The Third Pillar

by Raghuram Rajan

  Hopefully, China’s commitment to economic growth will keep it from becoming an autocracy that does not enjoy popular support. In the longer run, China will grow only if it can harness the immense innovative capabilities of its people—that is the nature of growth at the frontiers. People innovate when they are confident that they can question, when they are free to make radical changes, and when they do not fear reprisal for it. In China, such confidence can only come from continued trust in the leadership. While democracy is one way to verify that trust, and to delink the state from markets, perhaps China will find a different path. If so, it will be the first large country to do so.

  China needs a more appropriate balance. The party dominates the state and markets have been repressed. The old pathways to growth are no longer viable. The new ways to grow require more of an accent on innovation and efficient resource allocation, less on financial repression and corruption. They require decentralization, but with clearer rules at the regional level, not the exercise of discretion.21 All these, however, require the party to let go, to allow more freedom and independence to the market. The community will also have to be allowed more freedom and choice, both to sustain innovation and to maintain the separation between the state and markets. Whether all this can be done while the party retains its monopoly is the key question in China’s central dilemma.

  INDIA’S STORY: HOW TO HARNESS THE STRENGTHS OF A VIBRANT BUT CHAOTIC DEMOCRACY

  India has grown at 7 percent a year for the last twenty-five years, a number that looks small only compared to China. Under its first prime minister after independence, Jawaharlal Nehru, India drew inspiration from the extraordinary development story of those times, the Soviet Union, which had transformed itself from peasant economy to industrial giant in the span of a generation. Following Lenin’s dictum, Nehru reserved the “commanding heights of the economy,” including critical industries like steel and heavy machinery for the state sector. Development economists at that time believed that poor countries would grow only through massive investment in critical industries that produced machines or infrastructure. This would increase their productive capacity and thus income. They should neither produce “frivolous” luxury goods for consumption, nor should domestic households consume much beyond basic necessities themselves. Only thus would they be able to husband savings for productive purposes, or so the thinking went.

  SOCIALISM WITH INDIAN CHARACTERISTICS

  Nehru’s India did not actively suppress the private sector. Instead, a system of industrial licensing—that became known as the License Permit Raj—was put in place, ostensibly to use the country’s savings carefully. Bureaucrats refused to grant licenses for industries that they believed were making unnecessary consumption goods (even durable ones such as cars), and instead encouraged investment in sectors that could support future growth such as the production of heavy machinery.

  The consequence of licensing was that incumbents, typically private firms from established families that were connected enough to procure early licenses, were protected from competition. The government also erected barriers against foreign competition—the idea was this would give a respite to India’s infant industries, allowing them a nurturing environment while they matured and became competitive. However, no incumbent, having become profitable behind barriers, had any incentive to allow the barriers to come down. The protection India offered its infant industries thus became an excuse for the companies to become “Peter Pans”—companies who never grew up. There were only five different variants of the Ambassador car, India’s only large car, over its nearly four decades of commercial production, and all that seemed to change through much of this period were the headlights and the shape of the front grill. After growing rapidly during an initial period of post-independence industrialization, India got stuck at a per capita real growth rate of about 1 percent—dubbed the “Hindu” rate of growth. The private sector was inefficient and hugely indebted to the government for protection. Cronyism was rife—the state and markets coalesced into one.

  Did democracy not make a difference? Unfortunately not! India held elections every five years or so, but this did not mean that democracy gave a significant voice to the people. The Congress Party had led the fight for independence and people trusted it for a while, so the party dominated elections in most states. The lack of competition proved problematic. As Congress Party affiliation, rather than local policies, seemed to be more important to winning elections, decision making became more centralized. Indira Gandhi, the prime minister who probably arouses the most varied emotions among Indians, both positive and negative, appointed her chief ministers with a greater emphasis on their personal loyalty to her than on their competence or integrity. Strong independent regional politicians left the Congress Party for the political wilderness, while party positions were filled with sycophants. With the delivery of public services in India abysmal because of India’s ineffective state, patronage politics and public apathy that we encountered earlier in the book dominated.

  By the early 1970s, much of the wealth in the economy was either in the state sector, controlled by it (many banks were nationalized in 1969), or held by pliant private-sector magnates, so there was little power independent of the state. The Congress Party itself was bereft of intraparty democracy. There were still a few nonpartisan institutions, but most were powerless against a determined prime minister. When, in 1975, a high court disbarred Indira Gandhi from holding office because of an election violation, she invoked emergency powers and abrogated civil liberties, jailing much of the opposition. The constitution was amended in 1976 to make India officially a socialist republic, reflecting India’s continued distrust of markets and its longing for a stronger state. That amendment also reduced the power of the inconvenient judiciary, thus taking India further down the road of economic and political illiberalism.

  Though the power of the Indian state was almost unlimited, its performance in areas like the public provision of services was abysmal. In 1950, Indians had, on average, 0.92 years of education, somewhat better than the then Chinese average of 0.65.22 By 1970, after twenty more years of democracy, India had crept up to 1.24. In contrast, China’s population at that time had 2.77 years of education, nearly three times its earlier level. Apathetic uncompetitive democracy did not do much for the well-being of its people! Indian sham socialism merely gave top politicians, bureaucrats, and businesspeople a fig leaf with which to engage in cronyism—a reason to restrain the private sector with red tape so that it could selectively be peeled off.

  INDIA AWAKENS AGAIN

  India did move away from this path, though later than China did. Indira Gandhi ended the Emergency in 1977 and announced elections. Her party suffered a resounding defeat, suggesting that when roused the Indian electorate did vote their mind. India was back to being a chaotic democracy. After the opposition failed to make a go of it, Indira Gandhi returned to power in 1980, and India began a hesitant process of liberalization.23

  Over the next two decades, India took some important steps toward becoming a liberal democracy. It did reverse some of the illiberal constitutional changes that had taken place during the Emergency. There were other developments that helped contain some of the arbitrary powers of the state. First, the Congress Party was no longer the electorate’s inevitable choice. With the space opened for political competition, a number of regional and caste-based parties emerged to challenge the Congress Party. With such parties in power in different regional states, India effectively became more decentralized in its structure. Parties representing the lower castes, people who had historically been ignored by the elite, saw the need to develop the capabilities of their supporters. These parties pushed for an expansion in public services like health care and education in their states. Well-governed states started growing much faster.24 Between 1970 and 1990, the average years of education in the Indian population more than doubled, from 1.24 to 2.96, and nearly doubled again from 1990 to 2
010, to 5.39.

  In the early 1990s, India decentralized further by formally creating a third level of governance at the village or municipal level.25 Each village had to have an elected headman (the sarpanch) and a governing committee (the panchayat), and elections took place every five years. While state governments and local governments still tussle for resources and powers, decentralization continues.

  Even as India was decentralizing and strengthening the community roots of democracy, a financial crisis marked the beginning of the end of sham socialism. India’s external finances deteriorated so much over the 1980s that it had to go to the International Monetary Fund for emergency funding. The crisis made it abundantly clear that the system was not working, that the small reforms since 1980 were insufficient. China’s tremendous progress over the previous decade made India’s excuses for not liberalizing—that it worked only for small countries, and would empower predatory capitalists—seem like ways to justify continuing cronyism. The Congress Party realized India had to change. In his historic budget in March 1991, which started the process of dismantling the whole License Permit Raj system, Dr. Manmohan Singh said, “Let the whole world hear it loud and clear. India is now wide awake.” His comment was a play on Jawaharlal Nehru’s speech on India’s gaining political independence, when Nehru said, “At the midnight hour, while the world sleeps, India will awake to life and freedom. . . .” Essentially, Dr. Singh heralded India’s economic independence, as it threw off the economic shackles it had imposed on its own people.

  The reform process had started in earnest, twelve years after China, but there were strong interests who opposed it. Once bureaucrats become used to helping businesspeople navigate the thicket of rules that they themselves have created, they do not let go easily. An Indian government bureaucrat explained it to me as “the sting of the scorpion.” In any move toward liberalization, the bureaucrat plays along, but at the end, after all is debated and the thicket of earlier regulations consigned to the dustbin, he inserts an innocuous-looking-but-impossible-to-fulfill clause that reintroduces the need for bureaucratic discretion. Such resistance meant corruption did not go away. Nevertheless, the liberalization was genuine, steady, and significant. Growth picked up strongly as India’s faith in markets grew.

  Import tariffs were drastically reduced, subjecting Indian firms to greater competition. As with any liberalization, this did cause job losses in incumbent firms. Studies show that in trade-affected districts in India, the incidence of poverty was relatively higher, as was violent crime and property crimes.26 Interestingly, these studies of the negative impacts of trade competition in trade-exposed areas appeared before the studies we described in Chapter 6 that were done in the United States. The reality is that trade, while typically beneficial overall, has a distributional impact. Emerging markets have long known this, but decided to embrace openness because of the overall positive benefits. It is ironic that having done so and absorbed the costs, they find some developed countries backing away from practicing what they used to preach. The costs of economic policy do become more real when they hit at home!

  As business expanded, India did not just need to prune the old rule book, it needed new regulatory structures and processes. In the first decade of this century, the demand for, and value of, resources such as mineral deposits, land, and spectrum exploded. The government, which owned these resources, continued to give them away in an informal and nontransparent way, lining the pockets of the politicians, bureaucrats, and businesspeople involved. In the past, the apathetic public had not paid much attention. The India of the twenty-first century was very different, though, from the India that had folded supinely under Indira Gandhi’s Emergency. As corruption became blatant there was clear pushback from the community.

  It helped that a number of the public’s watchdog institutions started asserting their independence. This was not based on a concerted decision by the elite establishment to give up its discretion and become better regulated. It was more a matter of happenstance, with the right person in the right place deciding to reform their watchdog institution so that it actually carried out its function. They were undoubtedly aided by a more decentralized and politically competitive India, which had become much more favorable to open political and economic access. So a chief election commissioner, a chief justice, or a comptroller and auditor general, refusing to accept the status quo, and urging their institution to perform their role effectively, could make a difference. As the economic and political system became increasingly pluralistic, it allowed such individuals to create space for their institutions, space that survived their departure. Even if the system pushed back a little, the institution had developed a tradition that it had to live up to, and that their successors could not neglect.

  Therefore, as corruption assumed worrisome proportions, India’s institutions such as the comptroller and auditor general and the judges of the Supreme Court investigated, publicized, and prosecuted the instances. Public outrage grew. Populist parties such as the Aam Aadmi Party (Common Person’s Party) contested elections on an anti-corruption platform, emphasizing their willingness to listen to their constituents and work transparently on their behalf. Indeed, corruption was one of the two central issues in the 2014 general elections (the other was jobs). The ruling United Progressive Alliance lost decisively to the National Democratic Alliance.

  THE STATE, MARKETS, AND DEMOCRACY IN INDIA

  India is therefore different from many of the developed countries we have seen earlier in that it was a democracy before it industrialized, before it had a strong state, and before it had an independent private sector or healthy markets. While democracy was apathetic initially, political decentralization has revived political engagement, and has helped strengthen democratic institutions. It is hard to think of any system that would work in India other than democracy. Given the multiplicity of languages (twenty-two major ones and over seven hundred dialects), religions (India has fewer Muslims than only Indonesia and Pakistan), castes, and ethnicities, India needs a system that allows grievances to be expressed through democratic protest and dialogue, rather than one that bottles them up so that they explode later. India’s raucous democracy alleviates pressures, and allows the country to be governed.

  India’s problems stem from the other two pillars. First, unlike the United States, where a still-independent private sector criticizes government policy, including on social and political issues that are not directly related to their business, the Indian private sector—the market pillar—largely applauds all government policy. A determined government, despite being ineffective in most areas that benefit the public, can still cow the private sector and the press with threats, or bribe them with credit or government contracts. Even decades after liberalization began, there is still a sense among the public that the largest magnates have gotten where they are because of their ability to manipulate the system. The leaders of the party in power know the private sector’s poor reputation well. Since there is usually some past sin buried in a magnate’s past, as in China, which can be investigated and publicized if the magnate is uncooperative, very few are willing to speak out against the government of the day, let alone take steps to oppose it. This also means that when the party in power needs election financing, it only has to ask.

  As a result, the opposition parties at the center find it harder to be heard, especially if the ruling party has a strong majority since both private-sector financing and press attention tend to dwindle after an election for fear of upsetting the government in power. This means the government’s deficiencies and authoritarian tendencies are primarily checked only by the judiciary, by democratic institutions like the Election Commission, and by governments at the state level run by opposition parties.

  An interesting event brought home to me the lowly status of the private sector in government eyes in India. President Obama was visiting Delhi, and the entire Indian elite was invited to meet him at a reception in the I
ndian president’s house. True to form, the bureaucrats running the reception had identified everyone’s precise place in the political hierarchy, and lined them up to shake President Obama’s hand. It was a long line, starting with the Indian prime minister, the former prime minister, cabinet ministers, the leader of the opposition, military chiefs . . . retired dignitaries from the ruling party, ministers from various states . . . the Indian president’s grandson, serving bureaucrats . . . and at number eighty-three, the chairman of India’s largest private-sector group, accounting for over $100 billion in market value, followed by other tycoons and bankers. Admittedly, public service should be rewarded with higher status, to compensate for its lack of monetary rewards, but is not number eighty-three in the hierarchy for India’s top businessman alarmingly low? This is not to say that power and dependence flows only one way. Ironically, after they retire, many of the bureaucrats who preceded the tycoons in the line will be working for them.