The journey of Indian finance

by Ajay Shah.

A great tool for making sense of things is a sense of history. At each point in time, we should wonder: what was the situation, what was the problem that was sought to be solved, what was done, how did it work out? This helps in all fields; e.g. we understand special relativity better when we understand the journey of ideas leading up to Einstein.

In this spirit, economic history is central to understanding economics. One of the great failures of modern economics is the loss of the economic history perspective. Most people in a formal education in economics do more convex optimisations than economic history, and that's unwise.

Latika Chaudhary, Tirthankar Roy and Anand V. Swamy invited me to write for their edited book, the Cambridge Economic History of Modern South Asia (forthcoming). I wrote a paper on the journey of Indian finance, starting at 1947. Many odd features of Indian finance make sense when viewed in this economic history perspective.

There is an important kind of economic history, an epsilon-delta tradition, where data, archival texts and documents are precisely pinned down. Alongside this, it is good to also have a strategic view. The paper has such a high level treatment of the journey of ideas, interests and institutions. It is organised as 10 sections on banking, the equity market, other financial firms, capital controls, bankruptcy, monetary policy, household finance, systemic risk, the working of financial agencies and the policy process.

In each of the 10 areas, I try to offer the birds eye view, a sense of what happened and why, of what got done and what didn't, and the forces at work. There is a unified chronology, evaluation and bibliography. Many epiphenomena are glossed over, so as to focus on the essence of finance: the play of time, risk, information, individual optimisation, and principal-agent problems. Each of the 10 area-essays needs to be turned into a full blown economic history paper, including epsilon-delta style work. This paper can help others get started on such research projects.

There are two ways to interpret the journey of Indian finance: a market failure view, and a public choice view.

On one hand, there was a journey of ideas, with learning (in some areas) about how state coercion can counter the market failures in finance. This is a story of building knowledge about the place of the state in Indian finance, and then building state capacity to try to help with useful interventions. The story contains many crises, some useful feedback loops, and some loss of institutional memory.

And then, there was the power conflict. The financial system constitutes the commanding heights of the economy. The Indian state has tried to control the financial system, and direct its resource allocation in ways that suit the state. There has been an ebb and flow of different degrees of state control, and different methods through which the control is achieved. Alongside this, policy makers have sought praise through isomorphic mimicry.

A lot was done in the two phases identified in the paper. But it is far from finished. The basic machinery of markets and financial firms is quite incomplete. State coercion in finance requires fundamental reorientation towards state capacity in addressing market failure, through clarifying the objectives of financial agencies and establishing their checks and balances. These difficulties are an important source of Indian economic underperformance: finance remains central to the journey of Indian economic development. The future of Indian finance lies in building the knowledge and the community for these tasks.