Kautilya- the True Founder of Economics

by Balbir Singh Sihag

  It is clear from the above statements that Kautilya believed that establishment of law and order was essential to growth in knowledge, and knowledge in turn, was essential (by restraining the king) in maintaining political stability and enhancing economic growth by helping in the formulation of sound policies. Similarly, political stability and independence were essential to economic growth, which in turn helped to strengthen national security. Thus, according to Kautilya, knowledge, governance, national security and prosperity were determined endogenously. But he was not aware of any such distinction between exogenous and endogenous variables. A sustained growth required a government to be stable, efficient, and ethical (honest and fair).

  Specification of Kautilya’s Model: Kautilya could not and did not have even the faintest idea about model specification, identification or proper estimation since there was no calculus, probability theory or econometrics available to him. However, based on his statements, a formal model may be specified as:

  Max U(C, S)

  Subject to:

  Y= A F (KP , Lf , T) (8.1) A= G (GG, M, KN, KG) (8.2) GG= GG (M, Y, KN) (8.3) M= M (EED, EE) (8.4) d KN /dt = Z (GG, Y, KN, LKN) (8.5) d KP / dt = (1–t) Y–C (8.6) d KG / dt = β (0.75) t.Y (8.7) WB= (1–δ–β) (0.75) t.Y (8.8) DE= δ (0.75) t Y (8.9) t (0.75) Y= DE + WB + d KG / dt (8.10) P = X (J, H) Kλ (E Lm)(1–λ) (8.11) S = S (P1/P2) (8.12) E= e (W, MM) (8.13) L= Lf + LKN + Lm (8.14)

  Where C =consumption, S = national security, Y= income, KP = capital in the private sector, KG= public infrastructure, T = land, t Y =tax revenue, WB= expenditure on welfare programmes, DE (defense expenditure) = K (horses, elephants, chariots, armament, etc.) + Salary for soldiers, P =power, P1 and P2 = powers of king one and king two respectively, RP1= relative power of a king (king one) to his potential enemy (king two). KN= knowledge, Lf= labor devoted to food production, Lm =labour joining the military, private investment, d KP / dt = (1–t) Y–C, A= efficiency parameter, H = experience and analytical skills of the advisers and availability of information through intelligence, E = enthusiasm and training, EED= ethical education, EE= ethical environment, J = level of public support for a just and kind-hearted king, d KN /dt =increase in knowledge of all four disciplines (KN), LKN = knowledge creating workers (Brahmins), GG=good governance, M=ethical conduct and F (KP, Lf, T) is the production function and MM=moral motivation.

  Sections 8.2 and 8.3 presented Kautilya’s ideas on sources of economic growth and importance of institutions and governance. Equations (8.1) and (8.2) capture these ideas. It indicates that a country that had better governance, ethical conduct, infrastructure and knowledge base would have a higher standard of living than another, even though they both might have the same levels of land, labour and capital. The level of productivity, A depended on good governance, ethical conduct, income and knowledge as captured by equation (8.2). According to Kautilya, good governance depended on income, ethical conduct, and knowledge. Equation (8.3) is used to explain this relationship.

  Private investment is captured by equation (8.4). Equation (8.5) indicates that growth in knowledge depended on knowledge-creating workers, income and existing knowledge. Kautilya did not explicitly mention income as a relevant factor to the creation of knowledge but the very existence of an intellectual class depended on the level of income. Drekmeier notes that the emergence of an economic surplus made it possible to support a rich culture and help in the rise of an empire in ancient India. He (1962, p 105) says, ‘With the coming of an agricultural economy, there came also the promise of economic surplus—the production of goods and services in excess of what was needed for survival. This is the condition of civilization: the possibility of supporting a culture-creating class of professionals.’

  Twenty-five per cent of the tax revenue was earmarked for administration and the remaining was allocated among public infrastructure (equation 8.7), welfare benefits (equation 8.8) and defense (equation 8.9). Equations (8.11), (8.12) and (8.13) reflect Kautilya’s ideas on national security. According to him, power of a nation, P, depended on the army, armament, army’s enthusiasm, experience and intelligence of advisers and public support. Equation (8.11) represents this relationship. According to equation (8.12), national security S depended on the relative power of King One compared to that of King Two. According to him, enthusiasm (E) depended on both material incentives (Wage) and moral motivation (MM). The total available labour was allocated among agriculture Lf, military Lm and knowledge producing workers LKN, as indicated by equation (8.14). As mentioned in Chapter 2, there was a shortage of labour and Kautilya did everything possible to increase its growth rate.

  According to him, government could create good institutions and could provide good governance but it could not create desire among people to exploit the existing opportunities. He extolled the public about the virtues of getting rich. He (Subramanian, p 50, 52, 54, 61, 79) believed, ‘Poverty is death, while living. There is no enemy equal to hunger. A poor man’s word, even if apt, is not heard. It is not difficult for the rich to do good deeds. Death is preferable to poverty.’ The presence of capital, land and labour in equation (8.1) captures the intensity of desire in the attainment of prosperity.

  SUMMARY Kautilya argued that ethical conduct was the ‘deep determinant’ and not the institutions as claimed by some economists. He was the first economist who identified labour, capital and land as sources of economic growth. He believed that good policies were needed to create opportunities and fair institutions were needed to exploit those opportunities. That is, good institutions and good governance are complements and not substitutes and both were essential to economic prosperity. Recent contributions have not properly tested the virtuous cycle hypothesis and instead their tests are specified to validate their own brands of hypotheses.10

  It is truly remarkable that Kautilya’s ideas are as relevant today as they were in his times. Drekmeier (1962, p 300) puts it very aptly, ‘Today the Indian state is as new as it was in Kautilya’s time. And it is as old as all states must be in an age when sovereignty has proven an inadequate answer to the organizational requirements of security and peace. A solution as creative as that put forth in Arthashastra is needed if the amoral tribalism of our century is not to end.’

  Kautilya recommended codification[s] of the rules and emphasized compliance. The public and the government servants were to be constrained by rules and regulations, and also by making appeal to the moral values while the enforcer (the king) was to be restrained by reminding him of his moral duty, and self-interest, ie. identity of his interest with that of the people.

  9

  Preventing Market and Government Failures

  Theologians, moral philosophers, sociologists, political scientists and economists have been debating, surmising, evaluating and commenting for over two thousand years on the performance of market as a harbinger of miracles or menaces. A considerable amount of intellectual energy has been devoted to finding answers to many fundamental questions, such as, is the market moral?1 and has it been a civilizing force or a destructive influence on the moral foundations of a society?2 Each discipline offers its unique perspective and the scholars are spread all over the spectrum from pro-market ones to anti-market ones. Theologians and moral philosophers usually discuss the fairness aspect of the market. Pro-market scholars argue that the market allows freedom of choice and encourages creativity and entrepreneurship. On the other hand, the anti-market scholars deplore the fact that those who do not have any purchasing power are excluded from the market. However, they often ignore the Paretian efficiency considerations.3

  Generally speaking, economists concentrate on the Paretian efficiency conditions for evaluating the performance of markets. The traditional view in the West, at least since Adam Smith, has been that unless monopolies, public goods and externalities, and other contributors to market failures, were present, markets would remain efficient. Again, since the Sherman Act of 1890, the traditional response to these market failures has been government regulation. J
onathan Baker (2003) discusses the ‘necessity and successes’ of AntiTrust enforcement. However, the beneficiary effects of Anti-trust laws have been challenged, particularly since the last quarter of the last century. Clifford Winston (2006) collects and synthesizes many empirical studies on market and government failures and concludes that often the cure for market failure has been worse than the disease. He lists shortsightedness, inflexibility and contradictory policies as the causes of government failure to cure the market failure. The underlying assumption for such an analysis has been that the political stability was unaffected even if the system became blatantly unfair over time.

  Kautilya believed that market failure was bad, government failure was worse but moral failure was the worst of all. According to him, a nation grew at a faster rate if its people were anchored to Vedic values since he believed that Vedic values created trust, harmony and peace, which promoted economic prosperity, which, in turn helped in the preservation of those core values. He argued that often, moral failure and poor organizational design were the root causes for both market and government failures. He believed that prevention was always better than cure and proposed an ethics-intensive education for building sound moral character and well thought out organizational design, with an intended goal of preventing both market and government failures and to have legal measures at hand to correct them if they occurred.

  Kautilya followed a very pragmatic approach and recommended a mixed economy in which both the private sector and the public sector played complementary roles. He proposed establishment of law and order, provision of public infrastructure and tax incentives to encourage investment by the private sector. Additionally, government played an active role in providing national security, stabilizing the economy, regulating monopoly and pollution, banning child labour and sexual harassment, and protecting the consumers against fraud. According to him, the state (king) had three basic responsibilities: rakshana (protection), palana (nurturing, administration) and yogakshema (welfare—material and spiritual) of its citizens. He recommended that the government should not only help the old, the sick, children and the helpless but also should provide insurance against natural disasters to everyone. Thus, the usual distinction between a residual and a universal welfare state may not be a very useful one in visualizing the functioning of Kautilyan state.4

  Kautilya recognized the potential of the human tendency of selfcenteredness, and believed that while it could be a positive force in bringing prosperity, if unchecked, it could become a negative one by indulging in rent-seeking activities, shirking from duties or pursuing corrupt practices (due to excessive greed). Various possibilities under which moral, market and government failures could occur are discernible from his observations. Section 9.1 presents his implied taxonomy of these failures explicitly. Kautilya was quite concerned about the disastrous consequences resulting from possible occurrence of both market and government failures. He identified the traditional market failures and surprisingly, some post-modern information-based market failures also. He believed that if a country did not have sovereignty, it would have nothing but misery and squalor. He emphasized national security and assigned its provision to the government (as discussed in Part Five). According to him, the second important role of government, as discussed in the previous chapter, was to maintain law and order, which he considered as a prerequisite to prosperity.

  He believed that monopolies and monopsonies were a serious threat not only to the functioning of the market but also to political stability. Consequently, the disruption costs to the economy might be much larger than the distortionary costs. Additionally, he essentially equated monopoly rents to theft and considered their existence not only a market failure but also a moral failure. He proposed regulation of monopolies and other externalities for correcting the market failure. He suggested measures for combating the ‘moral hazard’ problem also. These ideas are contained in Section 9.2. This section also includes laws to protect consumers. He was equally concerned about the government failure resulting from corruption, inefficiency and indifference. These ideas are contained in Section 9.3. He advocated writing the laws clearly to reduce the scope for multiple interpretations. Secondly, he proposed an organizational structure that reduced the scope for conflicts of interest. Section 9.4 presents Kautilya’s ideas on organizational design and rules and regulations for reducing fraud.

  9.1 IDENTIFICATION OF MORAL, MARKET AND GOVERNMENT FAILURES Kautilya’s goal was to establish a prosperous and secure nation. The prevailing conditions at the time were not conducive to the attainment of prosperity or national security. He was aware of the powerful force of self-interest in bringing riches, but was concerned about its potential for pursuing socially unproductive or harmful activities. He classified individuals into three categories: moral, amoral (utility maximizing agent) and immoral. According to him, there would not be any government failure if the king and the bureaucrats were ethical and similarly there would be no market failure if the private sector were ethical. On the other hand, if the government administration and the private sector were immoral, the whole system would collapse. Kautilya was aware of various combinations of these and, therefore, many scenarios are implicit in his statements. However, the presentation here is confined to the amoral case only, since it has drawn a lot of attention and also is more relevant to describing today’s situation in most countries. The following table presents his general understanding of the various failures for the amoral case.

  Table 9.1 Taxonomy of Various Failures King (President, Congress or any Public Official) Personal Interest

  Public Interest Not in Public Interest

  Not in Personal Interest Public Not in Interest Public

  Interest Contd...

  King (President, Congress or any Public Official) Personal Interest Not in Personal Interest Private Interest Best

  Case I Conflict

  of Interest

  (rent-seeking activities)

  Case III

  Not in Private Interest Inducing the private sector to be benevolent Case II

  Overzealous public

  official

  Case IV

  Conflict

  of Interest

  (classic red tape or

  undermining) Case V

  Case VI

  Case VII

  Rejected by

  everyone Case VIII

  Case I: This is the ideal situation since there is no moral dilemma. Activities, such as building of public infrastructure, that would enhance the productivity of the private investment, are in everyone’s interest. In this case there is no moral, market or government failure.

  Case II: Kautilya emphasized compassion. The private sector was unlikely to care for the public interest, such as, making charitable donations for helping the needy unless it was induced by moral and material incentives. In a broader sense, reduction of inequality was in public interest. According to theologists, market fails to reduce it. They label it a moral failure. Kautilya recommended many programmes to help the poor and the sick.

  Case III: Moral, Market and Government Failures. Kautilya was particularly concerned about Case III, Case IV and Case V. Incidentally, these are relevant even today. Case III is a real case of conflict of interest. It has drawn a lot of attention. In fact, the debate concerning market failure versus government failure is centered on this possibility. Many rent-seeking activities, such as lobbying, financial manipulation and monopoly etc. exist due to moral, market and government failures. It appears that unethical public officials and the private sector are like conjoined twins with a common stomach. A public official and a private party could join together to impoverish the public. For example, exercise of monopoly power would indicate market failure and government failure both of which were due to moral failure, that is both the private sector and the king and his administration were unethical.

  Case IV: Tax collectors were rewarded with promotions etc. if they brought in larger amounts of revenue. However,
according to Kautilya, overzealous tax collectors could work against both, the public and private interests (see Chapter 12 for details).

  Case V: Kautilya specifically mentioned this possibility. A policy that served both, the public and private interests, should not be discussed with an adviser, who was likely to be adversely affected by that policy. He (p 200) recommended, ‘No one who belongs to the side likely to be adversely affected by the project shall be consulted (1.15).’

  9.2 CONSEQUENCES OF MARKET FAILURE

  Merchants are all thieves, in effect, if not in name; they shall be prevented from oppressing the people (4.1) — Kautilya (p 236) According to Kautilya, the very origin of government indicated market failure since the private sector could neither maintain law and order, nor provide protection against foreign aggression. He (p 820) wrote, ‘When there was no order in society and only the law of the jungle prevailed, people [were unhappy and being desirous of order] made Manu, the son of Vivasvat, their king; and they assigned to the king one-sixth part of the grains grown by them, one-tenth of other commodities and money. The king then used these to safeguard the welfare of his subjects (1.13).’

  Traditional Market Failures: We know it today that unfettered private markets do not work efficiently in the presence of monopolies, public goods and externalities. Just like the classicists, Kautilya did not label them as market failures. However, he recognized these problems and recommended the provision of public goods and the regulation

  Figure 9.1: AE=average expenditure, ME=marginal expenditure, AR=average revenue, MR=marginal revenue, PP=price paid to the producers and PC=price charged from the consumers. Posner’s Monopoly-Monopsony rents=rectangle FMPCPP and Harberger’s deadweight loss=triangle FCM.