Failures of intermediation

Producers in the theatre use the concept of a "beat" to mark off sections of a play where the emotional or physical pace changes. It is tempting to apply the same imagery to economic management. The Indian economy is entering a new beat, with corresponding challenges for our economic managers.

This was the sense conveyed at the recent annual conference on the Indian economy at Neemrana in Rajasthan organised by the National Bureau of Economic Research of Cambridge, Massachussetts, and the NCAER. Our economic challenges have changed, partly reflecting past successes. At the same time, our ideas, public rhetoric, political habits and economic institutions are having difficulty keeping pace.

In the past it has taken crisis, both economic and political, to catalyse the necessary changes: 1956; 1969; 1981; 1991. Most liberal-minded economists would argue that India made the wrong choices in 1956 (under Nehru) and 1969 (under Indira Gandhi) and more sensible choices in 1981 (under Indira Gandhi) and again in 1991 (under P V Narasimha Rao).

All the major forks in the road have occurred under Congress leadership: innovation, for good or for ill, seems to be a burden the Congress has to bear. Fourteen years after 1991, the nation again faces some important choices. Will Congress (now leading a coalition) choose wisely or poorly in 2005?

The three great shapers of post-war Indian economic policy were the cold war, the problem of food, and the problem of foreign exchange. Each of these factors shaped the Indian response to its previous crises; each has today been transformed beyond recognition. The world of managed trade has disappeared along with the USSR (how quaint that name already sounds), while food and foreign exchange overwhelm us with their abundance.

The last three of the four crises were heavily coloured by the World Bank and the IMF. The World Bank mounted the Bell mission in the late1960s, the perceived failure of which underlay Indira Gandhi's lurch to the left. India entered into IMF programmes in 1981 and 1991.

The loss of policy and diplomatic autonomy in each case was a major domestic political issue. It seems unlikely that India will soon enter another Fund arrangement; instead India is lending to the Fund, turning away relief assistance, and rejecting official support from the smaller bilateral donors.

The old challenges have accordingly largely been met, leading one speaker at Neemrana to assert that the external constraints on India's developments had disappeared. Another, discussing our balance of payments, spoke of India's problem of plenty. The earlier world was dominated by administrative controls and public sector organisations.

That mindset is slow to change, not only in our political parties, but even in the public at large. Part of the problem may be vested interests, but part is also inadequate political leadership and public education. Our political class remains wary of changing the paradigm, and tentative rather than enthusiastic in grasping the opportunities presented by the global economy.

Those opportunities remain unabated. In the discussions at Neemrana on the international economy, there was a general sense of continued robust growth. The major imbalance is the US current account deficit, which largely reflects the unprecedented collapse in the household savings rate in the US (interestingly, the exact opposite of what has been happening in India).

Opinions were divided on the mix of interest rate increases and real dollar depreciation that would be needed to bring the US current account deficit down to a more sustainable 2-3 per cent of GDP, but the consensus seemed in favour of a soft landing for the world economy as this adjustment occurs.

A recurring theme at Neemrana was what I might call failures of intermediation in the domestic economy. There is unsatisfied demand and potential supply, but the mechanisms for linking demand and supply function poorly, leading to immense lost opportunities, and creating fertile ground for foolish palliatives.

The most visible example of this is our financial system. It was nationalised in 1969 to reorient itself to the needs of small farmers and businesses.

Most informed observers would agree that performance has been disappointing, and this is confirmed empirically by quantitative research (see Banerjee, Cole, and Duflo, "Banking Reform in India," India Policy Forum, Volume 1, 2004, NCAER, New Delhi, and Brookings Institution, Washington D.C.).

Public ownership and control have resulted in a combination of risk aversion and monopoly in the formal financial system, which has inhibited innovation, and prevented many sound investment projects from being financed.

At the economy-wide level, this failure has resulted in shipping our savings abroad through reserve accumulation, instead of deploying them profitably at home. It also raises demands for increases in public investment even where there is no clear case for public intervention.

Yet all attempts at changing the ownership structure of the public sector banks is opposed by the very constituents of the government who lament our low investment rate.

A similar story applies to the education sector. As is well-known (and as was recounted at Neemrana), on the supply side India enjoys an impressive demographic advantage over the next 15 years, while on the demand side the services outsourcing business is still in its infancy.

Yet there is real concern that our educational system will fail to transform the raw manpower available into even the minimally trained labour that can then be further developed by the IT industry.

While all would concede that elementary education is a public responsibility, current educational policies entrench an inefficient and costly public delivery system rather than fostering innovation.

Combining the financing responsibility of the state with greater competition in actual delivery (through voucher schemes, for example) is certainly worth trying on a pilot basis. As Surjit Bhalla has written in these columns, merely increasing public spending is not adequate, as exemplified by the experience of West Bengal.

Even our fiscal deficit (at least at the Centre) can be presented as a failure of intermediation, in that the Centre does not earn on its assets what it has to pay on its liabilities.

Rakesh Mohan, secretary, economic affairs, often remarked when he held my job at the NCAER that the vogue for public investment reflects a time when the central government was generating a revenue surplus.

Today, and for the likely life of this government, all public investment is directly being financed by market borrowing. If such investment is not to aggravate the fiscal deficit, it must yield not only a positive economic rate of return but also a positive financial rate of return.

A crisis of plenty may in fact turn out to be harder to manage than the crises of the past. There is less domestic sense of urgency. India has gained the policy autonomy that it wished, so there are few external forces to compel action. Yet the long-term political and economic consequences of continued economic underperformance could nonetheless be grave.

What is needed is no less than a radical rethinking of the role of the public sector in the economy, so that it becomes an instrument of change rather than an impediment. The economic team clearly understands what is needed. The question is whether they have the political backing to get the job done. This month's Budget will begin to answer that question.