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04/12/2019 11:52 AM IST

Indian Economy Needs Better Institutions To Sustain GDP Growth

Spurts in GDP growth that are state-led tend to peter out. The only way to run the fifty-year marathon is through building institutions, argues a new book.

Andrii Yalanskyi via Getty Images
In recent months, India's Gross Domestic Product has been consistently plunging, raising concerns about the state of the economy and the nature of its economic growth.

The dominant imperative for India is to increase GDP, so as to bring prosperity to over a billion people. There are few things more important than our challenge of becoming rich before we become old. We know, from the historical experience, that the only way out of mass poverty is to obtain modest rates of growth of per capita GDP that are sustained for many decades. As an example, if per capita GDP grows at 4 per cent per year, there is one doubling every eighteen years. Per capita GDP would go up by eight times in fifty years, and at the end of this, we would have graduated beyond middle income.

The problem with focusing on GDP growth as the immediate determinant of policy decisions is that there are many pathways to obtaining short spurts of GDP growth. GDP growth can be obtained through a great surge of debt, through a boom in government investment, by destroying the environment, by distorting the exchange rate, by establishing central planning structures that use coercion to mobilize and deploy resources, etc. Each of these pathways gives a short spurt of growth, but does not last in the long run. 

The experiences of the USSR and Japan are salutary reminders of the ability of states to set up short bursts of growth through methods that lack sustainability. For each USSR or Japan that actually managed to obtain state-led growth for a few decades, the historical experience contains many countries that failed to do even this much when opting for a state-led model of growth. 

In a simplistic notion of development, we have to combine capital and modern technology in order to achieve high productivity. This can readily lead to notions of high modernism. In the extreme, we may think of placing modern technology into government-owned monopolies, and using state coercion to force everyone to work with these monopolies. In the short run, this does give capital deepening and technical change. But this works out poorly in the medium term. We cannot be assured of benevolent and competent leaders in the public sector. We lose out on the energy of private innovation and competition. The economy loses flexibility and continuous adaptation when it is trapped by dominant state-controlled monopolies. And when we go down this route, we tend to revere and prioritize the big prestige projects over the subtlety of institutions.

Sustained improvement in institutional quality is hard, but it is the only way to obtain sustained GDP growth.

Many technologists slip into a different strain of high modernism, with an enthusiasm for designing state-run or state- imposed monopolies upon the economy. Deep knowledge of the humanities and social sciences is an antidote for this optimism. We are generally better off with multiple competing efforts, organic evolution of standards and technologies, and the minimal involvement of the state. A good model to look back upon is the rise of the Internet. While there was public funding in the research that built the Internet, there was no state coercion to encourage or force the use of Internet standards. If anything, the global telecom giants—many of whom were public sector companies—had put their shoulders behind a different standard (X.25), and they were wrong in their key design ideas.

A complex modern economy only works when it is a self-organizing system. It has to have the creative efforts of a large number of individuals, all working in their own self-interest. Central planning and a leadership role for the state do not work for a modern complex economy.

Building the republic, then, is about the policy institutions which shape the incentives of each person and help intermediate the interactions between individuals. Building these institutions is a slow and complex problem. In the short run, it is always possible to obtain GDP growth without solving these deeper problems. We would all do well to shift focus from the numbers for GDP growth, to focusing on the state of health of state institutions.

In the short run, central planning and state-led development can yield GDP growth. But as the economy becomes more complex, the need for state institutions that reshape incentives becomes even greater. Spurts in growth that are state-led tend to peter out. The only way to run the fifty-year marathon is through building institutions. We should pursue institution building rather than GDP growth. Sustained improvement in institutional quality is hard, but it is the only way to obtain sustained GDP growth...

There is no one measure of institutional quality, but we can think of a few measures that are useful in thinking about how we are faring in building a republic.

Safety: The number of young women walking alone on a street, at night, shows the extent of perceived safety and the functioning of the criminal justice system. This is a good measure of Indian institutional quality.

Flight of millionaires: The number of millionaires who emigrate out of India, per year, is an important measure. Millionaires in India are not ordinary people. They have acquired deep locale- specific knowledge, have achieved economic success and have roots in India. They do not leave the country looking for better economic opportunities. They are buying homes and citizenship in a mature liberal democracy owing to the fear of expropriation at home. Their departure suggests there are concerns about safety and the rule of law in India. Similar problems are being seen in China also. Our progress towards the rule of law is measured by the extent to which millionaires do not seek to leave the country.

Flight of India-centric firms: The phenomenon of India-centric firms that do not organize themselves as an Indian company is quite revealing. These firms go through considerable expense to set up a Singapore-based or a London-based entity, so as to avoid the legal and political risk associated with being an Indian company. This is a telling sign of institutional failure in India.

Flight of India-centric trading: Trading activity in the Indian rupee and the Nifty should, by rights, be located in India. However, from 2007 onward, over half of this activity has shifted to overseas locations. This reflects the failure of Indian institutions. Every year, we get new repressive measures in financial regulation, tax policy and capital controls, which pushes a greater proportion of activity overseas. This market share is a revealing indicator of Indian institutional quality.

Flight of India-centric contract enforcement: The extent to which private contracts in India rely on arbitration outside India is a comment on the quality of the Indian legal system. If India’s courts, judges, lawyers and laws worked better, it would be much cheaper to settle disputes in India. The fact that vastly greater legal costs are incurred outside India is a demonstration of Indian institutional weakness.

Mocking the powerful: The extent to which comedy shows torment the present leadership is a measure of the de facto freedom of speech present in the country. Under the rule of law, a Donald Trump is unable to inflict harm upon all persons who build these shows. The extent to which comedy shows take on the most powerful figures is a measure of institutional quality in India.

HuffPost India
Front cover of the book.

Vijay Kelkar served the Government of India as Petroleum Secretary, Finance
Secretary, Chairman of the Thirteenth Finance Commission of India. He also
served as a Director at UNCTAD and as Executive Director of the International
Monetary Fund. In 2011, the President of India conferred the Padma Vibhushan
upon him. He has a PhD in economics from University of California, Berkeley.

Ajay Shah has worked at the Centre for Monitoring Indian Economy, Indira
Gandhi Institute for Development Research and the Ministry of Finance. He is
Professor at NIPFP. His research is in economics, law and public administration.
He has a BTech in Aeronautical Engineering from IIT, Bombay and a PhD in
Economics from University of Southern California at Los Angeles. 

Excerpted with permission from ‘In Service Of The Republic: The Art and Science of Economic Policy’ by Vijay Kelkar and Ajay Shah.

HB | Non Fiction | 448 pp |699 Rs