Published in The Business Standard March 19, 2011 and posted here with the kind permission of Professor Lal.

In the late 1980s, along with Hla Myint, I co-directed a large comparative study of 21 developing countries of The Political Economy of Poverty, Equity and Growth (Oxford, 1996). One of our surprises was that two of our largest countries — Brazil and Mexico — which had three decades of spectacular growth suffered prolonged “growth collapses” in the 1980s. Thus, from 1950 to 1980, Brazil’s GDP grew at 6.8 per cent, and Mexico’s at 6.4 per cent per annum, as compared with Korea’s at 7.4 per cent per annum. This was followed by “growth collapses”, with Brazil’s GDP growth rate falling to 2.4 per cent, Mexico’s to 1.0 per cent, and per capita growth rates declining to — 0.1 per cent in Brazil, and —1.2 per cent in Mexico between 1980 and 87 (see The Political Economy of Poverty, Equity and Growth: Brazil and Mexico by Angus Maddison and Associates). Their lessons for India’s current political economy, as a corrective to the hubris flowing from recent Indian growth performance, is the subject of this column.

In both the Brazilian and Mexican cases the proximate cause of the growth collapse was severe macroeconomic imbalances leading to hyperinflation and debt crises. But, the deeper causes were numerous microeconomic distortions and unsustainable fiscal expenditures on politically determined income streams.

We begin with Mexico. It had followed a policy of relatively balanced development with macroeconomic prudence till about 1970. This changed with the 1968 suppression of the protest movement before the Olympic games. Luis Echeverria assumed the Presidency in 1970, and announced his new policy of “shared development” — reminiscent of Indira Gandhi’s garibi hatao slogan of the 1970s and the current UPA’s slogan of development for the aam aadmi — in contrast to the “stabilising development” economic policy since 1958. Echeverria thought that, even though poverty had declined as a result of the rise of per capita incomes in the 1960s, the inequalities in income distribution could be tackled by increasing public expenditure and expanding the public sector. This led in short turn to mounting inflationary pressures, a rising current account deficit, an overvalued exchange rate, and increased foreign borrowing. The hitherto conservative Bank of Mexico “became a printing press to finance rising budget deficits and public sector enterprises” (Maddison, p.133).

Echeverria’s aim to improve income distribution was belied as, “the 1977 family expenditure and income survey showed little improvement over conditions existing in 1973, in 1963, and as far back as 1950” (ibid, p.135). The discovery of large oil deposits in 1972-73 provided a temporary bailout. But Echeverria’s successor, Lopez Portillo, took the oil price rise of 1978 as a permanent rise in Mexican income and began a further expansion of Echeverria’s populist economic policies. A mild boom resulted, fuelled in part by foreign borrowing based on the new found oil reserves. When oil prices collapsed with Volcker’s tightening of US monetary policy, the unsustainability of the Echeverria -Lopez Portillo populist policies of dessarrollo compartido was exposed, as the macroeconomic imbalances they had created led to the debt crisis of 1982, and the Mexican “growth collapse”.

There are eerie similarities with India’s current economic policies. Believing that because of its “demographic dividend” India is now on a permanent 9 per cent growth path, a vast network of fiscal entitlements has been enacted, and is planned from the burgeoning tax revenues, which are assumed to automatically accrue. If these assumptions are belied because of terms of trade shocks related to the currently projected trends in world food and oil prices, India might — like Mexico — find that these politically-determined entitlements become unsustainable. Moreover, as Surjit Bhalla has documented, the “leakage” from these entitlement schemes remains as great as Rajiv Gandhi’s 1980s estimate. Much faith is put in Nilekani’s electronic ID cards. But this may be premature, given the “arms race” that is likely to develop with the counterfeiters. Nor do I believe that there is a demand for “equality of outcomes” as opposed to “equality of opportunity” in the Indian polity. As discussed in previous columns and in my Unintended Consequences, there is a difference in the cosmological beliefs of the semitic egalitarian religions and the hierarchical “religions” of Asia. It is this profound cultural misunderstanding of the Nehruvian wing of Macaulay’s children, which accounts for their current endorsement of the populist policies and, that could lead, as in Mexico, to a growth collapse.

The lessons from Brazil and its growth collapse for India are somewhat different. In a 1970s study of effective protection in Brazilian industry, Joel Bergsman was puzzled that Brazil could produce highly capital intensive private jets competitively, when labour-intensive industries like textiles required heavy protection to be sustained domestically against imports. The Lal-Myint comparative study, by distinguishing between the different development paths of countries with abundant labour and scarce land (including natural resources), and those which were land abundant but labour scarce, argued that, as the wage levels in the latter would necessarily be higher compared to their labour abundant cousins, their comparative advantage would lie in the capital-intensive end of the manufacturing sector. As capital was also scarce in these developing countries, and with growing labour forces they would over time be forced on to a lower wage path if capital did not grow as fast as population. To prevent this disastrous outcome, and to validate the high wage capital-intensive development path, they needed to see the capital stock growing faster than the population. As domestic savings were insufficient, they sought to garner forced savings through inflation, supplemented by foreign borrowing to continue the high wage development path.

Brazil has periodically followed this route. An innovative package, which included widespread wage indexation and relatively conservative macroeconomic policies, was initiated by my old friend Roberto Campos as planning minister and his fellow classical liberal Octavio Gouveia de Bulhos as finance minister in Castelo Branco’s 1967 administration. The “big push” initiated by Delfim Netto in 1979, after the second oil shock, sabotaged this strategy. The terms of trade shock was accommodated by changing the indexation formula to current rather than forecast inflation and higher adjustments for lower paid workers. The resulting macroeconomic imbalances led to the Brazilian growth collapse of the 1980s.

India’s similarity with Brazil is not in its factor endowments. Rather, because of labour laws going back to the Raj, India has created an artificial industrial sector reminiscent of Brazil. India, too, has high-tech, capital-intensive industries, which can be globally competitive at the artificially inflated wages in the organised sector. Whilst the labour-intensive unorganised sector languishes, as it cannot grow to sufficient scale (as in China) if it is to avoid these labour laws. This is going to make a mockery of India’s projected “demographic dividend” as the millions of ill-educated youth flood the unorganised sector. Meanwhile, palliatives like wage indexation, which are now being introduced for the “poor” could, as in Brazil, lead to macroeconomic imbalances.

India today, therefore, needs to rescind its colonial era labour laws, and reappraise its populist economic path. For the wages of populism, as in Mexico or Brazil, may turn its much hyped “economic miracle” into a “growth collapse”.