employment in manufacturing that you saw in Taiwan or Korea or China and other places like that so this argument has come back in a new way you know in this century it was sort of slightly differently packaged in the previous century what is the relationship between free trade and unemployment especially domestic employment or unemployment and is there any merit that protectionism will increase employment within the country this is a there is not a whole lot to say on this one because I think the evidence is very clear if you are talking of aggregate employment show me any country you know if there is a relationship between protection and aggregate employment surely if you are talking about any sectoral employment then of course you know you give protection to auto industry and you will get higher employment in auto industry but what about the jobs in the rest of the economy so evidence really doesn't there is no evidence actually the trade policy has an impact on the aggregate employment ultimately which is what employment is about now India itself is a good example you 1991 starting massively opened up the economy in fact trade also expended we know it quite dramatically right you know exports were 7% went up to 20% imports were about 10% went up to some 30% of the GDP and during this period our own employment and employment surveys actually show hardly any impact you know the employment rates whether you look at in the two or three different criteria that get used by by any criterion it doesn't shift much at all I mean it's only the PLFS produced a slightly higher employment rate which should be discussed and all but during that period if anything we had increased protection not reduced protection during this period so if one were to draw at least some basic correlation there is the opposite the correlation is moving the opposite direction I mean I don't want to draw that because I don't think that number it's you know rise from about 2-3% to 6% had anything to do with trade policy I don't think so in fact if you look at some of the other countries South Korea, Taiwan China successful countries quite the contrary what you see is massive employment opportunities created by this expansion of trade and so therefore the industry and services are drawing workers out of agriculture in a big way and in the face of very very rapidly rising real wages in Korea in 1965 on words you see these wages are rising at the rate of some 9-10% a year through the 1980s you know every one of these decades you see this 9-10% growth in the real wages and at the same time there is no more being very large volume of workforce so clearly you know it's a labor scarce economy I mean it's turning into labor scarce economy which is why the real wages are rising I mean it's not Korean case is not like Arthur Lewis type of disguised unemployment model even you know the workers have to be paid higher and higher wages actually as they are being drawn out of agriculture evidence simply on the aggregate it's simply not supportive now in fact if we then go back and see Indian problem which is the problem of under-employment I have always said this under-employment in agriculture and under-employment in industry and services meaning that you know two workers or three workers are doing a job which can be easily done by one worker so and that of course means that our worker is incredibly low low productivity employment that's under-employment and there actually trade will help you go the other way I mean it will reduce this under-employment and raise the productivity so I think politically it's good easy to make that kind of argument perhaps you know everybody who is looking for a job identifies with it but it really doesn't have anything to do with if that were the case right if protection I mean even more stark I mean truly stark example is our days of 50s 60s and 70s close economy when we are completely closed economy and look how many jobs we created hardly any jobs got created right I mean for my generation you know all the even movies that would come out for all about the these young men you know seeking jobs and all yeah and you know that often for any single job large number of people arriving and then the hero kind of making the sacrifice that you know oh well you know that let's go out the opportunity so you know it's just and progressively in fact in the clerical jobs there was a generation when high school was enough you know for clerical jobs then bachelor's degree and then master's degree became the norm now you have PhDs applying for like there's a pure job in the railways and two lakh people applying and things like that and that's a reflection of you know it's still very limited jobs that we have created in the private sector so you know the best jobs are you know 18,000 rupees per year job guarantee for life pension assured you've got health benefits assured in a few years you also get housing you know in the private sector a lecturer will probably get just 18,000 rupees with no job security no health benefits covered no housing nothing you know and you have to work very hard whereas you know as a class 4 employee in the government of India the so called multi-tasking staff really half the time they're totally free not very much to do so you know here I understand the argument in the aggregate right so we understand that free trade will basically increase the size of the pie right so as the economy grows there will be more jobs and so on now I want to dig in a little bit into the sectoral question and this has proven true more for developed countries than developing countries like India so you have developed countries where you had like large manufacturing you know with as free trade opened up places like China and Taiwan Bangladesh they started developing a comparative advantage in those sectors those industries factories went to those countries and therefore the jobs went to those countries so you had some sectoral churn right so if 50 years ago you were working in a shoe factory in the United States for instance today that job simply doesn't exist and now the question in developed countries is not so much protectionism but how do we make sure that people who are employed in one sector where they are no longer as productive can be reintegrated into the rest of the economy in some other sector right this is also related to arguments about automation all the technology artificial intelligence all these new sorts of things which are coming in and taking away traditional jobs but trade is a very large part of the argument against this kind of sectoral mass unemployment in the short term which really devastates families cities regions and so on what is your view on this kind of very specific sectoral unemployment and free trade here also in the developed country context actually even at the aggregate level even at the aggregate level what you do observe where this pressure at least in the United States seems to manifest more is in terms of the wages so we have this wage inequality debate that the skilled wages to unskilled wage ratio has been rising I mean some exceptionally periods have been there but broad trend particularly if you really take from late 1970s to 2000 or something you know you see that the so called skilled premium has been on the rise and so it's at the bottom which is where you really care for people that's where the poor people are where the wages have not risen I mean in real terms perhaps they've risen marginally you know there is a difference often times that people conflate the relative wages to real wages so that distinction should be made but at least the evidence I saw from some work by Rothfiendstra and all the real wages were not negatively impacted but but the you know the wage gap is very clear the question simply is that you know can protection solve that and there is no evidence really that protection will successfully solve that problem because lot of this you know at least the view of trade economists has been that the very significant part of this you know shift in favor of the skilled labor in the wages and by that shift in technology that you know the the production processes have become progressively more and more skilled intensive and so they have progressively increased the demand for skilled labor relative to done skilled labor and that is the main driver of the wage premium or a skilled premium in the wages you know obviously you don't want to stop the technological change ultimately it's to the good of everybody but it does have that effect of wages at the bottom and so that's where and there is a lot of pain there is no doubt at the bottom in the United States Europe and so forth and something so traditionally argued always you know have good social safety nets they don't have to be you know for political reasons maybe they have to be trade related to some degree you know but I think that should be more generalized because trade is not the only policy that is at play there are other policies at play as well and technology is at play as well you know so generalized social safety nets now that's easier said than done obviously there are still a lot of issues that remain but you know one can you know blame trade but the simple example I gave is look you know I mean if you've traded not played its big role look what would have happened to the iPhone I mean at the end of the day the very fact that everybody can afford an almost you know in the developed countries and the developed world at least some version of iPhone everybody can afford it's because the Chinese manufacturing has prices so far down and the massive scale you know if production had been if production of iPhone had been actually confined to the US there's no chance I couldn't afford an iPhone then I mean there will not be that many iPhones I mean you know there would not I mean but for Korea and China and Taiwan and now you know it's spreading a bit to Vietnam and maybe India also and all but principally those three countries but for them mobile revolution across the world couldn't have happened I mean it's those countries that you know massively at a very low cost to manufacture these mobile phones and even when we replace these feature phones by the mobile phones smartphones also very quickly fell in cost and that's because of the manufacturing prowess of these countries and without that and just imagine how much good it has done to almost everybody you know so that kind of gets lost in this conversation absolutely but you know I think also more fundamentally free trade developing countries to switch gears back bring structural transformation that's fundamentally what we need and structural transformation is not painless you know it does require people to stop doing their traditional trade or agriculture or something they've been engaged in for a long period of time and start doing something else which is higher productivity job and on the one hand we want the structural transformation because that's the path to you know higher GDP higher GDP per capita better wages and you know sort of like a growth trajectory and on the other hand it's not painless right so now since that's the prescription for developing countries it would be weird if that's not also the prescription for developing countries the margins on which they can afford to ease the distress by providing you know unemployment welfare schemes or universal basic income or something else of course that's of a different magnitude but the prescription for growth and productivity can't be that different across both and it's over that's true and as you can see that's the choice most developed countries have made they're not generally impeded I mean there are some protectionist noises here and there but largely the markets have remained open and if you look at the flow of trade that flow has not been impeded I mean if you look at global exports of either goods or services boy that has continued to expand this continued to expand dramatically and then merchandise exports is in the range of 18-19 trillion and services is another 6 trillion so together they are more than quarter of the GDP or the global GDP so in the end they have chosen that path and look I mean advanced economies certainly are in a much better position to build social safety nets the XX revenues are quite substantial even to build the social security net you need free trade and economic growth because that's what gets you the higher revenue so at some point there is very few options if the goal is prosperity for large numbers of people all you can say is that if they develop countries resort to protectionism the cost of it to them might be a little smaller than what it is to developing countries I think developing countries pay a huge cost and we know the Indian experience particularly how much we paid for almost 50 years it's almost a luxury that only a few countries can afford and even they can't afford it for too long protectionism as a luxury good is an interesting way to think about it this is a good point to set up our next conversation I think you've been very patient with us in explaining and laying the ground for arguments in favor of free trade and sort of walking us through the merits mostly demerits of arguments in favor of protectionism so hopefully we can continue this conversation in that direction we shall do that thank you so much as always