Liberalization: the importance of institutional reform

Daron Acemoglu and James Robinson, argue that the success or failure of nations depends on the quality of an economy’s institutions. Given that the political atmosphere in any economy is crucial in determining the extent to which governments intervene in free markets, it becomes essential to look closely at institutions to analyze how and why globalization is largely successful. It is also equally important but frequently overlooked, that institutional changes in the form of reforms can be equally crippling. The latter aspect has been covered to some extent in the other articles as a part of this series. 

Post-independence, the Indian economy was socialist. The underlying assumption was that free-market outcomes would not yield desirable social outcomes; therefore, the allocation of resources must best be determined by the government. Choice in consumption of goods and services was not to be decided by the people, the government would answer the key economic questions of what to produce, how to produce, and whom to produce for. Furthermore, the fear of submitting to foreign subsidiaries as a result of opening up was prevalent. Of course, the implicit assumption is that all serving political leaders have in their self-interest to remain in power. Therefore, especially after independence, capitalizing on governmental power must have been lucrative. This notion of power is important as shall be explored later on.  

As a result of these factors, the Indian economy was virtually closed with its global trade share being reduced to a meagre 0.45%. Internally, there were cumbersome licenses that had to be obtained in an even longer process, applicable to virtually all sectors ranging from the private sector to imports. Tax rates were lofty, with income tax rates soaring as high as 97.7%. The population only doubled between 1947 until reform, doubling the absolute number of poor people who lived below the poverty line. Any promise to reduce poverty was not realized until much later. Stock markets were rigged and potentially beneficial to brokers alone. Finally, the allocation of resources was so inefficient, that India was famous for borrowing aid to finance basic supplies including food. This severely toppled the balance of payments, out of favor of the Indian government. All these factors culminated in the speculation of a financial crisis. The liberalization of its neighbor (China) which lead to record high economic achievement, coupled with the failing Soviet Union, paved the path for the 1991 economic reform.

Liberalization from an economic point of view

Globalization results in a set of standard outcomes: higher economic performance with respect to GDP, wider consumer consumption and production choices, better and more efficient allocation of resources that primes the macroeconomy to facilitate healthy competition, and naturally eliminates those that cannot keep up. It regulates financial and stock markets, increases employment opportunities, lifts many out of poverty, and encourages spending and saving. This, in turn, fuels innovation and suddenly the economy is lucrative for attracting foreign direct investment and multi-nationals corporations. Essentially, it paints a happy picture. The private sector is given the opportunity to function within the framework of the free markets, with relaxed government rules wherein it withdraws or redesigns the licensing policies to facilitate private sector businesses and industries, cuts taxes, entrusts nationalization of industries to the private sector, digitalization of stock markets to increase investor confidence, among other reforms. 

Largely, this is what followed the 1991 economic reforms. India’s real GDP soared by 2216% in a period of 25 years. It transformed exponentially from a struggling economy to the second-fastest growing economy, only behind China in that period. Foreign direct investment grew largely – India received $63 billion dollars in FDI in 2015 — obliterating its dependence on foreign aid, and making it a benefactor to other developing countries for certain goods. India certified the ‘middle-income country’ hallmark when its Purchasing Power Parity increased from $375 per year in 1991 to $1700 in 2016. Poverty rate declined majorly between 2004 and 2012, wherein 138 million Indians rose above the poverty line. This is a remarkable feat achieved by the liberalization process, given 60% of Indians were below the poverty line before. This improvement is even more applaudable for its homogeneous increase across different social groups in India: Dalits, scheduled tribes, Hindus, and Muslims. 

As far as sectors of the economy are concerned, the industrial and agricultural sectors flourished. Pharmaceuticals, automobiles, computer software, business services, satellite launchers, research, and development, are the most notable sectors that have remarkably grown post-liberalization. Not only did these sectors rapidly develop within India, but also saw India’s position on the global trade share improve as the country now exported enormously from among these goods and services. Furthermore, other countries viewed India as a possible host country for production because of the availability of cheap labor. From India’s point of view, this is why employment rose quite a lot during the period, despite labor market rigidities. In addition, in contrast to the apprehension of the pre-liberalization government that India will succumb to foreign subsidiaries, India gave rise to some of the world’s most powerful people and their ventures today. Pharmaceutical companies such as Cipla, Lupin, Dr. Reddy’s Labs export more than is sold at home today. Furthermore, the TATA group became the largest private-sector employer in the United Kingdom. 

These positive externalities in terms of economic growth, improved standards of living, government revenue generation, employment opportunities, diversification of skills and talents among the labor force, were possible due to relaxed government intervention and the decrease in tax rates and regulation of other policies which fostered an atmosphere for the private sector to bloom nationally and internationally. 

  Alas, while the private sector growth cloaks India as a fast-growing economy that can be opportunistic, the same period that saw incredible feats also faced institutional challenges: public sector distribution of goods and services is still in an abysmal state to date. 

Inflexibility of Institutions and public policy outcomes

When an economy is still poor, the institutions can afford to be rigid. However, the transition from low-income to middle-income involves just as thorough an institutional reform in countries such as India. The reason is simple enough: for a free-market to function with limited and necessary government intervention, the rule of law that helps devise policies must be strong and efficient. However, in India, if the judicial institutions are themselves inadequate, accountability of those in power in the government becomes low, thereby spilling over into huge economic costs that can be grave for the economy. 

One example would suffice. The Tamil Nadu state has two competing parties. Both have the same aim: bag the electorate and swing votes to their party in order for them to stay in power. In a democracy where elections are held to select leaders, offering public goods becomes the wisest choice to win their voters. Public goods include national defense, the judiciary system, rule of law. These are goods that fall under the category of ‘non-rivalry’ (one person consuming it does not decrease it for others) and ‘non-excludability’(one cannot use price to exclude others from affording the good/service). The government is also obligated to provide merit goods such as education, healthcare, and other goods that it feels is necessary for its citizens to have, regardless of their ability to pay for the same.  However, while the two parties have spent and invested in these goods, they have also equally spent irrational amounts of money subsidizing electricity, water availability, and provided free computers, mobile phones, grinders, TV, and other non-durables or ‘freebies’ for the sheer purpose of elections. When taxpayer money is spent to buy votes, that is a huge opportunity cost for how the money could have been spent elsewhere, nationally or state-wise. 

Today the country’s police system, the judicial system, governing institutions, health care facilities, schools and universities as well as infrastructure still remain incompetent with respect to how much the country has developed private sector-wise. Why? The institution that is devising these policies is corrupt and they rely on their self-interest of staying in power to do anything necessary to achieve the same objective. This comes at the cost of effective governance that is necessary to further liberalize the economy and achieve its end goals. 

It also explains why during times of crisis, such as the current pandemic, the ruling government has been inefficient at tackling the issue on a relatively worse scale than other nations: the framework that allows the economy to be run with respect to institutions itself is so rigid, it curbs economic opportunities from fully being realized. The plunge in GDP by 23.8% was almost predictable, given that the institutional framework is so inflexible today. Consequently, recovery and economic improvement seem like a utopian dream. In essence, liberalization and globalization were crucial. It saw and greatly benefited the Indian economy. However, the fact that economies will have institutions that govern laws and policies means that these bodies will also need to be on par and strong, in order to truly achieve stable growth. 

Tejaswini Vondivillu is a second-year undergraduate student at Ashoka University, pursuing Politics, Philosophy and Economics as her major and International Relations as her minor.

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