Unimaginative Counsel

Historical lessons that popular prescriptions for the Indian economy ignore

Mihir S Sharma’s criticism of the Indian pharmaceutical industry for its lack of innovation betrays a misunderstanding of how innovation actually occurs. The breakthroughs in America’s pharmaceutical industry, for instance, resulted from concerted government investment in medical research. DHIRAJ SINGH / BLOOMBERG / GETTY IMAGES
Mihir S Sharma’s criticism of the Indian pharmaceutical industry for its lack of innovation betrays a misunderstanding of how innovation actually occurs. The breakthroughs in America’s pharmaceutical industry, for instance, resulted from concerted government investment in medical research. DHIRAJ SINGH / BLOOMBERG / GETTY IMAGES
01 March, 2016

FOR NUMEROUS PUNDITS the advent of the Narendra Modi government after the 2014 election meant a revival of the Indian economic renaissance. The growth during the earlier boom years had petered out, according to these commentators, because of the Congress-led United Progressive Alliance’s policies—the environment ministry’s “licence raj” obstructing various projects, welfare policies such as the NREGA and the Food Security Bill allegedly adding to inflation, and crony capitalism leading to scams in such things as allocating 2G spectrum and coal blocks. By contrast, it was widely held, the Modi-led National Democratic Alliance would accelerate India’s economic growth, and put the country back on the path to its much-delayed modernisation.

Yet, till about five years ago, there was a consensus among the intelligentsia—both local and global—that India was already on its way to becoming the next China. The period of a nearly double-digit growth rate, from approximately 2003 to 2011, saw plenty of “India rising” books, by writers including Patrick French, Akash Kapur and Oliver Balch. These documented the lives of the many Indians making the leap from community life, poverty and the village to individual freedom, consumerism and the city, and tied this trend to the grand narrative of India as the next Asian miracle economy. In the popular mind, India’s apparent destiny was embodied by the growth of IT companies such as Wipro, Infosys and Tata Consultancy Services, by glitzy new international airports in Mumbai and Delhi, and by a mushrooming of millionaires and billionaires.

However, even before the economic boom eventually tapered off, between 2012 and 2014, plenty of inconvenient caveats became evident in the Indian growth chronicle. Despite its $2-trillion economy, India’s record on the basics of literacy and health remained abysmal. In 2011, with a literacy rate of 74 percent, India was less educated than any of its counterparts among the BRICs—Brazil, Russia and China—were over two decades ago. By any measure, at least 40 percent of Indian children under the age of five remain malnourished—a feat matched only in sub-Saharan Africa. Moreover, the extremely unhealthy balance sheets of India’s top corporate groups suggest that the last ten years might have seen a bout of irrational, and irretrievable, investment, as opposed to productive capital-chasing technology and exports.

Most damagingly, India’s growth spurt—possibly the most intensive creation of wealth in the subcontinent’s history—was tepid in its creation of jobs. The decade of UPA rule yielded fewer than 55 million jobs for an economy with an additional 12 million people joining a workforce of over 400 million every year. These numbers mean that the share of informal workers in India’s labour market remains extremely large, at over 90 percent. And this is the most significant factor underscoring the severe weakness of the Indian manufacturing sector—whose contribution to the country’s GDP, at less than 17 percent, remains far below the equivalent contributions of the manufacturing sectors of its East Asian counterparts. India, a nation of 1.25 billion people, has a smaller manufacturing sector than South Korea, a nation of 50 million.

Restart The Last Chance for the Indian Economy Mihir S Sharma Random House India, 384 pages, T599

With a weak manufacturing sector, feeble job-creation, and persistently dismal human development indicators, India’s growth story leaves much to be desired. The need of the hour is a grand strategy for a sustained economic take-off. What such a strategy might look like is the chief concern of two popular economic columnists, Mihir S Sharma and TN Ninan, in their recent books: respectively, Restart: Last Chance for the Indian Economy and The Turn of the Tortoise: The Challenge and Promise of India’s Future.

Sharma and Ninan’s arguments are similar, perhaps because both writers come from the same milieu. Sharma is the opinion editor and a columnist for Business Standard, a newspaper guided through its most formative years by the editorial leadership of TN Ninan. Both deride the pre-liberalisation era, before 1991, as “backward,” because of its protectionism and the state’s control over the means of production. Both writers tend to have an extremely favourable view of the reforms of 1991, and of the role of the market in economic development. Although markedly different in style—Sharma’s witty prose makes for a great contrast with the prosaic, analytical thrust of Ninan’s writing—both books offer largely comparable prescriptions. First, they argue that the processes of deregulation and liberalisation initiated in 1991 remain unfinished, and must be expanded. Second, they hold that the Indian state desperately needs to get better at the basics of governing.

But while the authors display much insight in their discussion of the causes of economic stagnation, their prescriptions are unlikely to see us home. Sharma and Ninan limit themselves to a neoclassical economic framework, which, save in a few instances, emphasises the withdrawal of the state from any active interference in industry. In that, these books are perhaps the clearest exposition—Ninan’s the most analytical, Sharma’s the most lucid—of the ideological consensus that permeates the editorial pages of India’s financial press. But the evidence of history is stacked up against them. As the banker and economic analyst Ruchir Sharma noted in Breakout Nations, his bestselling 2012 study of emerging markets and the global economy, the most astounding aspect of the world’s developmental history is that “very few nations achieve long-term growth.” In the more than 100 years since the Wright brothers flew their first plane, no major country outside Europe, North America or north-east Asia has succeeded in industrialising. The historical literature on the handful that have—the United States, Germany, China, Korea, Japan and others—shows that their growth strategies, while varied, departed significantly from those advocated by Sharma and Ninan. The authors’ adherence to the current ideological consensus prevents them from envisaging other, more historically sound, approaches to development. But India, if it is to reinvigorate its economy, cannot afford such a blinkered view.

Ninan is mistaken when he writes that great infrastructure and lax regulation have alone been responsible for China’s unparalleled industrial transformation. He fails to note that Chinese industrial upgrading is as much a story of coordinated investment through five-year plans, state-controlled finances and state-owned oligarchies to allow for scale. QILAI SHEN / BLOOMBERG / GETTY IMAGES

FOR BOTH SHARMA AND NINAN, a key reason as to why India’s upward trajectory has proved woefully unsustainable is because, as Sharma notes, the country’s earlier “reforms did not go far enough.” The 1991 balance-of-payments crisis—a product of a towering oil-import bill and excessive foreign debt—pushed the then prime minister, Narasimha Rao, into devaluating the rupee and destroying an infamous regime of tariffs, industrial licences and trade controls. But was that enough to let the market reign? Evidently not: Sharma writes that “markets for the labour, land and capital remain restricted even though the markets for the stuff you create with them have been freed up.”

For Ninan, too, Indian producers, when compared to their international competitors, are hampered by higher land prices, an inability to fire and hire with ease, and barriers to accessing capital. He writes that the 2013 land acquisition law—which mandates that acquiring authorities pay extremely high compensation, secure the consent of at least three-fourths of affected landowners, and conduct social-impact studies of their projects as part of the acquisition—has made acquiring land “unaffordable from the perspective of project viability in many cases.” Rural Punjab, he points out, has land prices higher than in “any rural area of United States barring New Jersey.”

Both Ninan and Sharma criticise current labour laws as the single greatest factor in hampering Indian manufacturing. Ninan writes that, “since the more restrictive labour laws kick in only for the organized sector (units that employ ten workers or more)—there is a bias against crossing that threshold.” The result is that “the share of micro and small enterprises in manufacturing employment is 84 per cent versus 27 per cent for Malaysia and 25 per cent for China.”

This is all in keeping with the established view that the spirit of deregulation, which gave the Indian middle class access to a variety of television channels and international consumer goods, needs to be taken further in order for it to make a dent on the factors of production—which, as understood by currently conventional economic thinking, include land, labour, capital and entrepreneurship. But the authors go beyond just this in their admonishment of the Indian state, and this is where both books get most interesting. While rapping the government for decelerating growth through faulty policy, failing to provide public health and education, and harbouring a native distrust of markets, Sharma and Ninan rightly recognise that the “Indian state is inefficient because it is overworked” and under-skilled. In a public discourse where ridiculing the government for being too big and intrusive has almost become de rigueur, this is a breath of fresh air.

The state’s basic incapability is evident in the way it has handled public-private partnerships, or PPPs, in trying to build infrastructure and exploit natural resources over the last decade. The private sector was asked to pitch in—as Ninan notes, “perhaps for the first time in the history of any large economy”—towards propelling India’s ailing infrastructure into the twenty-first century. The government then muscled state-owned banks into lending money for this work. This then underpinned both the increase in investment during the boom years—resulting in the nearly double-digit growth rate—and the calamitous drop of it during the bust years.

Why the drop? Because the PPP model is inherently flawed. Building infrastructure, for instance, rarely allows for any short-term revenues—leaving bankers and investors without regular returns. Moreover, in India, many resource projects involving PPPs get stuck in the logjam surrounding land acquisition and environmental clearances. This is compounded by the corruption in the distribution of natural resources. The private sector was to service half of the $1 trillion needed to fix the country’s shoddy infrastructure, but eventually, Sharma writes, the “amount the private partner put into the average PPP project decreased dramatically.”

The Turn of the Tortoise: The Challenge and Promise of India’s Future TN Ninan Penguin, 368 pages, T699

But this doesn’t mean the writers let industrialists off the hook. In superbly withering language, Sharma shows how a cardinal problem with the Indian state is its failure to rein in bad business practices and its susceptibility to special interests. From Vijay Mallya taking on excessive debt with impunity—the tycoon “personifies everything that has gone wrong with the Indian business”—to letting the richest business houses, such as Reliance and GMR, grab natural resources and secure extremely favourable contracts with the government, the state has a lot to answer for. As Ninan notes, “all too often, when it comes to policymaking, the interests of seventy-five business families have trumped those of 750 million consumers.”

The problem with India’s industrialists is that they are very often sluggish and uncompetitive. Sharma reserves a good deal of his derision for the generic pharmaceuticals industry, one of India’s few internationally competitive manufacturing sectors. In a ruthless description of the falling quality standards of the once celebrated Ranbaxy, Sharma shows how pharmaceutical companies in particular, and Indian manufacturers in general, “do no research,” “don’t bother with quality control,” and “lie to regulators.”

Despite both authors’ deep frustration with the Indian state, and their calls for significant administrative reform, it is only Ninan who offers a coherent proposal for reconstructing the bureaucracy. Drawing on the revolution of “new public management” in, primarily, the United Kingdom and the United States—which involves the lateral hiring of personnel from the private sector, and an extended reliance on consultants and contractors—Ninan argues that it is time to replace the “classically structured,” Weberian bureaucracy that is the Indian Administrative Service.

In superbly withering language, Mihir S Sharma shows how a cardinal problem with the Indian state is its failure to rein in bad business practices and its susceptibility to special interests.

But he fails to note that this kind of restructuring has lately attracted powerful critiques from political scientists such as John J Dilulio Jr and Francis Fukuyama, who have argued that the excessive retreat of the state in the United States, for instance, has often been counterproductive, and has led to the concentration of too much power in the hands of contractors. Indeed, they voice an urgent need to hire more bureaucrats. Moreover, the classically structured bureaucracies of Japan and Germany—who, like India, recruit generalist corps for top administrative tasks—continue to score extremely high on indicators of governance.

Both Sharma and Ninan are also concerned with ridding the state of its, as the latter notes, “ever-ready willingness to interfere with the functioning of the market.” Accordingly, they endorse solutions that range from using direct cash transfers in order to plug leakage in the delivery of food, fuel and fertiliser subsidies, to ending government control of prices for commodities such as sugar, grain and diesel. As they see it, India’s shortcomings in basic utilities and urban planning can be overcome if only the government begins to listen to the market: let public-utility operators charge people the “right” price for such things as electricity, and “make trains pay for themselves.”

In the end, and in keeping with the ideological consensus in the financial press, both authors more or less settle on the neoclassical vision of an ideal state: one which does a good job at regulation, dispute-resolution, investing in basic research and infrastructure, and fixing market failures—for instance, taxing polluters and prosecuting corporations for monopolistic practices—while letting the market function largely unfettered. This hardly delivers on the promise, made on the dust jacket of Sharma’s book, of providing answers “that are not obvious … comforting or conventional.”

NEOCLASSICAL ECONOMICS understands production as requiring inputs of capital, land, entrepreneurship and labour. It assumes that technological improvement and innovation—everything from adopting better machinery to adopting better processes—is automatic in a state where factor-markets (land, labour and capital) are free, and where the government invests in research and infrastructure. The formula for growth that follows from these assumptions would have the government handle the basics, and stop there. Those basics include providing infrastructure, health and education, enforcing contracts, and creating a national market through such things as a uniform tax code; addressing negative effects that the market fails to control, by, for instance, regulating the quality of food and pharmaceuticals; deregulating factors of production, which in this model are land, labour and capital; and maintaining macroeconomic stability by ensuring that variables such as the rates of inflation, employment and overall GDP growth stay in a healthy balance with each other. Such an approach to the state’s role despises tariffs, subsidies, or preferential finance arrangements for particular sectors—most of which are dismissed as “distortionary.”

Save for a few interesting suggestions for improving state capacity, the above more or less captures the recipe for Indian economic growth proposed by Sharma and Ninan. They call for labour and land reforms, increased government focus on getting health, education and regulation right, and an end to state intervention in chosen industries, whether in the form of price caps on fertiliser or fuel, the financing of state-owned banks, or special subsidies for solar power and other sectors.

But, in making these recommendations, the authors ignore an entire spectrum of alternative economic literature and theory on bolstering industrialisation. Economists and writers including Alice Amsden, Eamonn Fingleton, Joe Studwell, Ha Joon Chang and Robert Wade have made profound contributions to economic thought with their close studies of Western industrialisation in the late nineteenth and early twentieth centuries, and of the more recent industrialisation of East Asian economies. These scholars use economic history to draw their conjectures, where neoclassical economists tend to rely on deductive reasoning—an approach borrowed from, and more suited to, the natural sciences.

This historical method offers a new economic approach—which is traceable not to Adam Smith, celebrated as the founder of free-market economics, but to Friedrich List, whose analysis of early-nineteenth-century American and British industrial strategy profoundly influenced German industrialisation in the mid to late nineteenth century. Such an outlook sees the expansion of productive capabilities to be a matter of rearing the necessary institutions and economic ecosystems, and of what heterodox economists like to call “learning by doing.” In other words, a nation needs to have certain institutions that can help incorporate existing technologies into its economy, or invent new ones. The task of public policy is to nurture such productive institutional and systemic capacity—which would mean not simply letting the market operate, but making activist interventions in trade and industry of a kind that Sharma and Ninan largely eschew.

Japan's growth was built by a state that practised an almost chauvinistic promotion of domestic producers. Japan’s Ministry of International Trade and Industry intervened dutifully to ensure that scale and improvements in technology allowed rapid industrial upgrading of its car-making industry. MICHAEL S YAMASHITA / CORBIS

These may include facilitating cartelisation to prevent over-investment in a sector, forcing mergers to address an absence of economies of scale—over-investment and absence of scale are constant problems in new manufacturing industries—preferential financing, state subsidisation, temporary trade protection and state-assisted technology transfers. Why do industries need such help in their infancy? Because developing productive capacity—creating, for instance, giant corporations capable of world-class manufacturing and marketing—takes time. And because this is a matter of learning processes, developing industry-wide ecosystems of a mass market, raw-material suppliers and technology consultants, and mastering existing technologies. This process is, in practice, far slower and more organic than neoclassical models make it out to be.

The United States, as the economic historian Paul Bairoch wrote in his 1995 book Economics and World History, was the “bastion of modern protectionism” till the First World War—and historians credit its high protectionist measures with saving American heavy industry, in its infancy, from British competition. Indeed, the right of the industrialising American north to levy tariffs against the agrarian, cotton-exporting south was as much an issue as slavery during the American Civil War. Similarly, German industrial success in the late nineteenth century, through what historians often describe as “the marriage of iron and rye”—a coalition of industrialists and landowners—was due to state-subsidised cartels driven towards exemplary export performance.

More recently, as the political scientist Chalmers Johnson famously documented in his 1982 study MITI and the Japanese Miracle, Japan’s growth was built by a state that practiced an almost chauvinistic promotion of domestic producers. From textiles to steel- and car-making, Japan’s Ministry of International Trade and Industry intervened dutifully to ensure that scale and improvements in technology allowed rapid industrial upgrading of Japanese industry. In the 1940s, for instance, it forced small textile firms to merge, and the Japanese eventually came to dominate the textile industry. Such “industrial rationalisation” policies were perfected as MITI developed vertical bureaus for fostering the most important industries in the market. Measures such as “government-guaranteed financing, targeted tax breaks, government-supervised investment co-ordination … government assistance in the commercialisation and sale of productions” were directly responsible for making Japan a world leader in the manufacture of cars, ships and robotics.

Such Japanese strategies were soon successfully copied and indigenised by China and Korea. Ninan is fundamentally mistaken when he writes that great infrastructure and lax regulation have alone been responsible for China’s unparalleled industrial transformation. He fails to note that Chinese industrial upgrading is as much a story of coordinated investment through five-year plans, state-owned oligarchies to allow for scale, and immense financial repression—that is, coercive policies to enhance aggregate savings—to ensure that substantial finance is available for manufacturing and infrastructure. Most finance in China is state-controlled, over 90 percent of Chinese Fortune 500 companies are state-owned, and the Chinese government has actively helped its companies obtain new technologies. China’s is perhaps the greatest story of the success of state-led industrialisation.

When Sharma scolds Indian pharmaceutical companies for not “innovating enough,” he betrays a similar misunderstanding of how innovation actually occurs. America’s giant pharmaceutical industry, for instance, did not rely solely on individual firms to come up with its ground-breaking drugs. Rather, its breakthroughs resulted from concerted government investment in medical research through the establishment of multiple National Institutes of Health across the United States, as the economist Marianna Mazucatto has shown in her excellent book The Entrepreneurial State, published in 2013. Pharmaceutical corporations eventually adapted the most viable drugs for the market. But the initial research—which forayed into uncharted territory—was clearly a government-subsidised project. Indeed, most of the “innovation” these firms have done themselves, Mazuccato writes, has been in “me-too” drugs, which are slight variations on existing products created in order to secure new patents for the sake of product differentiation. In that light, just berating Indian entrepreneurs for not innovating will not do—the Indian state needs to bear some responsibility too. Yet, Sharma writes that the tendency to “pick winners”—that is, selectively support particular companies and industries—is “the final thing that needs to change” about the Indian state.

This, again, ignores the fact that the state has played a major role in directing finance, often against the wishes of the market, in most success stories in development history—from Germany to Korea to Taiwan. This is crucial, because industrial upgrading requires breathing space—or, as Mazzucato calls it, “patient capital”—for infant companies to learn and grow. But history suggests that free capital markets are usually concerned with short- to medium-term returns, and thus only back industries already doing well, along with finance, insurance, real-estate and other sectors given to bouts of speculation. In Korea, it was the state that provided room for the carmaker Hyundai to learn and grow, through a protected domestic market and cheap credit—so much so that the company only began making a profit in the mid 1990s, even though it was already manufacturing 60,000 cars annually in the 1970s. Today, Hyundai is among the leading automotive brands in the world. Such patient capital would not have been viable if financing was left wholly to the free market.

From Silicon Valley and the pharmaceutical industry in the West to car-making in Japan and Korea, the most successful industries have often been “picked” by the state. If India is to get serious about manufacturing, it shall have to do a lot more than simply fixing roads and loosening labour laws. In fact, with the rise in the popularity of contract labour—which now constitutes more than 40 percent of India’s industrial workforce—the present clamour for reforming labour laws may just be misplaced.

Ninan is correct in describing East Asian economies’ focus on exports as being key to their success, but is unable to link this to the broader theme of an activist industrial policy.

An industrial policy geared towards making domestic manufacturers export powerhouses in certain industries seems to be the key. Such policy should not shy away from trade protection, export-conditioned subsidies, state-assistance in transfers of technology, and state-sponsored sectoral bias in finance. The exact measures necessary would depend on the industrial sectors targeted, the country’s stage of development, and the international economic environment, but, as the journalist Joe Studwell notes in How Asia Works, his masterful 2014 study of East Asian economic history, they need to be geared towards allowing domestic producers space to adopt the latest production methods, while holding them accountable for competitiveness through exports.

It is remarkable that Ninan and Sharma show little awareness of the intricacies of East Asian, or Western, economic histories, and do not engage with the obvious holes those narratives puncture in their arguments. Sharma’s two-paragraph discussion of the role of industrial policy in development comes plagued with unsatisfactory conclusions. He notes, for instance, that for every country where state-driven industrial policy worked, “like Korea or Taiwan, there are places where it didn’t like Ghana and Brazil.” But that does not add up to an argument against the need for such policy. Indeed, one may say the same thing about the market’s ability to encourage industrialisation as Sharma does about the state’s. History shows, through the countless bubbles that pervade the financial record of the nineteenth, twentieth and twenty-first centuries, that the market has at best a patchy record of making sustainable investments, and no record of single-handedly helping a major country industrialise.

Ninan notes that the difference between East Asia and India is that “East Asian countries focused on the logical step of setting up light, labour-intensive industries” early on in their development, where India “chose to emphasize capital-intensive heavy industry.” This is patently false. Korea’s plans for POSCO, the now-privatised steel company, were formulated—much against the wishes of the World Bank, which considered it to be against Korea’s comparative advantage in world trade—in the mid 1960s. In Taiwan and China, too, improving heavy industries—such as those of steel, cement and heavy chemicals—remained a priority throughout the early stages of development. But Ninan is certainly correct in describing East Asian economies’ focus on exports as being key to their success. It is unfortunate that he is not able to link this to the broader theme of an activist industrial policy.

Sharma and Ninan are right in claiming that the Indian state’s interventions in fostering production have so far been plagued with failure and ineptitude. Its policies prior to 1991 laid too much of the responsibility for industrialising on the public sector, which squelched competition; did not look to foreign technology and processes, which killed competitiveness; and did not use exports as a benchmark of performance. Yet the solution to India’s series of failures may lie in getting state activism in industry right, as opposed to rejecting idea of state activism in principle. Sadly, neither author—like most popular commentators on India’s economic woes—has grasped this point.