Democracy Lab

India, Meet Icarus

Why no one should be surprised that the emerging economic superpower is getting cut back down to size.

Did you hear the good news? India's economy grew at an (annualized) rate of 5.5 percent in the second quarter of 2012 (the last period for which data is available).

But wait: India averaged 8.1 percent growth from 2004 through 2011 -- a period that included the global recession. What sort of Pollyanna is ready to give high marks for 5.5 percent?

This modest number did, in fact, beat growth in the first quarter of 2012. But the real story here is how rapidly expectations have evaporated that India's day in the sun had finally arrived. With hindsight, it's not difficult to explain the slowdown: Interest groups that have more to lose than gain from rapid growth have managed to reassert their veto power over dislocating economic reforms. And in India's messy, corrupt (albeit democratic) political system, it is very difficult to take back the ground lost to defenders of the status quo.

Indian politics isn't about to change. A big question, then, is whether India's brand of governance is really compatible with a return of eight-percent-plus growth, or whether the world's second largest country is going to have to make the journey to affluence one fumbling step at a time.

It's easy to forget that India was the poster child of failed development strategy. From independence in 1947 to the late 1980s, it averaged just a shade more than two percent annual growth, barely enough to offset population growth. Pretty much everyone agreed long ago that the Indian economy had potential -- fine elite education, a culture of enterprise, a wealthy diaspora eager to prove itself back home, and a common language that happened to be the language of international business. But it was horribly burdened by a venal bureaucracy, a hopelessly overtaxed infrastructure, and (worst of all) an ideology of self-reliance and central economic planning that had largely isolated Indian markets from global competition.

It's also easy to forget that India's economic breakthrough was virtually an accident: In 1991, facing a foreign exchange crisis created by currency mismanagement, the government appointed an apolitical technocrat, Manmohan Singh, as finance minister, with the goal of giving India a more credible façade for international lenders. Singh grabbed the mandate and ran with it, devaluing the rupee, cutting confiscatory tax rates, opening the door to import competition, and reducing regulation of large enterprises to a level closer to, say, Europe, than to Cuba.

The economy responded with such alacrity to newly unleashed market forces that pragmatic politicians saw a future in defending the reforms. And with GDP doubling in the first decade under Singh, and more than doubling in the second, the idea took hold that the Indian economic juggernaut was unstoppable. But it was never that simple, as recent growth rates clearly show; contrary forces were building. To understand why, consider a little perspective.

The great majority of Indians are much better off today than they were four (or fourteen) years ago. Gross Domestic Product per capita income, measured in terms of today's purchasing power, has quadrupled between 1991 and 2011 to a respectable $3,600. What's more, the distribution of income did not change radically. India's GINI coefficient (a technical measure of inequality) hardly budged; neither did the percentage of India's income going to the bottom-fifth of the population. But rapid change did make great wealth more conspicuous -- especially in cities. According to Forbes, India has 55 billionaires (in U.S. dollars), most of whom do not hide their good fortune.

Moreover, income inequality between cities and the countryside has increased substantially. By no coincidence, one-third of all Indians (400 million people) who disproportionately reside in rural areas survive on less than $1.25 a day in terms of purchasing power.  

What's more, Indians have little sense that the reformers are on the side of the poor. Big business was relieved of smothering regulation; yet for most of the population, daily life is still under the thumb of a corrupt, nitpicking bureaucracy that routinely sells services (education, welfare benefits, rule of law) that are supposed to be free.

Then there is the wretched state of India's infrastructure. Everybody suffers from congested transportation, unreliable electricity, and hit-or-miss communications. But the poor (and, for that matter, the new urban middle class) suffer far more than big business and the wealthy, who have backup generators, private aircrafts, and dedicated telecom lines.

A few more words about corruption. India ranks 95th on Transparency International's Corruption Perceptions Index, behind such paragons of virtue as Liberia, Sri Lanka, and Jamaica. That hasn't stopped businesses that can afford to grease the palms of politicians and senior bureaucrats from progressing; indeed, it helps them by raising the barrier to would-be competitors who don't have the cash or the knowhow to spread the baksheesh.

But it is ferociously frustrating to everybody else: According to the World Bank, India ranks 182nd (that's right, 182nd) on a list of 183 countries in terms of the difficulty of enforcing contracts. And the resulting pent-up fury has recently fueled a powerful populist reaction to the social displacement that is inevitable in a rapidly growing economy. As a result, pro-growth elements in the current ruling coalition (led by now Prime Minister Manmohan Singh) have been severely weakened.

Consider the issue of foreign investment in retailing. Singh wanted to allow foreign "big box" retailers like Walmart and Tesco to set up shop in India fuel the spectacular sorts of efficiency gains in consumer services that have swept through India's business-service sectors -- and to reduce the portion of crops that rot on the way to market. But the coalition required support from Mamata Banerjee, the chief minister of West Bengal who came to power defending farmers against attempts to take over their land in order to build an auto factory. Banerjee also proved to be an equally tenacious defender of shopkeepers as well as incumbent wholesalers who controlled the movement of fresh food from rural areas.

The rejection certainly jolted the perceptions of foreign businesses, which had begun to regard India as a must-invest economy, like China and Brazil. It wouldn't be a make-it-or-break-it issue -- if it didn't reflect the larger reality that the country's economic culture isn't yet up to the challenge of supporting Asian-tiger rates of growth.

This is neatly illustrated in the confluence of factors that have limited the growth of manufacturing in India. Every East-Asian economic success story has been built around manufacturing exports. But, in spite of its vast supply of cheap, surplus labor and relatively strong management, only about 15 percent of Indian GDP is in manufacturing.

One of the most striking obstacles are the rigid labor laws created by independent India's first governments. South Asia's manufacturing juggernaut is fed by an endless, rapidly-churning supply of unskilled rural laborers seeking a better life in cities. But in India, once a worker is hired by a medium- or large-sized business, it's almost impossible to fire him or her. So multinationals selling labor-intensive goods ranging from shoes to low-end consumer electronics are now gravitating to countries like Vietnam, where labor is malleable and where 40 percent of the GDP consists of manufactures.

Nor are labor laws the only obstacle. India, home to 1.2 billion in a land less than one-third the size of the United States, is a very crowded country; not surprisingly, siting a factory can be a legal and political ordeal. By World Bank tally, India ranks 181st out of 183 countries in difficulty of obtaining a construction permit. (As alluded to above, Mamata Banerjee rose to power by stopping construction of a factory that was slated to build Tata Motors' ultra-cheap, breakthrough car, the Nano.)

Even if one manages to find a place to build a big business facility, there's the problem of supporting infrastructure. India's roads, rail lines, and electric power and port facilities are all overtaxed. This factor alone can spell the difference in competitiveness in global markets that favor flexibility, speed, and just-in-time inventory policies.

And why, you might ask, is Indian infrastructure inferior to that of potential rivals? One factor is the legendary inefficiency of its state-owned enterprises, which serve political constituencies rather markets. Another is the inability to build new rail corridors through densely-populated regions, which channels low-cost rail traffic into high-cost truck traffic. Yet another factor is the failure to attract capital from foreigners who are wary of the uncertain legal climate -- especially when it comes to big, high-profile projects that are catnip to corrupt politicians and bureaucrats.

All that said, the Indian economy is not about to fall off an economic cliff, or even return to the pre-1980s "Hindu rate of growth"-- it still has much going for it. But these days, development specialists are more likely to cite economic institutions -- regulation, rule of law, entrenchment of local interests ---than logistics or education or natural resources in explaining why economies succeed or fail. And from this perspective, there's no mystery why the Indian economy has downshifted. Indeed, the better question is, how has it managed to get this far?    

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Argument

Paul Krugman's Baltic Problem

Why is the Nobel Prize-winning economist mocking the countries that have escaped the eurocrisis?

Amid the carnage of the European financial crisis, the Baltic countries, by and large, are doing quite well. Estonia, Latvia, and Lithuania are booming. Last year, their growth rates reached 7.6 percent, 5.5 percent, and 5.9 percent, respectively. The turnaround, driven largely by manufacturing exports, has been one of the most remarkable and promising stories of the crisis. In 2008-2009, all three countries were badly hit by a nearly complete liquidity freeze, which sank their economies by as much as 24 percent. Even so, only Latvia required an IMF and EU bailout, and all three returned to growth after only two years of recession. Today, all three Baltic countries have ample access to international financial markets, and their credit ratings have risen steadily since the summer of 2009.

The Balts' rebound stands in stark contrast to the fate of eight mainly southern EU countries -- Hungary, Romania, Greece, Ireland, Portugal, Cyprus, Spain, and Slovenia -- which either already have or probably will require stabilization programs with external financial support.

So what happened?

The simple explanation is that the Baltic countries have pursued the opposite policy of the southern Europeans. In 2009, the Baltic governments each carried out strict austerity, with a fiscal adjustment of about 9.5 percent of GDP, mainly though expenditure cuts and substantial structural reforms. The southern Europeans, by contrast, delivered substantial fiscal stimulus in 2009. Previously fiscally conservative Cyprus and Slovenia ran up budget deficits of 6 percent of GDP in 2009, but neither benefited from greater growth. Instead, they have been trapped with large budget deficits and are now being overwhelmed by their public debt, admittedly also because of banking crises.

One would think, given the divergent outcomes, that a serious economist would advocate for countries to follow the successful example of northern Europe rather than the failed strategies of the south. Nobel laureate and New York Times columnist Paul Krugman doesn't seem to see it that way. Throughout the crisis, Krugman has attempted to explain away or even mock the Baltic countries' success even as they have continued to inconveniently disprove his arguments.

On Dec. 15, 2008, Krugman issued his first pronouncement on the Baltic crisis in a post titled, "Latvia is the New Argentina." He meant that Latvia would have to devalue its currency and perhaps default, as Argentina did in 2001. Neither happened. Latvia returned faster to fiscal health than anybody had anticipated. Krugman's claim that devaluation was necessary for Latvia's recovery (and presumably also Estonia and Lithuania's) turned out to be wrong.

Krugman's main line of argument has been that more fiscal stimulus is always needed as long as a significant output gap exists. But in Cyprus and Slovenia, very substantial fiscal stimulus generated minimal growth.  Neither country would be suffering from its current financial conundrum had it not followed such a policy. Spain would probably be safe as well.

Krugman's disregard for the risk of sovereign default is perplexing. His main line of thinking seems to be that Europe has a growth problem, not a debt problem, and he appears to believe that a fiscal stimulus can always overcome the threat of the increased public debt burden. Even in the case of Greece, which had a gross public debt of 165 percent of GDP at the end of 2011, he failed to notice the danger but financial markets declared that the country's public debt was excessive. Slovenia's public debt of 50 percent of GDP, for instance, is more than the markets accept, as its bond yields have exceeded 7 percent.

It is difficult to understand how Krugman can ignore the structural reforms that are urgently needed in Europe. All the southern European countries have overregulated labor markets that have caused persistently high unemployment. In Spain, it is easier to get a divorce than to sack a worker -- which explains in part why companies are very reluctant to hire new ones. But to Krugman, unemployment is merely a matter of lack of demand: "The urge to declare our unemployment problem "structural" -- a supply-side problem of some kind, not solvable by the "simplistic Keynesian" notion of just increasing demand -- has been quite something to behold," he wrote on June 8.

Greece stands out as the main villain of the European crisis. Multiple Greek governments had grossly falsified their statistics and maintained an average budget deficit of 7 percent of GDP for the last two decades, refusing to fulfill their EU obligations. The George Papandreou government adopted a stabilization program in May 2010, with more IMF funding than any IMF program in history but one year later it had expanded the already excessive public administration by a net of 5,000 civil servants. Papandreou raised already high taxes rather than cutting public expenditures.

Yet incredibly, Krugman calls Greece a victim, laying all blame for its predicament on the EU, the European Monetary Union, and Germany. When he's not exclaiming "this isn't a Greek problem... it's a European problem," he's pointing the finger at "the arrogance of European officials, mostly from richer countries, who convinced themselves that they could make a single currency work without a single government."

More bizarrely, while he considers Greece innocent, Krugman has attacked the far smaller and poorer Baltic countries in perhaps a dozen blog posts. Krugman is not, presumably, some kind of bizarre anti-Baltic bigot. His problem is that they have pursued austerity and succeeded; they prove that Krugman's analysis of the European crisis is wrong. As it happens, Estonia actually adopted the euro in January 2011, and the Baltic economies appear to have entered a high-growth trajectory.

Krugman's sour grapes are on full display. He dismissed the success of Estonia, "the poster child for austerity defenders" as insignificant in a June 6 post that provoked the wrath of Estonia's President Toomas Hendrik Ilves on Twitter. Undeterred, on July 1, he wrote,  "the best the defenders of orthodoxy can do is to point to a couple of small Baltic nations that have seen partial recoveries from Depression-level slumps, but are still far poorer than they were before the crisis." On one rare occasion, Krugman partially admitted a positive effect from austerity: "yes, it's actually worth noting that essentially nobody has managed to regain the confidence of the markets [through austerity], except for, you know, Latvia, which had almost no debt." Well, if you pursue austerity, you do escape debt.

The most generous explanation for Krugman's Baltic blind spot is that he thinks mostly about big states, and perhaps only about the United States. Small, open economies work quite differently. Tiny countries tend to adopt a foreign currency or peg their exchange rates, as the Baltic countries and Bulgaria have done. They cannot allow themselves large budget deficits, because the markets will not allow them as high levels of public debt as the likes of Japan or the United States. Their bond yields will rise at even moderate debt levels, as Slovenia, Cyprus and Spain have discovered. Another way to look at it is that even when Krugman writes about European economic policy, he is actually only making arguments for what he believes the United States should do.

Citizens of the Baltic countries can be grateful that their leaders never listened to Krugman. He advocated devaluation when it proved unnecessary and probably would have been harmful. He has persistently argued for less austerity and more fiscal stimulus everywhere, blatantly disregarding the need for public debt to be sustainable. And the benefits of fiscal stimulus remain dubious, while the drawbacks -- excessive budget deficits have forced several countries to accept international bailouts to escape default -- are clear for all to see.

Krugman praises the fiscally irresponsible and scolds the virtuous, denigrating the Baltic achievements while trying to explain away miserable failures, such as Greece. Doesn't he see that his advice would only aggravate these crises, while the opposite policies resolve them? How can anybody be so wrong for so long without feeling at least a little bit ashamed?

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