From UPSC perspective, the following things are important :
Prelims level : Nothing much
Mains level : Middle Income Trap - role of institutions to tackle
For India, there are few things more important than our challenge of becoming a rich country.
- From experience, we know that the only way out of mass poverty is to obtain modest rates of growth of per capita GDP sustained for many decades.
- If per capita GDP grows at 4% per year, there is a doubling every 18 years. Per capita GDP would then go up by 8 times in 50 years.
- That graduates us beyond middle income.
Idea of development
- The early idea about economic development viewed an underdeveloped country as a child.
- Growth was inevitable. It was only a matter of putting in a few actions to enable that process.
- This leads to the risk of thinking that progress is inevitable.
- Now we know that there is no inevitability about the rise of a country to be a prosperous democracy.
- There are only four countries that were poor in 1945 that are now prosperous democracies: South Korea, Taiwan, Chile, and Israel.
- In all those countries, growth came as a result of improvements in state capability.
- A prominent measure of state capability is available for the 1996–2012 period.
- By this, the state capability in India declined in this period.
- Our institutional capacity got worse in a period of strong GDP growth.
- It is wrong to equate GDP growth with improvement in the foundations for GDP growth.
Higher GDP growth – reduced state capacity
- When bigger rupee values are at stake, private persons gain by undermining state institutions.
- We saw this in India in the period after 2005 when the country was starting to reap remarkable success by private sector firms.
- The prospective gains from subverting state institutions were suddenly larger and we got bigger investments into attacks on institutions.
- State apparatus that used to work when million-rupee bribes were offered broke down when the offers went to billions of rupees.
- Perhaps India’s growth of 1979–2011 was not adequately grounded in the required institutional capacity to be a prosperous liberal democracy.
- This has something to do with the difficulties that have been seen after 2011.
- The growth model of 1991–2011 has not carried forward into the following years.
- Private “under implementation” investment projects rose from ₹10 trillion in 2006 to ₹50 trillion in 2011.
- After that, there has been a decline in nominal terms to ₹40 trillion in mid-2019.
- The share of non-workers in the working-age population stands at 60.43% in April–June 2019.
- In many other countries, the phenomenon of a “middle-income trap” has been observed.
- At the early stages of development, the simple mobilization of labour and capital is enough to escape from abject poverty.
- But once the minimal market economy is in place, a different level of institutional quality is required.
- The maturation of firms and the government creates the need for complex contracts, contract enforcement, economic regulation, and institutions that channel the conflicts between social groups.
- When a middle-income country wants to rise to a mature market economy, and institutional capacity is weak growth stalls.
Reasons for underperformance
- A lot of government intervention and the license-permit-inspector raj remains in place.
- The economic freedom promised in 1991 has not evolved into a mature market economy.
- Private persons are beset with government intervention.
- The instincts of central planning are alive and well among policymakers.
- There is a great deal of arbitrary power in the hands of the government.
- Extensive interference in the economy by the government still exists.
- There is a policy risk associated with future interventions. The fear of how arbitrary power will be used has led to a loss of confidence in the private sector.
State capacity deficit
- When India was a small economy, the GDP was small, and the gains from violating rules were also relatively small.
- The tenfold growth in the size of the economy created new opportunities to obtain wealth.
- The gains from violating rules went up sharply. Large resources were brought to bear upon subverting state institutions.
- The foundations of state institutions in terms of the rule of law, and checks and balances were always weak.
- The combination of an amplified effort by private persons to subvert institutions, coupled with low state capacity, has resulted in a decline of institutional quality.
Addressing the problems
- Economic thinkers of the previous decades tended to focus on economics more narrowly, on issues such as the green revolution or heavy industry or trade liberalization.
- We need to more explicitly locate ourselves in the intersection of politics and the economy.
- The founding energy of liberal democracy is the pursuit of freedom, of people being masters of their own fate.
- We need to shift away from notions of a developmental state with big initiatives from the government, towards a philosophy of respect for the self-organizing system.
- We need to rely far more on private negotiations, private contracts, and civil society solutions, rather than turning to the government to solve problems.
- APMCs (agricultural produce market committees) were not intended to create entrenched power in the hands of traders. Land ceiling Acts were not intended to create shortages of real estate and high prices for real estate. Bank nationalization was not intended to hamper growth, stability, and inclusion.
- Single-window systems do not solve the problem of state coercion, and the threat of raids and punishments.
- In the absence of deeper reform, it is hard to build single-window systems that overcome a maze of restrictions.
- The reform required in the early 1990s was not a single-window system governing IPO approvals, it was the abolition of the office of the Controller of Capital Issues. The reform required in trade liberalization was not a single-window system for import approvals, it was the removal of trade barriers.
- Some of the work of regulation can be pushed down to private firms. To tackle the problem of regulating taxis, one possibility lies in setting up bureaucratic machinery that engages with each taxi driver. Another pathway lies in contracting out this regulation to private taxi companies.
- Aggregation business models, such as Airbnb, have an incentive to utilize customer feedback and supervisory staff to improve the quality of their customer experience.
- Modern technology makes it possible to remove the market failure.
- In allocating spectrum, the state creates bureaucratic machinery which auctions spectrum and polices for violations. There is an alternative methodology where intelligent devices establish a self-organizing system through which the spectrum is shared. The need for government control of spectrum allocation is removed.
- Nobel Prize-winning economist Elinor Ostrom reminds us of the remarkable outcomes through some traditional community arrangements. The possibilities for purely decentralized solutions to allocate common goods without requiring a bureaucratic apparatus are high.
- 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.
It is always possible to obtain GDP growth without solving these deeper problems. We should shift focus from the numbers for GDP growth to focusing on the state of health of state institutions. Sustained improvement in institutional quality is hard, but it is the only way to obtain sustained GDP growth.