Why Economic Theory Keeps Missing What Businesses Already Know

Thomas Carlyle called economics the “dismal science”, and history has periodically vindicated the label. Economists, as Barry Rosholt notes in Bailout Nation, failed “almost without exception” to foresee the last three recessions, even after they had begun. Nobel laureates Abhijit Banerjee and Esther Duflo have noted the low level of trust placed in economists globally, while Bloomberg columnist Mohamed El-Erian has criticised a discipline that can become detached from real-world relevance.

The problem is not that economists make mistakes. Every analytical discipline does. The more important question is why some mistakes recur, particularly when the underlying economic signals are visible in business and financial data.

As late as January 2008, Ben Bernanke was not forecasting a recession, while Alan Greenspan had not anticipated the scale of the sub-prime build-up. The failure crystallised in a question that remains part of economic folklore. During her visit to the London School of Economics in November that year, Queen Elizabeth II asked economists why nobody had seen the financial crisis coming. The Eurozone debt crisis of 2010–12 caught forecasters off guard as well, while the “transitory” inflation assessment of 2021–22 reinforced the same lesson: historical priors can blind experts to structural changes taking place in real time.

As Nassim Nicholas Taleb has argued in a different context, the problem is epistemological as much as technical. Experts can be highly competent within established frameworks and still fail to recognise what falls outside them.

India’s experience points to a recurring gap in analytical coverage. Bank-corporate circular financial flows, the financial instability embedded in the MSME sector beneath aggregate bank-credit numbers, mis-invoiced trade and the largely unmonitored trade credit economy have not always received the attention their economic significance warrants.

The 2004-08 Growth Story
The celebrated 2004–08 “golden growth” phase may have contained a substantial financialisation component that was mistaken for a conventional investment and capex boom.

Private corporate sector’s gross capital formation (PCS-GCF) appeared to surge from 7.0% of GDP in 1999-2000 to 17.3% in 2007-08, creating the impression of a powerful, investment-led manufacturing take-off.

Yet, Table 1 presents an important anomaly. PCS-GCF grew at a CAGR of 19.3% during 2000–10, while private corporate sector bank fixed deposits grew at 39.5%. During 2004–08, the respective CAGRs were approximately 43% and 48%. That combination is unusual for an economy experiencing a genuine capex-led manufacturing expansion.

Bank credit was increasingly recycled into financial assets. Sub-BPLR lending reached 77% of bank credit by 2006-07, while corporate fixed deposits expanded sharply, with their share of banks’ total deposits rising from 3.4% in 1999-2000 to 17% by 2009-10.

This created a powerful arbitrage opportunity: sub-PLR lending at preferential rates alongside high-yield bulk deposits enabled circular fund flows between banks and large corporates, without a corresponding increase in productive capital formation.

The measurement issue was equally important. PCS-GCF was estimated on a flow-of-funds basis, capturing funds flowing into the corporate sector rather than independently verifying their ultimate end use. If funds entered the corporate sector and were subsequently diverted into financial deposits, the headline capital-formation numbers could therefore overstate the amount of productive capacity being created.

The demand-capacity disconnect was reinforced by the rapid rise in Chinese imports, which grew at approximately 58% CAGR in US-dollar terms during FY2003–08. Strong demand was therefore not being matched by a comparable increase in domestic productive capacity but through imports. 

 Table 1: PCS Gross Capital Formation, Term Deposits, and Sub-BPLR Lending, FY2000–FY2010

Sources: RBI Handbook of Statistics on Indian Economy; Basic Statistical Returns of Scheduled Commercial Banks; Report of the Working Group on BPLR, 2009.

Balance-Sheet Cross-Check
The nature of the funds-flow data become considerably more revealing when tested against RBI corporate balance-sheet information.

Gross fixed assets declined from 74% to 53% of total assets between 2003 and 2012, while financial assets increased from 16% to 28%. The direction of the change is consistent with a substitution towards financial assets rather than sustained expansion of productive capacity.

This helps explain why the apparent corporate boom did not translate into the manufacturing transformation that many expected.

Strong PCS-GCF data helped underpin the National Manufacturing Policy of 2011 and subsequently the Make in India initiative of 2014, both of which envisaged rapid manufacturing growth of 12–14%, substantial job creation and a 25% share of manufacturing in GDP. Those ambitions were not realised. Manufacturing IIP grew at a modest 3.2% CAGR during 2012–26.

A portion of the apparent corporate expansion reflected treasury income and financial recycling rather than a commensurate increase in productive investment.

Since productivity, sustained production growth and movement up the value chain ultimately depends on productive capital formation, the celebrated “golden growth” period may, in significant measure, have been gilded growth: financialisation mistaken for capital formation.

The Financial Stability Report of June 2014 recorded that the financial income of India’s top ten corporates exceeded the treasury income of the top ten banks in 2012-13. That comparison should have prompted a deeper examination of where corporate financial income was coming from and what it implied for the quality of investment.

Diagnosis Gap
The rationale for the 2016 demonetisation rested partly on the steady increase in high-denomination notes, or HDNs, defined as ₹500 and above. The rise in these notes was interpreted primarily as evidence of black-money accumulation.

What this diagnosis may have under-weighted was the possibility that a significant share of HDN demand was linked to the financing of the under-invoiced and unaccounted portion of rapidly rising Chinese imports through cash and hawala channels.

That is a payment-flow explanation rather than a simple hoarding explanation.

The subsequent return of almost the entire stock of demonetised notes to the banking system, alongside the relatively limited detection of actual cash hoards, weakens the proposition that the entire increase in HDNs represented accumulated illicit wealth sitting idle outside the financial system.

At the household level, high-denomination cash can enter the economy through channels associated with Chinese imports, financing purchases of under-invoiced or covertly imported goods before circulating through retailers, traders and service providers. Enforcement investigations have documented instances of under-invoiced Chinese imports, cash transactions and hawala settlement.

At the production level, the same cash circuit can move through Chinese-linked supply chains, financing components, raw materials and ancillary inputs across industries, including electronics and other emerging manufacturing ecosystems that depend heavily on Chinese imports.

The point is not that every high-value cash transaction was connected to such activity. It is that the possibility of a structural transaction-flow explanation deserved greater weight before treating the rise in HDNs principally as evidence of hoarding. Theory detached from economic reality can distort policy. Rising HDNs warranted greater scrutiny before demonetisation.

Contextual Blindspot
RBI is the principal repository of India’s financial-sector data, with corporate-finance studies dating back to the 1950s. Yet the limited contextualisation of these datasets against business realities has sometimes led to overly simplified interpretations. RBI data show a marked shift in corporate asset allocation: the share of gross fixed assets in total assets fell from 66–74% for much of the pre-liberalisation period to 49.4% by 2011–16, while financial investment nearly tripled.

Table 2: Share of Gross Fixed Assets and Financial Investment in Total Assets of Select Non-Government, 

Non-Financial Public Limited Companies, FY1951–FY2016

Period	1951-60	1961-70	1971-80	1981-90	1991-00	2001-10	2011-16
Gross Fixed Assets (%)	67.1	73.5	71.1	69.7	66.6	58.3	49.4
Financial Investment (%)	7.0	3.7	2.1	3.2	8.1	15.4	14.9
Cash & Bank Balances (%)	5.2	3.4	4.3	3.7	3.5	6.4	5.4

Table: Annual average share of Gross Fixed Assets and Financial Investment in total assets of RBI's selected non-govt., non-financial public limited companies, FY1951-2016. Source: Compendium on Private Corporate Business Sector in India - Select Financial Statistics, 1950-51 to 2008-09, RBI Database on Indian Economy /Corporate Financials/ RBI Bulletins.

The evidence points to a gradual but pronounced shift from productive assets towards financial investments and liquid holdings, a structural change whose broader policy significance was not always fully reflected in the analytical narrative.

*This is Part I of a series examining how economic theory and policy frameworks can miss important realities embedded in business and financial behaviour. Part II addresses the missing variables that remain outside much of conventional economic analysis.