Financial Daily from THE HINDU group of publications
Saturday, Aug 31, 2002
The growth puzzle
SOME recent articles talked of the growth performance across various nations and how India is likely to fare in the years to come. The difference in the growth rate among various nations is surprising. Average incomes in rich nations are ten times than their poorer counterparts'. So what determines development across nations and why do countries grow differentially?
Despite the numerous theories of growth, the productivity level accounts for much of the growth disparities between countries. Robert Solow's neo-classical growth model says that the present level of economic well being in a particular region is positively related to its savings rate and negatively related to the rate of population growth. For instance, India's population is over a billion compared to the US' 300 million. India can only hope to narrow the gap through technological progress, leading to productivity improvement.
Although it is possible to grow by adding more inputs in the short run, it is not the case in the long run. The Asian Tigers growth performance is a case in point. Much of their high growth (especially the period before the South-East Asian crisis) was due to the heightened application of factor inputs. In June 1995, Hong Kong, Singapore, Indonesia and Malaysia were growing at an average annual growth rate of 5.4 per cent, 10.2 per cent, 6.5 per cent and 8.9 per cent respectively. The corresponding growth rate figures this year are only -0.9 per cent, - 1.7 per cent, 2.5 per cent and 1.1 per cent, respectively (The Economist, June 8).
Much of the growth performance of the Asian Tigers is because of additional inputs. In the early 1980s, each of these nations witnessed increased labour force participation by women. However, the long run growth through this phenomenon cannot be explained. The problem is that some inputs, especially human or physical capital, are scarce. Hence, it is not possible to increase output ad infinitum. After a point, the entrepreneur will end up with little or no capital, making further enhancement of output impossible.
So how do countries grow, or for that matter what determines technological breakthrough? The endogenous growth models (pioneered by Paul Romer) tried to answer these questions. The two important determinants for technological growth are externality in production and formation of human capital. With positive production externality (spread of Internet connections is a good example) the economy does not face a resource constraint. Likewise, human capital plays an important role in innovation and increasing labour productivity. Human capital, unlike physical capital (consisting of plant and equipment), undergoes schooling and on-the-job training. Both these components play an important role in augmenting labour productivity and long-run growth.
Almost all variation in living standards is attributable to differences in the countries' productivity, that is, the amount of goods and services workers produce every hour.
Therefore, to raise living standards, policy-makers need to raise productivity by ensuring that workers are well educated, have the requisite physical capital to work with, and can access the best available technology. Unfortunately, for any emerging economy such as India there are not enough resources to buy either physical capital or divert resources for the qualitative improvement of human capital.
In relative terms (vis-à-vis physical capital), India has a better stock of human capital. It has English-speaking labour, available cheap.
Domestic and foreign resources are available. The former can be increased through savings. However, it is not easy to change the behavioural pattern of a population.
Therefore, foreign resources, through foreign direct investment or exports, become significant. India's share in world trade is a meagre 0.6 per cent. India needs to compete for resources with emerging economies such as China and South-East Asian nations. Foreign investors are focussed on returns on investment. India's competitive edge in terms of English-speaking workers will not serve as a collateral for attracting FDI. In this respect the South-East Asian countries are ahead of us.
Moreover, South-East Asia has seen more demand for investments after the crisis. Before the crisis, efficient foreign firms were crowded out by inefficient domestic firms. So there is now a demand for investment in these areas.
India needs to improve its economic climate to attract FDI. This can happen through reform. It is important from the perspective of efficient resource allocation and, thereafter, increased returns on invested funds.
Government control on economic activities often results in the inefficient allocation of resources. First, social planners lack adequate information, which is reflected in the free movement of market prices. Second, nepotism and lobbying also affect government decisions.
The government's intervention is needed only in the event of a market failure, a situation in which the market fails to allocate resources efficiently. This happens in cases of externality. For example, when any factory is polluting the environment, the government can raise economic well-being through regulation. Alternatively, it should subsidise firms that make important discoveries. Hence, the argument in favour of reforms.
Examples of reform include the removal of quantitative restrictions, reducing tariffs (external sector reforms), liberalising the capital market and removing limits on the size and range of private investments.
However, in India the pace of reforms is slow. Few public enterprises have been privatised; the banking sector remains largely dominated by overstaffed government institutions; and the lack of power sector reforms mean that the State electricity boards are still draining government resources.
There are reasons for this. Reforms are opposed by labour unions, entire divisions of the Central and State bureaucracies, political parties, and special interest groups such as commercial farmers, small-scale business and industrialists fearful of the free play of international competition.
With these impediments, India will remain mired in the low productivity trap and continue missing the growth opportunities.
(The author is an independent economic analyst. Feedback can be addressed to email@example.com)
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