Lessons from afar

Indian Express, 18 November 2011

The Italian economy poses one of the biggest dangers to world GDP today. The story of how this came about has striking lessons for India. India's growth story, something we often take for granted, could well go badly unless rule of law is imposed, government becomes more effective and corruption is brought under control.

The recent corruption scandals in India have made many people concerned about growth. Yet, most of us continue to believe that this is only about the short term, and that India's long term growth prospects remain unchanged. Thanks to accumulation of physical and human capital, along with an enterprising, innovative private sector, productivity in India will continue to grow and push the economy forward. Human capital will grow as demographics are on our side. A young population with improving education levels will push growth in labour productivity higher. Domestic savings and inflow of foreign capital will help improve infrastructure which would increase efficiency. This argument suggests that in the coming decade a serious slowdown in GDP growth in India seems most unlikely. Bad governance might have a short term impact on private investment activity, but in the long run India will rise out of these small problems. But can worsening governance lead a country to a growth slowdown?

In a recent article Daniel Gros of the Centre for European Policy Studies argues that the Italian economy has underperformed in the last decade primarity due to a worsening of rule of law, government effectiveness and control of corruption. He shows how Italy has done well on all the other variables that are often blamed for a slowdown in growth, and these are really the key indicators where Italy has failed.

One of the reasons for many of us believing that growth in India will not falter is that Indian households are prudent and they save a large share of their incomes. Barely 10 percent of Indian households borrow from the formal financial sector. High savings to GDP rates then translate into high investment to GDP. India invests nearly a third of its income each year. High capital accumulation will guarantee high growth. But is that enough?

Italy invested 20 percent of its GDP each year in the last decade. This was more than what Germany invested. However, data suggests that in Italy capital stock was inefficiently used. This meant that despite investing more, growth did not pick up as much as it could have, and did in Germany.

As in India, another often heard arguement heard in Italy is inadequate infrastructure investment by the government. Again, for this indicator too Italy has surpassed Germany at 2.5 percent of GDP in the last 20 years. Italian workers are today more educated than they were 10 years ago. Graduates have increased rapidly from 13 to 18 percent of the workforce. But larger infrastructure investment or the improved quality of the workforce has not prevented a growth slowdown.

The lack of economic reforms is often blamed for a slowdown in investment and growth in India. A similar argument is made in Italy. Gros argues that even in terms of structural reforms in labour and product markets, Italy has done well and improved over the last decade. Another argument about what inhibits growth in Italy has been the low level of investment in R&D. We often hear the same argument for India. Again Gros argues that in Italy R&D's share in GDP has actually increased about one fourth over the last decade, proportionally as much as in Germany and more than in the rest of Europe. R&D spending differences do not explain the differences in growth rates.

What then explains the slowdown in Italian growth? Gros argues that Italy has shown a deterioration on governance. The three most imporant indicators of governance on which Italy has done badly are: rule of law, government effectiveness in general and control of corruption. On all three not only does Italy rank below most of Europe, it has worsened on these measures.

According to the Worldwide Governance Indicators, “control of corruption” captures perceptions of the extent to which public power is exercised for private gain. This includes both petty and grand forms of corruption. It also includes "capture" of the state by elites and private interests. “Rule of law” measures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. “Government effectiveness” captures perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures. It also includes the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies.

How has India done on these governance indicators? For one, India is below Italy on all of these. If looked at over the last 15 years, India has either worsened or improved very marginally. If the Italian performance on these measures is any indicator, then it bodes badly for India for long term growth. It suggests that even if we make improvements on all other reforms, infrastructure, education, capital investment and R&D, it may not be good enough to ensure long term growth.

Perhaps the unravelling to the recent scandals will help India put focus on these issues and solve them. If not, we cannot take long term growth for granted.

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