When he is not pretending to work, the proprietor of Café Economics likes to grab a cup of steaming coffee, walk out to the terrace that adjoins his office and examine the urban chaos from his fourth-floor perch. The telltale signs of an economic boom are all around him—expensive cars negotiating narrow streets, shoppers invading refurbished retail outlets and new buildings poking their heads above a horizon once dominated by squat bungalows.
The Indian economy grew at a blistering 9.2% in the second quarter of this financial year. Once the final numbers for 2006-07 are in, the average growth rate over the past four years will surely be in excess of 8%—a good 2% points above the commonly assumed long-term growth rate of the Indian economy. Hence, the growing fears that the economy is overheated and, perhaps, headed for a spot of trouble .
These are euphoria-soaked times, and some hard scepticism is not completely unwarranted. After all, look at the little red flags fluttering in front of our eyes—inflation has shot up, the trade deficit is widening, bank credit is growing at a rate that is too fast for comfort, and asset prices have soared. Such a combination of symptoms is often a precursor to a bubble. So, are we mistaking froth for fact?
A little graduate economics can help clear the air. There are three things that drive an economic expansion over the long run: capital, labour and productivity. Economic growth is the result of more investment, higher employment and the fact that capital and labour is used more efficiently. This is what is called total factor productivity. The overt mathematics may be maddeningly complex, but the underlying logic is as simple as that.
India has good news on all three fronts. One, the rate of investment has shot up from around 24% at the turn of the century to well over 30% today, and a further rise is possible as Indians save more and foreigners pour their money into the country. Two, a young and growing population has put India in a demographic sweet spot, where the number of dependents per worker is falling. Three, 15 years of reform and globalization have pushed up productivity levels, especially in services and industry.
India is perhaps in the initial stages of a long boom that could extend over several decades. Other countries in the region have gone down the same road—and eventually emerged out of mass poverty at the end of it. Japan maintained an average growth rate of 8% between 1950 and 1980; most of the East Asian countries grew even faster between 1960 and 1995; China has been scorching the turf at 10% a year since 1994.
The danger is that this sudden growth acceleration could lead to complacency on the policy front. Economic growth has moved up a couple of notches higher without any significant economic reforms since 2004. In other words, the extra growth we have seen may be treated like an unexpected cheque in the mailbox—you get it without really trying too hard On the other hand, the most dramatic reforms in India have always been pushed through during economic distress, be it the macroeconomic crisis of 1991 or the severe slowdown in the last years of the NDA government.
It is easy to forget that a higher investment rate, while useful, does not necessarily mean higher growth and incomes. William Easterly, professor of economics at New York University and a thorn in the side of the development economics establishment, has shown how, going only by its investment rate over the past few decades, Zambia should have had a per-capita income of $20,000 by 1994. In fact, its per-capita income in that year was a meagre $600.
“After wandering in the tropics for many years,” writes Easterly in an essay published in 1998, “economists on the quest for growth have made some progress towards the destination in recent years… There is no magical broomstick for economic development, there is only sound theory that people respond to incentives and empirical confirmation that they do.”
Economic reforms will further improve the incentives to work, save and invest—the real pillars of economic growth. The mere act of investment is overrated. What matters is how you put the money to work. And how hard people work. And how much freedom they have to trade. And that is also why the sign on the wall of Café Economics celebrates one of the most fundamental insights of economics: People respond to incentives.
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