India's Economic System To Blame for Its Stunted Growth

India needs to embrace foreign investment and end corruption if it wants to transition into a modern, market-driving economy.

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Indian laborers stack bricks at a work site in New Delhi, India, Tuesday, Oct. 30, 2012. India's central bank left its key interest rate unchanged Tuesday but trimmed the cash reserve ratio, resisting growing pressure from New Delhi to cut rates even as it slashed its growth forecast and raised its inflation projection for Asia's third-largest economy.

Peter Passell is a senior fellow at the Milken Institute, the editor of the Milken Institute Review, and a consultant to the Legatum Institute's Prosperity Index project.

Good economic news from India: The country's lawmakers endorsed Prime Minister Manmohan Singh's move to allow foreign big-box retailers like Wal-Mart and Tesco to open their own stores. That's a big deal because India has been slow to bless foreign direct investment, and retailing has been especially controversial because the foreign chains would threaten politically-connected local businesses. The new competition could lead to a virtuous circle in which local retailers are forced to become more efficient, passing along the savings to consumers.

But don't pop the champagne corks just yet. The Indian economy has been fizzling for the past year, with growth down to 5 percent from the 9 percent rate routinely achieved in the middle of the last decade. And the very fact that the fight over foreign retailing has been so bitter is an ominous sign of the strength of the backlash that is dogging the economy—a problem, incidentally, that China also faces, but has contained to date.

[See a collection of political cartoons on the economy.]

To understand where the Indian economy's going (or not going), consider where it's been. After independence, India's leaders, who were heavily influenced by Britain's democratic socialists, turned to central planning and trade protectionism, with both self-reliance and poverty relief in mind. They managed the self-reliance part, but at a cost: isolation from global markets meant that Indians were forced to make do with shoddy, overpriced goods.

Worse, the system spawned armies of bureaucrats who focused on issues of fairness rather than efficiency (when they weren't busy lining their own pockets). And it entrenched tens of thousands of inefficient businesses that learned how to use the system to their own advantage—and thus had a vested interest in stopping change. The result: India meandered along at the "Hindu rate" of growth—a rate that barely exceeded population growth for four decades and hardly made a dent in poverty.

Only government mismanagement, in the form of a balance of payments crisis in 1991 that left India unable to pay for imported oil, finally got the economy off the dime. In return for a cash fix, the International Monetary Fund forced New Delhi to open the economy to some foreign competition and to do away with the most intrusive planning—for example, the requirement that businesses obtain licenses before they expanded production.

[See a collection of political cartoons on gas prices.]

But, happily, the reforms developed a momentum of their own, coinciding with a changing of the guard in the upper echelons of the largest political parties. Growth surged to East Asian rates, which quadrupled average incomes (to a still-modest $3,600) in just two decades. Pundits everywhere proclaimed there was no going back.

It's true that hardly anybody's calling for a return to what's called the License Raj. But reform has stalled. Foreign direct investment is still limited, slowing the transfer of new technology. Once hired, it is still extremely difficult to close a plant or lay off factory workers—a reality that has strangled the expansion of manufacturing and the employment of tens of millions. And then there's the corruption that's part-and-parcel of over-regulation: the police still routinely shake down street vendors who can't possibly afford to operate legally, while officials still "sell" access to public schools and government hospitals.

Actually, there's a paradox here. The numbers suggest that the rising tide of growth has, in fact, carried almost all boats. But the gap between the top and the bottom has risen, and plainly, the discontent of the disenfranchised has been fed by the in-your-face consumption of the urban middle class and the ongoing petty corruption that takes a toll on a daily basis. It shouldn't be surprising, then, that populist politicians—notably, Mamata Banerjee, the firebrand chief minister of the state of West Bengal—have gained traction campaigning against almost anything the government wants.

[See a collection of political cartoons on the European debt crisis.]

China ought to be facing the same sort of backlash: corruption is every bit as bad, income inequality higher than in India, and conspicuous consumption is even more corrosive. Why hasn't growth been reined in? The obvious reason is that China isn't a democracy: if the leadership wants to build a highway that displaces the poor or ignore wretched working conditions, opposition can still be flattened by shows of force.

But I suspect that China's more important advantage here is the realignment of powerful interest groups with the proponents of growth. India is stymied by inefficient businesses with much to lose from change. China's equivalent—inefficient state-owned enterprises left over from the days of Mao—have been cannily co-opted by perks ranging from sweetheart government contracts to subsidized loans to superior healthcare. And while they are a drag on the economy, they haven't opposed the opening of China to investment or trade.

[Read the U.S. News Debate: Should Congress Interfere with China's Currency Policies?]

It's again fashionable to blame India's failings on its very messy democracy. But that's not the whole story. Yes, it would be nice if India's technocrats could bull their way past the populist opposition. But the real culprits here were India's founding fathers who saddled an industrious, innovative people with an economic system that made it easy for interest groups to stop change when it suited them.

India will eventually complete its transition to a modern, market-driven economy. But not soon enough for hundreds of millions of Indians who will never get the chance at the brass ring.

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