Why Growth Matters

Preface

In the 1950s, as developmental economists began to consider which countries would break out of the pack and become role models for other developing nations for their developmental strategies, India and China were regarded as certain bets. These giants would awaken after a long slumber.

India enjoyed an advantage on some dimensions but a handicap on others: India had inherited a splendid civil service, a fiercely independent judiciary, a relatively free press, and above all, politicians who had fought for independence and put social good ahead of personal profit. These attributes, which are now called institutions and define the underlying elements of good governance, were rare among most of the countries that reached independence as the Second World War ended.

The agronomer Rene Dumont, in A False Start in Africa, famously denounced the lifestyle of the African rulers who took over from the departing French, comparing it with that of the French court of the Bourbons! Indeed, pretty soon India was the only major postcolonial developing nation left standing as a democracy, even what we call now a “liberal” democracy characterized by the institutions of free elections, a free press, and an independent judiciary. Few development economists would have discounted the favorable implications of India’s political “exceptionalism.”

By contrast, China had emerged from the Long March and a fiercely contested civil war, and the liquidation of the kulaks in the process. If the Soviet Union under Stalin was any guide, the prospects for growth were shrouded in political uncertainties. In fact, the Great Famine and the Cultural Revolution were upheavals that underlined the legitimacy of these doubts about China. Until the 1980s, the Chinese giant therefore did not awaken; it continued snoring.

Yet, developmental economists in the 1950s favored the prospects of China over those of India. Why? The reason lay in the fact that development economists typically deploy simple models to arrive at judgments about development outcomes. At the time, the favorite developmental model shared widely by the economists depicted growth as dependent on two parameters: how much you saved (and invested) and how much you got out of that investment. As it happened, it was customary to assume that the savings rate could vary, and was subject to policy manipulation—typically, the government could use taxes to raise the domestic savings rate—but that the productivity of that investment, which was reflected in the “capital-to-output” ratio, was not significantly variable and was treated as a “technological datum.”

So, with the productivity factor neutralized, it was inferred that India would lose out to China simply because India, being a democracy, could not raise its savings rate through taxation as fast and as much as China, which was authoritarian and could extract savings—or what Marxists call a surplus—through draconian means from the population.¹ India, left on its own, would lose the developmental race to China.

But the fact that India was democratic meant that in the 1950s the West was rooting for its success against the communist behemoth, China.² Its inability to match China’s savings effort thus had to be matched by the West’s making up through foreign aid India’s handicap in raising savings and hence investment.

So, India became a recipient of substantial foreign aid and should have grown rapidly, in consequence. Yet, it did not. The Indian giant also continued to slumber and snore.

Both India and China were unable to grow very much during nearly three decades: China because of ruinous politics with disastrous economic policies prompted by Marxist doctrines that required autarky and regimentation of the economy, and India because of a disastrous economic policy framework that undermined the productivity of its investment efforts.³

Productivity and Growth

India’s growth rate turned out to be abysmal because the underlying assumption, that the productivity of the increased investment was a technical affair, turned out to be false. Domestic savings efforts were indeed being made,⁴ but the resulting growth fell far below expectation. Investment rose predominantly in the public sector, where productivity was low and stagnant. A complex regulatory regime tied otherwise dynamic entrepreneurs of India into knots. The result was low and stagnant growth rates until reforms began first grudgingly in the 1980s and then in earnest in 1991 (as seen in Figure 1).

The Indian situation was reminiscent of the 1970s and 1980s Soviet Union, which exhibited high and increasing savings and investment rates but whose growth rate kept falling (see Figure 2): there was blood, sweat, and tears, but no results. The cause of this disconnect was that the Soviet system was not putting the investments to productive use. This in turn had to do with the heavy hand of the central planning mechanism and the absence of incentives to produce and innovate that followed from the overwhelming dominance of public ownership of the “means of production.”

Figure 1. India: Low and stagnant growth rates despite rising investment-to-GDP ratio

Source: Author’s construction based on data from the Handbook of Statistics on India’s Economy, 2012, Reserve Bank of India, Mumbai

Figure 2. Soviet Union: Booming investment, collapsing growth

Source: Authors’ construction based on data in Desai, Padma, 1987, The Soviet Economic Slowdown: Problems and Prospects, Oxford: Basil Blackwell

By contrast, the East Asian economies registered extremely high investment rates but the investments were productive and thus the result was extraordinarily high growth rates, generally described as an “economic miracle” (see Figure 3). The investments were associated with extraordinary export performance, which resulted in imports of equipment embodying advanced technology.⁵

Economic Policies and Productivity

So what were the elements that reduced India’s growth rate to almost 3.5 percent annually over nearly three decades spanning 1950 to 1980? Four factors played a critical role:⁶

Figure 3. High growth rates in South Korea, Taiwan, Singapore, and Hong Kong in the 1960s and 1970s

Source: Authors’ construction based on data from World Bank’s World Development Indicators online (accessed on November 14, 2012)

      1.  There was an extensive system of controls over private investment and production. For example, industrial licensing regulated expansion of production, even its diversification;⁷ import licensing regulated all imports; investment licensing regulated expansion of new capacity. The result was a Kafkaesque maze of regulations that stifled any innovation, production, and investment, while also encouraging inefficiency because effective competition from domestic entry of new firms and from imports was virtually eliminated.

      2.  The public sector was steadily expanded and even granted monopoly in many activities that went beyond the conventional areas, such as utilities. In turn, these public enterprises predictably resulted in inefficient production and associated losses that also imposed a revenue burden on the state.⁸

      3.  Obsessive self-sufficiency defined trade policy. Domestic manufacture, once licensed, was automatically protected. The trade economist W. Max Corden has called this “made to measure” protection.

      4.  Similarly, India restrained direct foreign investment, which fell to dramatic lows during this period. When the reforms began in earnest in 1991, foreign investment flow amounted to barely $100 million, which is hard to believe for a country of India’s size.

Two central follies stood behind the policy features that undermined growth:

First, the heavy hand of the government in economic activity was so pervasive that one of us had remarked that the problem with India (and many other developing countries) prior to the reforms of the early 1990s was that Adam Smith’s Invisible Hand was nowhere to be seen.

Economist Joseph Stiglitz and financier George Soros talk of “market fundamentalism” as having been practiced when liberal reforms were introduced. In truth, in India the reforms represented a move to the pragmatic center from a situation in which markets were sacrificed, with grave consequences in efficiency and growth, to what can only be described as “anti-market fundamentalism.”

Second, the counterproductive policy framework was also inward-looking on trade and hostile to direct foreign investment (DFI), which meant that India turned away from integration into the world economy, forgoing important gains from taking advantage of such integration.⁹ The proponents of autarky in trade were of the view that, as the Chilean sociologist Oswaldo Sunkel put it, “integration into the international economy would lead to disintegration of the national economy.” This “malign-impact” view of opening to trade turned out to be generally wrong.

While the favorable experience of East Asia was built partly, in Singapore and Taiwan, on a pro-DFI policy, with DFI leading to multiple benign effects such as diffusion of know-how to local entrepreneurs, the same was not true of South Korea, which followed instead the Japanese-style policy where technology was imported instead. India did neither effectively. No benefits were derived from a general skepticism about DFI and the absence of an active technology-importation policy.

Growth Follows Reforms

Reforms led to growth in India in exactly the same way as in Brazil after President Hernando Cardoso, who as an academic sociologist had opposed globalization as leading to dependency (this is the famous dependencia thesis), took Brazil toward globalization. The same happened in China, starting in the late 1970s and early 1980s.

Some economists, such as Dani Rodrik, have argued that economies have grown despite embracing anti-trade policies and disregarding markets, so it is wrong to attribute success on growth to these liberal and pro-trade reforms. But this claim is hollow because there is no compelling case where such policies led to significant growth over a sustained period. This was particularly true of the Soviet Union, where growth rates were high for nearly two decades but then declined steadily as the autarky and the absence of market-based incentives steadily undermined the economy.

The old saying insists that economists never agree, but the late Joan Robinson, a radical economist from Cambridge who admired pre-reform China, and Gus Ranis, the mainstream Yale University economist, were overheard astonishingly agreeing on how remarkable Korean development was. It turned out that she had North Korea in mind, whereas he was thinking of South Korea. Of course, down the road, she turned out to be wrong. The North Korean autarkic and heavily anti-market developmental strategy could deliver missiles and nuclear weapons, but not sustained overall development. South Korea, which instituted “liberal reforms,” grew steadily.

The growth in China in the late 1970s and early 1980s was also led by the elimination of collective farming and the introduction of incentives to peasants. Subsequently, in response to sustained opening of trade and foreign investment, there followed the enormous expansion of exports from Guangdong province in the southeast, with large inflows of DFI and technology absorption resulting in an expansion of Chinese income and growth rate. A movement away from antimarket fundamentalism through the introduction of promarket policies and the removal of the disincentives against trade and DFI lay at the heart of the economics of Chinese gains in productivity and enhanced growth.

The East Asian miracle was also based on outward orientation in trade. The phenomenal growth in exports followed the deliberate integration into the world economy. Whereas India followed a policy of near-autarky in the pre-reform 1960s and 1970s, the East Asian economies looked ever more globally.¹⁰ As a consequence the Indian industry was constrained by the internal domestic demand. This meant that the inducement to invest in industry was constrained by the domestic expansion of agricultural incomes. But since agriculture rarely grows at a sustained rate in excess of 4 percent in historical experience, the East Asian decision to exploit foreign markets meant that the inducement to invest was not so constrained. Investment expansion on a dramatic scale followed and the expansion of exports that was its flip side meant also that East Asian economies could import capital goods that embodied advanced technology.

This in itself would not have been enough, however, to generate extraordinarily high returns and associated growth. To get the most out of the new technology, the workforce had to be literate enough to work with the advanced machinery. If not, the embodied technical progressivity would have borne no fruits. Thus, for example, the older of us has a DVD player with the latest features, but he is able to play only Start and Stop on the remote control; the productivity of his DVD player is the same as if no technical progress had been embodied in his state-of-the-art machine.

East Asia fortunately enjoyed, partly as an unintended benefit of Japanese occupation and the example of Japanese tradition of educating the masses—see the splendid autobiography of Junichiro Tanizaki (1988), arguably Japan’s greatest writer, which describes his school experiences—a primary and secondary education commitment that assured East Asian countries of astonishingly high levels of literacy. Besides, countries such as Singapore and Hong Kong freely imported skilled manpower at higher levels, making up for absent indigenous skills by importing foreigners with skills, and simultaneously sending masses of natives abroad to top universities to acquire the skills in the meantime and bringing them back at high remuneration. Benign attitudes toward trade and DFI combined with high and productive investment rates, importation of equipment with embodied know-how, and its successful exploitation by a highly literate population in a policy framework that additionally permitted incentives and rewards, created a virtuous circle that produced the East Asian miracle. But central to the phenomenon was the outward orientation in trade.

The experience of China, India, and East Asia—whose population amounts to not quite half of the global total population—demonstrates how growth is stimulated and sustained within the policy framework that exploits the opportunities provided by integration into the world economy, and also relies on a sophisticated use of market incentives in guiding production and investment.¹¹ Conversely, they also demonstrate that a shift away from such a policy framework undermines growth.

Three important caveats must be kept in mind. First, the liberal policy framework that has produced prosperity is not libertarian, nor is it one of “market fundamentalism.” For instance, it allows environmental objectives, such as reducing domestic pollution, while proposing the use of price-based instruments, such as emission taxes instead of direct quantitative controls. If producers of a good can simply dump waste into a lake or a river in the country, that will lead to overproduction of the good since the private cost to the producers will be lower than the social cost, which should not ignore the damage to the environment. We therefore need a polluter-pay tax, which puts a cost on the discharge of pollutants. The correct way to diagnose this issue is to say that we have a “missing market” regarding pollution, and in effect the tax creates that market. You do not have to be an ideologue of markets to embrace it as part of the appropriate policy agenda.

Second, openness in trade is only an enabling mechanism. If other domestic policies create obstacles to taking advantage of the trading opportunity, the gains from trade will be minuscule. If domestic restrictions on production and trade prevent investment in new capacities to undertake exports, any opening to trade would have been frustrated: gains from trade could not be obtained in any significant way if resources could not be pulled toward the export industries, old and new. To use an apt analogy, if a door is opened but you do not have traction in your legs, you will not get through that door.

Finally, much is made of the so-called Washington Consensus as having driven the shift from the counterproductive policy framework. But this is nothing more than Washington Conceit. The shift in development strategy owed, not to any institutions in Washington, whether Bretton Woods or the US Treasury, but to the theoretical ideas and analysis of actual experience with autarkic policies and mindless interventionism that were the result of domestic experience. That they were then taken over and folded into coherent prescriptions for sound development strategy by Washington institutions, chiefly the World Bank, does not give ownership of these ideas to these institutions.

During the last quarter of the twentieth century, three extraordinarily important countries, India, the Soviet Union, and China, changed their counterproductive policies that had been based on antimarket fundamentalism and autarkic inward-looking policies on globalization. The changes were self-motivated, as we discuss below, not imposed by Washington. Public opinion and/or the politicians had realized that the “old” model, which some, including Stiglitz and Soros, would like to resurrect in their virtual embrace of what might be called “Jurassic Park Economics,” was not working and a drastic change was necessary.¹² “Washington Consensus” was also a popular phrase in the antireform circles because it would galvanize the antireform anti–US imperialism forces that were in retreat by suggesting that the United States, directly or indirectly, was behind the liberal reforms.

It has become fashionable among opponents of the liberal reforms to say that the Washington Consensus has now been replaced by the Beijing Consensus, an ambiguous phrase with little content, but aimed at suggesting that the liberal developmental strategy is now replaced by China’s success with a very different state-dominated and state-driven developmental model.¹³

While China’s export-led development appears to suggest that one element of the liberal development model—openness to trade—is part of China’s developmental model, many features of China’s economy and political regime raise concerns instead of offering a role model. In particular, the huge reliance on the state-owned enterprises (SOEs) has not merely enabled the Chinese regime to have the Communist Party capture these enterprises—which many in the West, and increasingly in China itself, think of as SOBs instead of SOEs—to the advantage of the party functionaries. It has also meant that extensive corruption prevails in China as bureaucrats and party officials seek to put their children and spouses into every enterprise, siphoning a share of the profits themselves. This model is hardly sustainable as the common people begin to resent such corruption and their economic aspirations rise as the Chinese pie grows at an extraordinary pace. The authoritarian regime also denies political agitation for democracy that inevitably is breaking out, as elsewhere. While therefore China has grown dramatically, it is unlikely that the growth performance is sustainable.¹⁴ So the mix of political and economic features that characterizes China is hardly a role model for other nations to adopt for their development.

Growth and Poverty

If growth did follow liberal policies and reforms in the Indian economy, as we argue in this book, still some critics argue that the growth is not “inclusive,” that it has failed to reduce poverty and has not spread to the marginalized groups in society. It is often argued that a policy of redistribution is preferable. This sounds plausible except that the Indian experience, and we might also add the East Asian experience, shows otherwise.¹⁵

In 1980, economist Gary Fields, who specializes in poverty, described India as a “miserably poor country.” Yet the reforms that followed, especially beginning in 1991, transformed it from a basket case into a powerful engine of growth, with poverty declining at rates never before observed in the country. Because India experimented within the same democratic framework first with command-and-control and autarkic policies and then with a move away from those controls and toward a greater role for markets and globalization, its experience offers important lessons to other developing countries regarding their development strategies and for the many government aid budgets and NGOs that seek to end poverty in the developing world.

Common sense suggests that we should expect a rapidly growing economy to create more jobs and opportunities for the poor to escape poverty, whereas slow-growing economies would hardly do so. Poor and stagnant economies can no more offer hope to the poor than private-sector enterprises making losses can offer additional jobs. Pro-growth advocates are often confronted with the failure of “trickle-down” economics, which sounds like the Earl of Nottingham and his courtiers and vassals are eating venison and roast legs of lamb at the sumptuously endowed dining table and crumbs are falling to the serfs and dogs below. We don’t care for the concept or analogy. Instead we use the now-popular phrase “pull-up” growth strategy, which much better describes what we have observed: a radical, activist set of policies to accelerate growth and to pull up more of the poor into gainful employment. In fact, with the shift to systemic reforms after the 1991 crisis, Indian growth did take off dramatically and poverty declined as well. And as we demonstrate, the benefits extended to the marginalized groups, with poll data also confirming that these groups actually consider themselves to be better off.¹⁶

What is the mechanism by which this happened? Bhagwati argued nearly a quarter century ago that growth would create more jobs (in the rural sector itself) and opportunities for gainful improvement in income (as, for example, through migration to growing urban areas), directly pulling more of the poor above the poverty line and additionally would allow the government to pull in more revenues, which would enable the government to spend more on health-care, education, and other programs to further help the poor.¹⁷ Growth therefore would be a double-barreled assault on poverty.

The pre-reform policies produced little growth and therefore undermined any attempt at using growth to affect poverty directly. Slow growth failed to generate revenues, so the ability to finance health and education expenditures was stymied as well.

Why did the Indian government not find the moneys to finance these objectives by raising taxes or diverting, say, military expenditures? It is revealing that Mahbub ul Haq of Pakistan, who reminded us often how arithmetic showed that one less military tank would mean several additional primary schools, joined the cabinet of the military dictator Zia ul Haq, under whom military expenditures did not diminish, Islamism was encouraged, and education of the people was neglected. Arithmetic cannot solve the problem of lack of resources; only appropriate pro-growth policies will.

Besides, raising tax rates runs into the usual problem that this remains an unpopular course of action in democratic countries. This resentful attitude to taxes, unless they are to be paid by others and not oneself, is beautifully captured in the Beatles song “Taxman”:

       Let me tell you how it will be

       There’s one for you, nineteen for me

       ’Cause I am the taxman, yeah, I’m the taxman

       Should five per cent appear too small

       Be thankful I don’t take it all

       ’Cause I’m the taxman, yeah I’m the taxman

       If you drive a car, I’ll tax the street,

       If you try to sit, I’ll tax your seat.

       If you get too cold, I’ll tax the heat,

       If you take a walk, I’ll tax your feet.

The closing stanza says it all:

       Now my advice for those who die

       Declare the pennies on your eyes

       ’Cause I’m the taxman, yeah, I’m the taxman

       And you’re working for no one but me.

Growth raises revenues without government’s having to raise tax rates, as India experienced with the reforms since 1991. Only then, as our analysis shows, could the Indian government finally find the moneys to adequately fund the health-care, education, and other programs to help the poor.

Redistribution, as distinct from growth, cannot be the answer to removing poverty. In countries such as India, China, and Brazil, the large numbers of the poor mean that redistribution will do little and that, too, will not be sustainable. A peasant may get no more than another chappati or burrito a day: we quote the great communist economist Kalecki of Poland, who told one of us in 1962 that the problem for India is that “there are too many exploited and too few exploiters.” The pie has to grow; growth is a necessity.¹⁸

We also discuss in this book that, while India has demonstrated that growth can be inclusive in its direct impact, the India policy framework, because of its bias against large-scale enterprises and rigid labor legislation that militates against hiring more labor, has not gotten as much “bang for its buck” as the Far Eastern economies. In short, both growth and its inclusiveness could have gone further if only these additional reforms had been undertaken.¹⁹