India Overheating?

The answer to this question is not at all straightforward I believe but if you have been following the readings in the Economist as of late the journal has on several occasions pointed to the worrying signs of India's economic growth. A week ago the Economics Focus column featured two studies which compared economic growth in India and China; both of them by Barry Bosworth and Susan M. Collins from the Brookings Institution; 1) Accounting for Growth: Comparing India and China and 2) Sources of Growth in the Indian Economy. And the conclusion as quoted from the Economist Economics Focus column.

INDIA has been swept by optimism that its economy can do as well as China's. A recent article in the Economic Times claimed that the growth in India's total factor productivity (TFP), the efficiency with which inputs of both labour and capital are used, had accelerated, whereas China's had slowed owing to wasteful investment. As a result, the article boasted, rising productivity—the main driver of long-run economic growth—is now running neck and neck in the two economies. Close inspection of the numbers, however, reveals that China remains well ahead.

(...)

The authors tentatively suggest that the growth in services output (and hence TFP) may be overstated in India. They surmise that inflation in services is being underestimated, causing real growth to be overstated. If so, then India's overall GDP growth lags further behind China than the official figures show.

In any case, the study clearly shows that the main difference in the growth performance of China and India is not the strength of India's service sector, but the weakness of its manufacturing. Until India boosts its industrial productivity, which will require bolder reforms, it is premature to boast that its economic performance is as good as China's.

In this weeks edition of the Economist the same story has found its way to the cover of the magazine in form of a leader and a special report.

Firstly from the leader;

THE Indian tiger is on the prowl. This week, in an apt piece of symbolism, Tata Steel, which dates back to the days of the Raj, leapt into the league of top producers when it bought Britain's Corus, which includes the steelmaking remnants of the old imperial power. Nor is Tata alone: younger Indian companies such as Infosys and Wipro are storming international markets. Meanwhile, the world's business people and investors queue up to lavish money on India's talented engineers and computer scientists.

and the special report;

THE economy is sizzling and foreign businessmen and investors are swarming to Bangalore and Mumbai to grab a piece of the action. India's year-on-year growth rate could well hit double figures at some point in 2007, and the country may even grow faster than China for at least one quarter. But things are so hot there is a big problem: India's current pace of expansion may not be sustainable.

In fact, the Economist goes head on with those of us who have been arguing that growth in India increasingly is driven by its favorable demographic trajectory as the country passes through its demographic dividend. The Economist notes that policies in fact do matter and that demographics does not cut it alone; the human capital needs to be educated as well.

From the leader ...  

India's demographic structure is indeed starting to look more like that in East Asia when its growth took off. But this mechanistic view of growth assumes that demography is destiny and that economic policies do not matter. In fact, open markets, education and investment, especially in infrastructure, were the three chief ingredients of East Asia's success. Population growth by itself does not add to prosperity, unless young people are educated and new jobs are created. India needs to reform its absurdly restrictive labour laws which hold back the expansion of manufacturing particularly.

 and from the special report ...

The growth optimists point to India's favourable demography. The population of working age will continue to rise for several decades, whereas in China it is expected to fall. This, it is argued, will boost India's workforce and both saving and investment. Furthermore, 60% of India's labour force is engaged in low productivity farming. As workers shift from agriculture to more productive jobs in industry and services, this will automatically boost GDP growth. Yet this assumes the newcomers will all find jobs. If those jobs do not appear, the so-called demographic dividend will more likely turn into a demographic disaster. Some 60% of the demographic bulge will come in five poor and badly governed states.

This is just one example of how economic commentators tend to confuse India's long-term potential (what is feasible provided the best policies are put in place) with its current potential (ie, non inflationary) growth rate. That India has huge long-term potential is undeniable, but without reforms the country cannot fully exploit it.

I am sure The Economist is in fact referring here to, at least in part, the debate over at the Indian Economy Blog where the debate has been going on at full pace about the Indian economy. So have we who believe in the importance of demographics misunderstood the situation here? The first important point here I think is that The Economist indeed is right to point to the necessity for the right policies and political development to unlock India's long term potential. In fact, this is perhaps the most important point here and as such favorable demographics need to go hand in hand with sound policies especially in India where the risk of mounting regional inequality poses hazards for political stability and thus economic development. I don't think any of us has ever argued otherwise. However, now that we are talking about long term potential as oppose to trend growth it should be clear that these two cannot be totally detached and the reason is exactly the point The Economist itself implicitly refers to, namely the path dependancy of how demographics affect the long term growth potential. This is also why it is important to realize that demographics' effect on economic growth far from constitutes a mechanic view on economic growth. However, it is important I believe to the stress that the real source of India's long term potential first and foremost lies in the fact that the country now is passing through its DD and as such now has the potential to set in place policies which can ensure the apt exploitation of the economy's long term growth potential. Policies or perhaps more preciesly I think institutions do indeed matter for long term economic growth. The important point is though to realize that the population structure changes and as such the DD becomes a window of opportunity to lock the highest possible sustainable growth trajectory for India going forward. So in the end, I have one main point here.

I do not agree with the Economist that attributing a weight to demographics in long term growth comprises a mechanic view of economic growth. Far from it and in fact the neo-classical steady state assumption which is essentially neutral to the structural economic changes which occur as a result of demographics is much more mechanic in my view since this theory clearly is out of tune in terms of how demographics affect economics. However, I am not accusing the Economist for naive steady statism here and as such the view on economic growth fielded in the Economist relates much closer to the idea of endogenous growth which contrary to neo-classical (exogenous growth) emphasizes the endogenous nature of economic growth as a function of the importance of policies for long term growth. However, where does this leave demographics then? Surely, the original neo-classical assumption of a fixed rate of population increase as a positive contribution to the slope of the steady state curve clearly, I believe, misses the big picture in terms of how economic growth is affected as a country passes through the demographic transition which (and please pay attention here) does not end with fertility rates stabilizing at replacement levels and thus a natural increase in the population. As such the crucial process of ageing which is occuring with different pace all over the world cannot be fed into the traditional long term growth model. But what about endogenous growth then? How should this view on growth tackle demographics? Surely demographics still constitute an exogenous shock to the economy? Well, this is exactly the point, does it really? I won't go into detail with my views here since I fear it would be too long and twisty but just to say that this issue is in part what we are discussing in terms of India. In fact, the transmission mechanism and indeed feedback loop between enacted policies and how demographics positively or negatively impact the economy in the long run constitute some of the most important areas of economic research focus in these years since ageing is well upon us and ultimately since I sincerely believe that we need to understand this much better in order to be able to connect the dots and thus make the right decision.

Demographics are not destiny but damn important and reducing the view that demographics actually matter for economic growth to a mechanic view on the topic is a critical blow which misses the importants points I think.