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January 16, 2008

Economist's View - 6 new articles

Monetary versus Fiscal Policy

This is Axel Leijonhufvud on "Keynes and the Effectiveness of Monetary Policy." According to this, Keynes held monetary policy in higher regard as a stabilization tool than I thought. However, as noted below:

All Keynes' arguments ... dissolve entirely under the eyes of anyone convinced that, when everything is said and done, the fact remains that the improvement or augmentation of "Land, Buildings, Roads and Railroads" are not activities highly sensitive to changes in the rate of interest.

In such a case, fiscal policy is needed. There's been lots of talk about fiscal policy today (see DeLong, Chinn, Bernstein and Mishel, and the CBO Blog for openers). Here's how I see it. Monetary policy is very good at slowing down an overheated economy, but it is not always so good, for the reasons just stated, at stimulating a lagging economy. It might do the trick, lower interest rates and other measures might provide the needed stimulus, but it wasn't all that long ago that some of the smartest people in this business argued that money had little if any effect on the real economy - some still do - and there are still uncertainties about the extent to which monetary policy can revive a lagging economy, especially an economy in a fairly steep downturn. I don't think it's a given that monetary policy will work.

Unfortunately, a serial approach won't work either. If we wait to see if monetary policy will work, and if it doesn't then turn to fiscal policy, it will be too late for fiscal policy to do much good (Bernstein and Mishel note there are have been long lags in the employment response over recent business cycles so even a late response could still help with employment. Perhaps, it depends upon where the lags are, but in any case sooner is still much better than later).

So why not shoot with both barrels? Implement both monetary and fiscal policy measures as soon as possible, hope like heck one of the two works because there's no guarantee either will do enough to matter, and if the economy recovers and begins to overheat due to the dual stimulus, use monetary policy to cool things down. As I said, using monetary policy to temper an overheated economy seems to be the one place we are pretty sure policy can be effective, and monetary policy can be reversed fairly quickly (of course, fiscal policy should also be reversed). And even if we do provide too much stimulus for a time, if we put extra people to work, build a few more roads and bridges, give rebates to struggling families when less would have sufficed, measures such as that, well, I can think of worse mistakes to make. So the danger of overstimulating the economy isn't as large as the danger of failing to provide adequate stimulus, thus, why not use both types of policies?

Anyway, here's the introduction and the conclusion of a paper by Axel Leijonhufvud detailing Keynes views on the use monetary versus fiscal policy as stabilization tools. (It's an old paper, it was written 40 years ago, but what Keynes said hasn't changed since then, though interpretations of his work do get updated. Notice the difference over the last 40 years exhibited in the first sentence where it is asserted that fiscal policy is the preferred stabilization tool among Keynesian economists, we hear just the opposite today from many in the Keynesian camp; also, I left it out, but the main theoretical argument is in section IV of the paper.):

Keynes and the Effectiveness of Monetary Policy, by Axel Leijonhufvud, Economic Inquiry, Volume 6, Issue 2, Page 97-111, Mar 1968: The Keynesian tradition in macroeconomics, particularly in the United States, has been associated with a decided preference for fiscal over monetary stabilization policies. In the development of this school of thought, certain arguments to the effect that monetary policy is generally ineffective have historically played a large role. By no means all the major contributors to the Keynesian tradition can be tarred with this brush. But, of those who have been outspokenly pessimistic about the usefulness of monetary policy, the vast majority would certainly be popularly identified as "Keynesians." Since the proposition that monetary policy is ineffective has in this way become associated with his name, it is of some interest to examine the case originally made by Keynes.

Since abounding faith in fiscal measures and a withering away of interest in monetary policy was one of the most dramatic aspects of the so-called "Keynesian Revolution," there is, I believe, a tendency to impute these views, as well as the analytical tools with which they were propounded, to the General Theory. It is of course true that this work, on the one hand, expressed doubts about the efficacy of banking policy and, on the other, argued for public works programs and for "a somewhat comprehensive socialization of investment" [8, p. 378]. But Keynes' position on the issue was a good deal less clear-cut than one would gather from standard textbook expositions of the "Keynesian system." The position on these policy issues advocated in the General Theory, moreover, was not at all "revolutionary" in the sense of making a distinct break with Keynes' own past ideas. On the scales of his personal judgment, there had been only a subtle shift away from reliance on monetary policy and in favor of direct government measures. The extent of this shift has been much exaggerated.

The exaggerated popular view of the extent to which Keynes' magnum opus downgraded the usefulness of monetary policy reflects an over-simplified and mechanical interpretation of his contribution which is deeply embedded in the "Keynesian" tradition. This paper seeks to restore some perspective on the issue. The motive for this attempt is the one common to most doctrine-historical essays: Misconceptions of where one has been and of the path followed to the present most often mean ignorance of where one is, and where one is going. ...



All Keynes' arguments, of course, dissolve entirely under the eyes of anyone convinced that, when everything is said and done, the fact remains that the improvement or augmentation of "Land, Buildings, Roads and Railroads" are not activities highly sensitive to changes in the rate of interest. If the major components of aggregate expenditures are in fact highly interest-inelastic, that would pretty well settle the matter and one's interest in the more complicated case made by Keynes would then be merely "academic." Among the "elasticity-optimists," furthermore, some may well feel that his theoretical framework is not the most appropriate one for organizing the empirical questions bearing on the substantive issue, or even that it tends to be positively misleading for such purposes. Those, finally, who both tend to agree with Keynes on the interest-elasticities and find his theoretical framework useful, will presumably disagree with his empirical or political judgment on several of the points discussed above. The substantive issues, of course, remain untouched by the clarification of Keynes' views on them attempted here.

We may conclude that Keynes weighed fiscal vs. monetary policies on the basis of a more complex set of considerations than is apparent from the standard "Keynesian" textbook discussion and also that his views were quite different. It is especially important to consider carefully the nature of the case for government spending and against Central Bank action that emerges from the analysis of Section IV. It is a case against reliance on monetary policy for the pursuit of certain objectives under certain conditions, i.e., in this instance, for the reversal of a "cumulative" process triggered by a disequilibrium diagnosed as being of a particular type. It is not a case for the general uselessness of monetary policy. On the contrary, the analysis makes very clear the great power for good or evil that monetary policy is seen to retain within Keynes' theoretical framework. For it is still as vital as ever that the Central Bank acts vigorously so as to hold market rate continuously in the near neighbourhood of an appropriately defined natural rate. The main prescription of the Treatise is not affected by the finding that there are conditions to the correction of which fiscal measures are better fitted than monetary measures. In the context of Keynes' theory, the diagnosis of disequlibria, on the lines sketched in Sections III and IV, is thus seen as a prerequisite for the choice of an appropriate mix of fiscal and monetary policies in a particular situation.

Jeff Sachs: Solving the Crisis in the Drylands

Jeff Sachs has ideas about how to solve the "crisis in the drylands," but first this is Dani Rodrik noting that Sachs' views on distributing insecticide treated bed nets for free to populations threatened by malaria appear to have been vindicated:

Jeff Sachs vindicated: On insecticide-treated bed nets (ITNs), at least. There has been an ongoing battle between Sachs and segments of the global public health community on ... whether ITNs should be distributed free (the Sachs position) or at a positive, albeit subsidized price. Those who favor the latter argue, in part, that charging a fee makes the program more sustainable and that it reduces wastage from giving away the nets to those who do not need or will not use it. See the arguments here (gated, unfortunately).

A new randomized experiment carried out by Jessica Cohen and Pascaline Dupas reaches striking and unambiguous results:

Taken together, our results suggest that cost-sharing ITN programs may have difficulty reaching a large fraction of the populations most vulnerable to malaria. ...[W]e find that ... free distribution is more cost-effective than partial-but-still-highly subsidized distribution... We also find that ... the number of infant lives saved is highest when ITNs are distributed free.

Finally, we do not find that free distribution generates higher leakage of ITNs to non-intended beneficiaries. To the contrary, we observed more leakage and theft (by clinic staff) when ITNs were sold at a higher price. We also did not observe any second-hand market develop in areas with free distribution. .

This is randomized experiments at its best: it addresses an important policy question and significantly changes (or should change) our priors on it.

Here's more from Jeffrey Sachs, but on a different topic, solving the ongoing crisis in the drylands:

Crisis in the Drylands, by Jeffrey Sachs, Scientific American: The vast region of deserts, grasslands and sparse wood lands that stretches across the Sahel, the Horn of Africa, the Middle East and Central Asia is by far the most crisis-ridden part of the planet. With the exception of a few highly affluent states in the Persian Gulf, these dryland countries face severe and intensifying challenges, including frequent and deadly droughts, encroaching deserts, burgeoning populations and extreme poverty. The region scores at the very bottom of the United Nations' Index of Human Development...

As a result of these desperate conditions, the dryland countries are host to a disproportionate number of the world's violent conflicts. Look closely at the violence in Afghanistan, Chad, Ethiopia, Iraq, Pakistan, Somalia and Sudan—one finds tribal and often pastoralist communities struggling to survive deepening ecological crises. Water scarcity, in particular, has been a source of territorial conflict...

Washington looks at many of these clashes and erroneously sees Islamist ideology at the core. Our political leaders fail to realize that other Islamic populations are far more stable economically, politically and socially—and that the root of the crisis in the dryland countries is not Islam but extreme poverty and environmental stress.

The Washington mind-set also prefers military approaches to developmental ones. The U.S. has supported the Ethiopian army in a military incursion into Somalia. It has pushed for military forces to stop the violence in Darfur. It has armed the clans in the deserts of western Iraq and now proposes to arm pastoralist clans in Pakistan along the Afghan border. The trouble with the military approach is that it is extremely expensive and yet addresses none of the underlying problems. ...

Fortunately, much better solutions exist once the focus is put squarely on nurturing sustainable development. Today many proven techniques for "rainwater harvesting" can collect and store rain for later use by people, livestock and crops. In some areas, boreholes that tap underground aquifers can augment water availability; in others, rivers and seasonal surface runoff can be used for irrigation.

Such solutions may cost hundreds of dollars per household, ... far too much for the impoverished households to afford but far less than the costs to societies of conflicts and military interventions. The same is true for other low-cost interventions to fight diseases, provide schooling for children and ensure basic nutrition.

To end the poverty trap, pastoralists can increase the productivity of livestock through improved breeds, veterinary care and scientific management of fodder. ... The wealthy states of the Middle East are a potentially lucrative nearby market for the livestock industries of Africa and Central Asia.

To build this export market, pastoralist economies will need help with all-weather roads, storage facilities, cell phone coverage, power, veterinary care and technical advice, to mention just a few of the key investments. With crucial support and active engagement of the private sector, however, impoverished dryland communities will be able to take advantage of transformative ... technologies...

Today's dryland crises in Africa and Central Asia affect the entire world. The U.S. should rethink its overemphasis on military approaches, and Europe should honor its unmet commitments of aid to this region, but other nations—including the wealthy countries of the Middle East and new donors such as India and China—can also help turn the tide. The only reliable way to peace in the vast and troubled drylands will be through sustainable development.

"Dancing With Tycoons?"

Whenever I read about thinkers like Adam Smith or Karl Marx and their evolutionary approach to modes of production, e.g. their explanations for the transition from feudalism to capitalism, I always wonder if capitalism is the end of the road, the last of the great modes of production, or if something else will follow. Marx, of course, thought capitalism would be supplanted by socialism and then communism, but I'm not so sure about that. I've always thought one possibility for the next step is worker ownership, though it's not quite clear how such firms would get started in the first place, i.e. where the capital would come from and who would decide which firms to start. But I suppose institutions could be constructed that would solve this problem (I'm not recommending this, but you could, for example, pass a constitutional amendment or more simply a law requiring an entrepreneur to sell the firm to the employees after the initial investment had been tripled or after fifteen years had passed, whichever comes first, or something along those lines. But that lacks institutional imagination and in any case I'm probably thinking too narrowly. Technological change, robots, computers, things I can't think of yet because they haven't been invented, things like that will likely frame the next step in our evolution to the next mode of production). So is this - capitalism as we know it - the end of the road, or will something else follow? Will capitalism be replaced by a newer, better mode of production? What will it be?

Here's David Warsh on a related topic - employee stock ownership plans:

Dancing With Tycoons?, Economic Principles: One of the things that news reporters learn early in their careers, if they are fortunate, is not to take anyone's claim to authority too seriously. For example, I remember meeting Louis Kelso in the early 1980s.

Kelso was the San Francisco attorney and amateur economist who, starting in 1958, had gained a measure of fame as the author of a plea for employee ownership that he called The Capitalist Manifesto...

But it wasn't until Mortimer Adler, the entrepreneurial educator, University of Chicago hanger-on, and founder of a Great Books of the Western World business, took an interest ... and agreed to share a byline on The Capitalist Manifesto that Kelso's "two-factor economics of reality" began to attract a following, mainly among lawyers, small investors and businessfolk. A steady stream of books poured forth... He was in the process of taking his critique of neoclassical economics to Mike Wallace and 60 Minutes when we met.

Private-equity artists William Simon, Michael Milken, and Ronald Perelman were in their ascendancy at the time; the buyout firm of Kohlberg Kravis Roberts & Co. was gathering steam: famous journal articles, by Franco Modigliani & Merton Miller and Michael Jensen & William Meckling, were revolutionizing the practice of corporate finance: though wealthy, Kelso was an easy guy to ignore. He died, at 77, in 1991.

On the other hand, Kelso had been politically acute. In the early 1970s, he and his associates made a concerted effort to sell their ideas on Capitol Hill. They culminated in a famous dinner at the Madison Hotel in 1973 with Louisiana Sen. Russell Long. Son of famous Louisiana demagogue Huey Long and chairman of the Finance Committee, Sen. Long became a convert over the course of the four-hour meal. He was no populist Robin Hood, he asserted (implying that his father had been), but he liked the idea that every worker should become an owner of capital – he even paid for dinner. (Norman Kurland has written a thorough history of the episode.)

The upshot was that the influential Long wrote a series of little-noted tax breaks for Employee Stock Ownership Plans (ESOPs) into an enormous piece of legislation that eventually would become the Employee Retirement Income Security Act of 1974 (ERISA). The measure thus created a set of opportunities for a new generation of missionary organizers of worker ownership for firms for whom the Chrysler bailout of 1979 was a signal event. ...

In 1987, the same year that Avis employees bought their car-rental company with the assistance of Wesray Capital, William Simon's firm, Mackin of the ICA founded Ownership Associates to advise workers and managers in the growing ESOP world. Soon the collapse of central planning in Eastern Europe and Russia would open a new set of opportunities, even if they were seldom taken up. Thanks to the ESOP legal framework, worker ownership had a seat at the table, though the seat was small and the table enormous. In 1998, Harvard professor Richard Freeman started a research project in Shared Capitalism at the National Bureau of Economic Research.

Eastern Europe was one thing. Little did I imagine, even then, that the path of employee ownership would lead some day to the mighty Chicago Tribune. I am a Chicagoan, ... and ... I still remember the fortress-like solidity of the arch-conservative Chicago Tribune, to whom President Roosevelt's Lend-Lease Act of 1941 was "the Dictator bill." ... Such a fount were its earnings...

Tribune Co. had suffered greatly in recent years, having drafted as its top managers accountants and investment bankers with little feel for the newspaper business, but in 2000 the company still threw off enough free cash that when the Chandler family was looking for a buyer for its Los Angeles Times, Chicago had but to write the check. With that, it became the nation's second-largest newspaper publisher, after Gannett. (Among its other papers are New York's Newsday, the Baltimore Sun, the Hartford Courant, and the Orlando Sentinel. Its other assets include television stations and even the Chicago Cubs, though it has pledged to sell the baseball team. )

Never mind that the lip of the waterfall lay just ahead. ...[T]raditional sources of newspaper earnings, both circulation and advertising revenues, were in serious trouble. The ebullience of the 1990s turned to despair. First Knight Ridder put all newspapers up for sale. Then Rupert Murdoch made an offer to the Bancroft family for The Wall Street Journal and the rest of Dow Jones that ultimately proved irresistible, Finally Tribune Co. put itself up for auction, a moved which produced only a couple of leveraged buy-out offers, which it spurned, before zeroing in on a management-led "self-help" deal, which would have led to large borrowing and the draconian cuts necessary to make it work.

At which point Chicago real estate developer Sam Zell, who had plenty of experience buying and selling undervalued real estate, but none with newspapers, slipped in with a surprise offer to lead an ESOP with $315 million of his own money. ...

Zell was taking advantage of a provision slipped into law in 1997 under which converting Tribune from a C Corporation (many shareholders) to an S Corporation (fewer than 100 shareholders) would permit the employees trust (60 percent ownership) and Zell (40 percent) to qualify as an ESOP, thus avoiding all Federal taxes for ten years, ... creating savings sufficient to permit the company to borrow enough to pay the highest price to existing shareholders who would tender their shares. The deal "exploits a loophole so gaping that we taxpayers can only pray somebody closes it quickly." (Zell's interest may have been spurred by two other recent successful applications of the ESOP provision, Amsted Industries and Unites Airlines – both Chicago firms.) ...

Since then, Zell has been on a tear, meeting with Tribune staffers in Chicago, hanging banners around the newsroom of the LA Times proclaiming "You Own This Place Now," naming a board of directors conspicuous for its lack of experience in the newspaper industry, etc. He explained his new role to a reporter this way: "You call it CEO and I'll call it owner." ...

Perhaps Zell was just lucky to be at the right place at the right time. It is certainly true that, if it works, the deal offers a significant upside to employees. It prevented major cuts, at least to begin with. And the way it is structured, he won't see a payday until the employees receive $750 million in value, a figure that would average tens of thousands of dollars, perhaps hundred of thousands, per employee. (For Zell, that payday could be a whopper: he holds a warrant entitling him to eventually buy 40 percent of the company for $500 million. The company was worth $8.2 billion when it changed hands.)

There are flaws in the ESOP, naturally, from the employees' point of view. Union representatives point to the lack of any consultation by employees in selecting the ESOP trustee that will play the lead role in governing the corporation. They may be employee-owners, but they don't have much of a voice. Retirement accounts will remain partially diversified, but will be overly concentrated in Tribune stock. Still, at the end of the day the Zell transaction means that a company that is in need of significant change will succeed or fail through the workings of a partnership between a tycoon and his partners, the employees.

Is that a good thing? The chorus of complaints about the tax expenditures that make the Tribune ESOP work (and others like it) is growing, among those who ... take the Treasury Department seriously. Already Congressman Charles Rangel (D-NY) has inserted a provision that would shrink them in the omnibus tax bill he is preparing for when the next Congress convenes a year from now. But are such experiments in collaboration between the super-rich and the deeply-threatened necessarily such a bad thing? David Henderson of the Hoover Institution has derided them as "a step towards feudalism."

Suppose the Sulzberger family were able to use an S Corp ESOP to consolidate their control of The New York Times? Or the Graham family used the device to assure the continuing independence of The Washington Post? Suppose Warren Buffet were willing to take Michael Bloomberg out of the company he founded, by financing its sale to employees? As Mackin of Ownership Associates says, "In an economy as radically unequal as ours, it is difficult to defend tax breaks for the wealthy. But when the wealthy are ready to use those breaks to share real economic gains with workers they just might deserve a break. It all depends upon the alternatives. Sometimes a tycoon is the best friend a worker is going to get."

Looking back, then, I am inclined to revise upward my opinion of Louis Kelso and Sen. Long, downward my estimate of the importance of those famous journal articles by Modigliani & Miller (which asserted that debt was essentially no different than equity) and Jensen & Meckling (which argued that owners ordinarily made better decisions than the professional managers who were their agents). Kelso's ideas seemed a little wooly to me at the time; the journal articles had the virtues of clarity, depth and precision. Certainly Wall Street thought so. At one point, Jensen boasted, "By solving the central weakness of the public corporation - the conflict between owners and managers over the control and use of corporate resources - these new organizations [private equity firms] are making remarkable gains in operating efficiency, employee productivity, and shareholder value."

What I have concluded since then is that reformers often know things that economists don't begin to grasp. Sam Zell may think he's the Tribune's owner; he is also the steward of a 160-year-old newspaper. I'm rooting for the employees of Tribune Co.'s newspapers – past, present and future.

Does Increasing Taxes on the Richest One Percent Lower Economic Growth or Tax Revenues?

Raising taxes on the richest one percent appears to increase tax revenues without lowering economic growth. Here's Lane Kenworthy with the details (this continues the discussion here and here; there is also a graph showing effective versus actual taxes in the discussion of fairness that does not appear below):

Taxes at the Top, by Lane Kenworthy on Taxes: For many progressives it is an article of faith that tax rates on the richest Americans should be higher than they currently are.

Why? One reason is that it would be fairer. ... Some opponents of higher tax rates for the rich argue that fairness in taxation requires that everyone's income be taxed at the same rate. Taxation should be proportional rather than progressive. Not many people seem to share this view, however. Most feel that because they can afford to, the richest should pay not only more dollars but also a larger share of their income.

A second rationale for higher taxes on the most well-to-do is that it would increase government revenues, which could be used to help improve opportunity and outcomes for those less fortunate. Health care for all, a more generous Earned Income Tax Credit, and subsidized preschool and child care are among the many good ideas currently on the table.

The taxes paid by those at the top matter a great deal for government finances. As of 2005 the top 1% accounted for 28% of federal government tax revenues. That isn't because they are taxed at an outlandish rate; an effective tax rate of 30-40% is hardly confiscatory. Instead, it's because they get a very large share of the country's income — 18% as of 2005.

The following chart shows federal government tax revenues as a share of GDP by the effective tax rate on the top 1%. The data points represent each year for which data are available. Although the correlation is far from perfect, tax rates on the richest are positively associated with the portion of GDP collected in taxes. This is as we would expect. It suggests that steeper tax rates at the top are likely to bring in more revenue.

But not so fast. It is commonly objected that higher tax rates on the affluent will reduce incentives for saving, investment, entrepreneurialism, and hard work. Economic growth will slow. Thus, taxes will be collecting a larger share of a less-rapidly-growing economy. In the end, higher tax rates will yield no increase (and perhaps a reduction) in government revenues.

Is this true? A lot of research has been done on this question, but there is little agreement about the answer. (For a helpful overview, see Joel Slemrod and Jon Bakija, Taxing Ourselves.)

The next chart shows the growth rate of per capita GDP by the effective tax rate on the top 1%. The effective tax rate on the richest appears to have had no impact on economic growth. Averaging growth over several years does not change the picture.

What about the effect of tax changes? As the first chart above indicates, the effective tax rate on the top 1% fell sharply between 1979 and 1982. In the five-year period beginning in 1982 the growth rate of per capita GDP averaged 2.6%. By contrast, the effective rate on top incomes jumped appreciably between 1990 and 1995. Yet over the five-year period starting in 1995 the average rate of economic growth was virtually identical: 2.7%.

There have been several smaller changes in the high-end effective tax rate since the late 1970s..., however, assessment is complicated by the fact that recessions occurred fairly shortly afterwards...[or because] it is too early to fairly judge the impact.

To sum up: The effective tax rate on the incomes of the top 1% of Americans is substantially lower now (31%) than it was in the late 1970s (37%) and in the mid-1990s (36%). When the rate is higher, the federal government tends to collect a larger share of the national economy in taxes. And the experience of the past several decades suggests that higher rates have had no adverse impact on growth of the economy.

This evidence is by no means conclusive. But it lends credence to progressive hopes that a somewhat higher rate of taxation on the richest Americans would not only be fairer but also enhance the government's ability to provide valuable services and benefits.

Why Does India Lag Behind China?

Arvind Panagariya of Columbia University with "a discussion of how India could speed its transition to a modern economy":

What India must do to modernise, by Arvind Panagariya, Vox EU: A key advantage claimed for the outward-oriented development strategy is that it allows poor, labour-abundant countries to specialise in labour-intensive products and, thus make efficient use of limited capital stocks. To quote Anne O. Kruger (1985), "An export-oriented strategy permits countries to use the international market to exchange their own, relatively labour-intensive commodities for capital-intensive goods. They are thus able to take advantage of the division of labour and specialisation. This ability contrasts sharply with import-substitution policies under which labour-abundant developing countries produce the entire spectrum of manufacturing goods and experience high and rising capital/labour ratios."

The experiences of South Korea, Taiwan, Brazil and most recently China offer broad support to this claim. Increasing shares of industry in GDP in general and of labour-intensive manufactures in particular accompanied the adoption of outward-oriented strategies in these countries. Exports of unskilled-labour-intensive products such as apparel, footwear, toys and numerous light manufactures expanded rapidly.

India's recent engagement with the world economy has produced a contrasting pattern, however.[1] Contrary to the impression in many circles, India's industrial and services sectors are almost as open as those of China. The simple average of industrial tariffs is 12% compared with 9% in China. The highest industrial tariff rate (with tariff peaks in several sectors) has been brought down to 10%. In fiscal year 2005-06, custom duty as a proportion of merchandise imports was just 4.9%. With some negative-list exceptions—most notably multi-product retail—the goods and services sectors are quite open to foreign investment. Only in exceptional cases such as insurance and media the sectoral cap on foreign investment caps are below 51% and in most cases go up to 100%. While this opening-up has been accompanied by acceleration in growth to 6.3% during the last two decades and to almost 9% in the last four years, India's experience differs from that of China in at least three important respects. First, while India has seen the share of agriculture in the GDP decline, it has not experienced perceptible rise in the share of manufactures. Second, exports out of and direct foreign investment (DFI) into India have not seen the same rapid expansion as that seen in the case of China. Finally, fast-growing exports from India have been either capital-intensive or skilled-labour intensive. The shift in favour of unskilled-labour-intensive products traditionally observed in response to the adoption of outward-oriented polices has not happened in India.

Indian exceptions

The share of manufacturing in the GDP in India has been stagnant at 17% since the early 1990s. In China, this share stood at a hefty 41% in 2006. India's leading and fast-growing exports, such as engineering goods, petroleum products, gems and jewelry, and software, are either capital-intensive or skilled-labour intensive. The share of textiles and textile products in total merchandise exports has declined to 15% in 2005-06 from 20% in 2003-04. Within this category, unskilled-labour-intensive ready-made garments account for only half of the exports. In contrast, the export pattern of China quickly adjusted to its factor endowments after it began opening up its economy in the late 1970s and early 1980s. First, exports of textiles, apparel, toys, sports goods and footwear surged. Then in the 2000s, with rising skill endowments, it moved into more sophisticated assembly operations such as office machinery, telecommunications and electrical machinery.

The most dramatic difference between India and China lies in the magnitude of international economic engagement. One measure of this difference is that the annual expansion in China's trade has been larger than India's total annual trade during last several years. For instance, China's merchandise exports expanded by $169 billion to $762 billion in 2005 in comparison to India's total merchandise exports of $103 billion in 2005-06. Equally dramatic are Figures 1 and 2 with the former showing the evolution of China and India's two largest merchandise exports and the latter depicting DFI inflows.[2]


What holds back India?

How do we explain these differences in the response to trade openness of two economies with very similar factor endowments? The key to answering this question is the poor response of large-scale labour-intensive manufacturing including assembly and processing activities in India. As per the conventional wisdom, these activities have served as the magnet for DFI and a conduit for rapid expansion of exports in China. But this has not happened in India. Large-scale labour-intensive manufacturing activities have been virtually absent from India. Apparel factories employing thousands of workers under a single roof found in China are non-existent in India.

The explanation for the poor performance of large-scale labour-intensive manufacturing is, in turn, to be found in the domestic policy regime—both past and present. Until the late 1980s, large Indian firms were confined to a positive list of capital-intensive sectors. Even in these sectors, their size was limited through licensing based on the perceived size of the domestic market by the authorities. The same applied to foreign companies. These restrictions were largely ended by the mega reforms of 1991 and those that immediately followed them.

But this was insufficient to stimulate large-scale labour-intensive manufacturing. In the late 1960s, India had also adopted the policy of reserving labour-intensive manufactures for the exclusive production by small-scale enterprises. Even after years of steady relaxation, the small-scale enterprises face a ceiling of 50 million rupees (approximately $1.25 million) on investment in plant and machinery. The small-scale industry list grew over time and by the late 1980s came to include virtually all labour-intensive products.

As long as this reservation was in force, high-quality labour-intensive manufactures that could compete on the world markets had no chance of emerging in vast volumes. The bulk of the small-scale enterprises operated in the protected domestic market. The problem was finally recognized in the late 1990s and the government began to gradually trim the Small Scale Industy list. Even then progress was slow and the number of reserved items fell from 821 in 1998-99 to 114 in March 2007.

Most labour-intensive products including toys, footwear, sports goods and apparel have now been off the reservation list for some years. More importantly, even for products still on the list, large-scale production has been permitted since at least March 2000 as long as the enterprise exports 50% or more of its output. This latter change means that firms predominantly interested in exporting their output have been free of such restrictions since March 2000. Yet, labour-intensive manufacturing has remained stubbornly unresponsive.

The most important factor that still holds back large firms from entering these products is a set of draconian labour laws in India. Under these laws, it is virtually impossible for a firm with 100 or more employees to fire the workers even in the face of bankruptcy. It is equally difficult for the firms to reassign the workers from one task to another. These provisions impose very low worker productivity or a high real cost of labour. Large-scale capital-intensive sectors such as automobiles, where labour costs are a tiny proportion of the total costs, can profitably operate in such an environment. But the same is not true of large-scale labour-intensive sectors labour. Few foreign manufacturers are willing to enter India outside of a small subset of capital- and skilled-labour intensive sectors.

Two additional factors have held back the labour-intensive manufacturing in India: costly power and poor transport infrastructure. Not only do firms pay a much higher price for power in India than elsewhere in the world, they also face much greater uncertainty of supply. Likewise, despite considerable improvement, the transportation network in India remains unreliable and inefficient. The time taken to clear the goods entering and existing the ports and to move the goods between ports and manufacturing sites, which is so critical for assembly and processing activities, is much higher and more variable in India than in the competing countries such as China.

India's path to modernisation

While high growth has helped India bring its poverty ratio (the proportion of the poor below the official poverty line) down from 36% in 1993-94 to 27% in 2004-05, its transition to a modern economy remains problematic: it must still move the vast majority of its workforce out of farming into non-farming activities. With the services leg doing all of the walking, the economy can only limp along towards this transition. For a more rapid transformation, India must walk on two legs. That means more rapid growth of the labour-intensive manufacturing.


Krueger, Anne O. 1985. The Experience and Lessons of Asia's Super Exporters," in Vittotio Corbo, Anne O. Krueger, and Fernando Ossa, editors, Export Oriented Development Strategies, Boulder and London: Westview Press.

Panagariya, Arvind. 2008. India: The Emerging Giant, New York: Oxford University Press.

Prasad, Eswar and Shang-Jin Wei. (2006). 'Understanding the Structure of Cross border Capital Flows: The Case of China,' presented at the conference, "China at Crossroads: FX and Capital Markets Policies for the Coming Decade," held at the Columbia University on February 2-3, 2006.


1 This article is based on chapters 12 and 13 of the author's forthcoming book "India: The Emerging Giant" (OUP, USA) to be published in January 2008.

2 Sources: India: Foreign Direct Investment Policy, April 2006, Department of Industrial Policy & Promotion, Ministry of Commerce, Government of India combined with the Reserve Bank of India Handbook of Statistics on the Indian Economy 2005, Table 157. China: Prasad and Wei (2006, Table 6).

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