What went wrong with India, and was still not entirely manifest when Swan arrived in India, can be characterised by contrasting India with East Asia once we go beyond the 1950s. In fact, by understanding better why East Asia went ahead to build greater success post-1950s helps us to understand why India went ahead to decline instead in her economic performance: hence, I will focus on East Asia’s success and its causes for now.
Let me begin by observing that, in my judgment, the critical difference was that India turned to the IS (import substitution) strategy and East Asia to the EP (export promotion) strategy. A central implication, which I have not drawn sharply in my earlier writings (which have focused, not on the inducement to invest, but rather on the social returns from investment) is that India, during this Phase II, handicapped the private inducement to invest, while East Asia wound up enhancing it.
India turned inwards, starting with a balance of payments crisis in 1956-57 which precipitated the imposition of exchange controls which then became endemic to the regime, reflecting the currency overvaluation that implies the effective pursuit of an IS strategy. Again, the explicit pursuit of an IS strategy was also desired, reflecting the economic logic of elasticity pessimism that characterised the thinking of India’s planners.
The result was that the inducement to invest in the economy was constrained by the growth of demand from the agricultural sector, reflecting in turn the growth of that sector. But agriculture has grown almost nowhere by more than 4 per cent per annum over a sustained period of over a decade, so that the increment at the margin in India’s private investment rate was badly constrained by the fact that it was cut off from the elastic world markets and forced to depend on inevitably sluggish domestic agricultural expansion. Thus, it became customary for Indian economists to talk about ‘balanced growth’ and about the problem of raising the investment rate which, by the mid-1980s, was still in the range of 19–20 per cent.
By contrast, the East Asian investment rate began its take-off to phenomenal levels because East Asia turned to the EP strategy. The elimination of the ‘bias against exports’, and indeed a net (if mild) excess of the effective exchange rate for exports over the effective exchange rate for imports (signifying the relative profitability of the foreign over the home market), ensured that the world markets were profitable to aim for, assuring in turn that the inducement to invest was no longer constrained by the growth of the domestic market as in the IS strategy. Private domestic savings were either raised to match the increased private investment by policy deliberately encouraging them or by the sheer prospect of higher returns.
This argumentation is not easy to defend once you face up to what my student Don Davis, now at Harvard, has called the ‘tyranny of the Stolper-Samuelson’: for, when this theorem holds, wages and rentals on capital are inversely related. When exports are the labour-intensive, the EP strategy may be expected to raise the wage of labour but depress the return to capital, thus depressing, not raising, the inducement to invest. Clearly, therefore, the force of Stolper-Samuelson argument must be broken: as indeed it can be by relaxing one or more of the assumptions underlying that theorem.
Thus, Davis suggests that the forces of comparative advantage may be argued to have been sufficiently strong as to make East Asia specialise in the production of the labour-intensive goods. This
… decouples factor returns from the factor price frontier for the capital intensive good, leaving wages and rentals dependent only on productivity in the labor intensive good and the price of that good. In moving from autarky to free trade, both factor prices can rise, inducing an accumulation ‘miracle’.
Another way out would be to assume productivity differences across countries, as in Ricardian theory. In this case,
if we assume that the relative productivity gap of East Asia relative to the rest of the world is largest in the capital intensive sectors, and that trade serves to close this gap, then it is again possible for both wages and rentals to rise.’
While therefore it is possible to formalise the argument I have made that the EP strategy increased the inducement to invest, I must also address Dani Rodrik’s recent objection that exports were a relatively small part of the economy at the outset so that EP strategy could not have resulted in any significant impact, and therefore the source of the investment must be found in governmental subventions and interventions whereas the growth of trade is simply a passive result of the growth induced by these other factors. This argument is unpersuasive because East Asia would have run into precisely the problem of demand constraint that India was afflicted with if an IS strategy had been followed, with the efficacy of these other policies in generating investment seriously impaired. Moreover, the ultra-EP strategy, with its mild bias in favour of the export market and the policy-backed ethos of getting into world markets, meant that export incentives must have played a major role in influencing investment decisions, not just in the exporting industries, but also in the much larger range of non-traded but tradeable industries. In any event, the growth of exports from East Asia was so phenomenal that the share of initial exports in GNP quickly rose to levels that would lay Rodrik’s objection to rest, even if it were conceptually correct.
The flip side of the process was, of course, the generation of substantial export earnings that enabled the growing investment to be implemented by imports of equipment embodying new technical change.
Now, if the Social Marginal Product (SMP) of this equipment exceeded the cost of its importation, there would be a ‘surplus’ that would accrue as an income gain to East Asia and would also, as I argue below, boost the growth rate. For this argument to hold, however, the international cost of the newer-vintage equipment must not reflect fully its SMP for East Asia. In a competitive international market for equipment, therefore, I must assume that East Asia was a small player whose higher SMP, did not pull up the world price to reflect the higher SMP i.e., that East Asia could, even without ‘piracy’ and ‘theft’ of intellectual property (which was widespread in the region until the new WTO regime), get embodied technology at bargain prices. This seems a reasonable assumption to make, especially when one sees that the world prices of the last-but-one vintage equipment fall drastically due to rapid obsolescence in the presence of quick product innovation: just think of your PCs. (To understand fully the foregoing point, note that an economy in 1970 such as Soviet Russia’s which was confined to using its own 1930s-vintage technology in equipment would not lose to East Asia which could use a heuristically 20 times more productive 1960s technology if East Asia had to pay a 20 times greater price for it. The surplus arises because East Asia pays, say, only a 5 times greater price in world markets for equipment that is 20 times more productive in East Asia.)
This argument is illustrated in Figure 1 in a simple diagram, with the SMP curve for increasing imports of the vintage capital equipment for East Asia put against the international cost of importing it, the striped area then representing the surplus that accrues to East Asia.
But there may also be another reservation about this argument’s effect on the growth rate, as distinct from its effect on income. It is fair to say that, thanks to the focus on the steady state in Solow-type models, it has now become fashionable to assert that the gains from trade, like any allocative efficiency gains, amount to one-time gains, not affecting the growth rate. This is, however, wrongheaded as a general assertion. Thus, consider the simple Harrod–Domar corn-producing-corn growth model with labour a slack variable. If allocative efficiency regarding land use (say, from one inefficient farm to another efficient farm) leads to a greater return to the total amount of (‘invested’) corn being put into the ground, the marginal capital-output ratio will fall, ceteris paribus, and will lead to a permanently higher growth rate. Similarly, it takes no sweat for a first-rate theorist to construct models where trade in capital goods leads to higher growth rates, without building in externalities etc. and relying exclusively on the fact that they can be imported more cheaply than constructed under autarky.
Thus, TN Srinivasan has extended the Mahalanobis-type putty-clay model to include trade and demonstrated precisely this. Thus, he assumes (in place of just one capital and one consumer good in the autarkic version) that there are two of each class of goods, with the marginal product of capital constant in each sector as in the Harrod–Domar model. The social utility function and the function that transforms the output of the two investment goods into aggregate investment are Cobb–Douglas. There is no intersectoral (i.e., between the consumer goods and the capital goods sectors), as against intrasectoral (i.e., between the two goods in each sector), mobility of capital: this is the clay assumption.
Assuming that all four goods are produced under autarky, that free trade is undertaken at fixed terms of trade, and that the share of investment going to augmenting capacity in each of the two sectors is fixed exogenously, Srinivasan then demonstrates plausibly that free trade in consumer goods (but with autarky continuing in investment goods) will raise welfare relative to autarky but not affect the growth rate of income or utility. On the other hand, freeing trade in investment goods will have a positive effect on transitional as well as on long-run (steady state) growth effect, and also a beneficial welfare effect relative to autarky. The vulgar belief that trade gains cannot affect the growth rate is thus easily disposed of.
However, how does one reconcile the ‘surplus’ argument with the findings that TFP growth has been a negligible factor in East Asia? So, is my story plausible but not borne out by the facts, as is often the case with our most interesting theories? I think not.
Thus, consider precisely the case where the imported equipment is 20 times more productive in Period 2 than in Period 1, but its price is only 5 times as high. If the valuation of this equipment is at domestic (producer) opportunity cost, as it should be, then it will indeed be priced 20 times higher than the older-vintage equipment of Period 1, so the measure of capital contribution at the level of the industry will rise commensurately and I presume that the estimated TFP growth in the industry will be zero: in that case, my thesis about the surplus is totally compatible with measured TFP emerging as negligible. But, of course, if the equipment is priced at its international cost, then I presume that TFP growth will pick up three-fourths of the gain that accrues from the ‘surplus’ of SMP over the international cost. My guess then is that, in East Asia, the former was the case. This might have been, not because the accountants were smart and valued Period 2 equipment at domestic opportunity cost, but because I guess that much of the imported equipment may have gone through importing trading firms which collected the three-fourths premium rather than the producing firms.
The role of literacy and education comes in precisely at the stage of the second step in my story above. For, the productivity or SMP of the imported equipment would be greater with a workforce that was literate and would be further enhanced if many had even secondary education. Thus, as shown in Figure 2, the SMP curve could shift to the right with literacy and education, leading to greater surplus for any given international cost of newer-vintage equipment.
Here I may cite Little, using the pretext that a Lecture justifies the informality of argumentation that a Conference paper does not:
It was largely from the experience of conducting this [1975, South Korean] survey, involving visits to the [28 randomly selected] firms ranging from 1.5 to 3.5 hours, that my own impressions of such matters as the acquisition of technology and skills on the part of the labour force ... were formed. I also visited a number of high exporting medium-size labour-intensive firms in Taiwan in 1976. ... Two points are mainly relevant in the present context. First the technology was simple, non-proprietary and easily acquired ... Secondly, both Korean and Taiwan workers were very quick to learn. Employees would usually reach the expected high level of productivity within a few weeks. This would probably not have been the case if the standards of primary education had not been high.
Of course, as these economies grew rapidly, the demand for secondary and higher education in turn would rise and a virtuous circle would follow: primary education would enhance the growth that the EP strategy brought whereas the enhanced growth would demand and lead to a more educated workforce. I see therefore primary education and literacy as playing an enhancing, rather than an initiating, role in the EP-strategy-led East Asian drama.
Thus, my story of East Asia’s success, and by contrast that of India’s failure, combines in its own way three major elements, in that order: (i) the enhanced inducement to invest due to the EP strategy; (ii) the benefit from the surplus of domestic SMP over international cost of imported newer-vintage capital equipment; and (iii) the raising of this SMP by the presence of a literate workforce. But if the main plot is this, the story has doubtless many sub-plots. I will touch on just one of them, especially as the analysis dates back to the early 1970s and to the NBER project which I had the pleasure of codirecting with Professor Anne Krueger, yet another of Australia’s gifts to Economics.
In my synthesis volume for the NBER Project findings, I had noted that among the advantages of the EP strategy, which the Project had found beneficial, one had to count the fact that trade barriers-jumping DFI in the IS countries was likely to be limited for these countries by the size of the domestic market by which it was motivated — there are shades here of the inducement-to-invest argument I have made today, but only in the faintest strokes. Secondly, such DFI as was attracted in the IS countries was also likely to be less productive because it would be going into economic regimes characterised by significant trade distortions that could even generate negative value added at socially-relevant world prices — a possibility that was discussed by me (based on an extension to the DFI issue of the contribution by Harry Johnson to the theory of immiserising growth in tariff-distorted economies) and then nailed down in well-known articles into a certainty under certain conditions by Hirofumi Uzawa and by Richard Brecher and Carlos Diaz Alejandro independently. I should mention that both these (thoroughly plausible in terms of their economic rationale) hypotheses have been examined, with some success, in cross-country regressions by another former student of mine, V N Balasubramanyam at Lancaster University and his co-authors. So, this element may also be added to the explanation of East Asia’s superior performance relative to that of IS-strategy-plagued countries such as India.
Indeed, the inefficiency of the limited investment that did occur is the other side of India’s miseries in the post-1950s Phase II. As India turned inward, the absence of competition and its salutary effects on efficiency were also lost. This loss was further compounded as the original, promotional apparatus established in the Ministry of Industry (the DGTD) turned swiftly into a restrictive agency instead. The government turned from indicative planning to a mechanism for masterminding, with the aid of a stifling licensing system, the production, investment and import decisions in the economy to a degree unimaginable to anyone outside the regime. I am reminded that, eventually when, in the early 1990s just prior to the beginning of the reforms in earnest in 1991 under what we might call Phase III, The Economist ran a long piece on India, describing and denouncing its policies, a visiting Russian economist, Maxim Boycko, who then went on to play a major part in the Russian privatisation program of Anatoly Chubais, told me: ‘that article could well have been describing the Soviet Union’. We had clearly reproduced beautifully the disadvantages of communism without any of its benefits!
In addition, the early policy adopted in the 1950s itself, under which a growing share of the country’s investments would occur in the public sector, spawned inefficient public sector enterprises whose losses would make a significant contribution to a macro crisis in the 1980s and which, in addition, crippled the efficiency of the private sector as well since the public sector enterprises supplied, or rather failed to adequately and efficiently supply, infrastructure inputs such as electricity and transportation over which they were granted monopoly of production.
So, if I were to summarise briefly the period of three decades between the end of the 1950s and of the 1980s, I would reach the following sobering conclusion:
We had started out in the 1950s with:
But we ended the 1980s with: