An Indian plowman in West Bengal working in India’s largest industry: Agriculture
Wikimedia Commons / ILRI

In my last two posts,  I have taken looks at the history of leftist revolutions and of Europe to glean lessons about what works and does not work in economies. In this essay I will try to explore what the underdeveloped and developing economies of the world have to teach us.

Because this is such an immense subject, I will concentrate on examining only two countries: India and Mexico. But first it will be worthwhile to revisit an old subject of three of my essays, the Solow-Swan growth model.

The Solow-Swan Growth Model

The Solow-Swan model  is a neoclassical growth model developed independently by the American economist Robert Solow and the Australian Trevor Swan in 1956. It is a simple yet elegant model that relates a country’s GDP to its inputs of capital and labor. These inputs are called the primary factors of economic production. All other factors of production, such as the level of workers’ education  and the level of technology, are called secondary factors. To display the model algebraically, we define the following variables for a single country.

• y = Annual Gross Domestic Product (GDP) in the country’s monetary units.
• k = Amount of Capital invested — factories, machinery, computers, ships, etc. —  in the country’s monetary units.
• l = Total number of workers
• A = Total factor productivity, which is an as yet unspecified function of all the secondary factors of productivity.

In terms of these variables, the most general production function can be written as

where f(k, l) is some general function of capital and labor. The most important properties the function f(k, l) must exhibit are that it must constantly increase, but increase less and less as capital and labor independently increase. This is called the marginal diminishing productivity of those factors. The Solow-Swan model uses a particular version of the production function called the Cobb-Douglas production function, which is of the form

This expression in turn on division by the number of laborers can be expressed as

Since the function fk/l) must be an increasing function of its argument, it and the GDP y will decrease if either k decreases or the population increases, thereby increasing l. This allows us to put in the time-dependent phenomena of capital depreciation and population increase.

To complete the model, we must include the effects of savings s, investment i, the depreciation rate d, and the rate of population increase n.   Also let us make a change of variable from capital k to capital per capita κ ≡ k/l. Almost by definition all savings, defined as the portion of GDP that is not consumed in a single year, must end up as investment, even if some workers stuff their wages under a mattress! Remember that money is merely a claim-check to wealth, not the actual wealth itself. If a worker does not use the wealth he can claim by buying it, it is used in some other fashion. Any wealth ending up in inventory is balanced by the decrease in GDP caused by the worker stuffing his wages under a mattress.

The Solow-Swan growth model assumes a simple savings model for the per capita savings s/l of the form

where θ is the average savings rate for the year, the fraction of GDP that is saved. Two other relationships are needed. First, we need the replacement investments per capita to replace worn out and obsolete equipment and to retrain workers in new technology, which is given by the sum of depreciations per capita, dκ and the added investment needed to employ the increase in the population, nκ.

Second, we need the fact that all investment over and above replacement investments is net investment, n_i, (not to be confused with the rate of population increase n) that increases the economy’s output.

In the very last expression the net investment per capita is identified as the change in the capital stock per capita. The real lesson in all this is a country must have more investment than the replacement investment in order to get growth. If it has less investment than what is required for replacements, net investment and the change in the capital stock are negative.

Using a small amount of simple differential calculus and a little basic algebra, shown in detail here and here, we end up with three equations for the GDP per capita,

the replacement investment per capita given by

and the savings per capita given by

If we were then to plot the monetary value of these three functions versus the invested capital per capita, κ, we would get a plot something like below.

Now, nothing says that the invested capital per capita must necessarily have the equilibrium value of κ₀, but if it is either larger or smaller, market forces will drive the system toward the equilibrium point. The process by which this happens is described in the post The Solow-Swan Model and Where We Are Economically (2).  In a free-market, the system will always inevitably arrive at the equilibrium point. After that to change matters, the society, and not merely the government, must change one of three quantities that have been assumed constant so far.

1. The total factor productivity, A.
2. The sum of the depreciation rate and the rate of population growth, d + n.
3. The savings rate θ.

The effects of changing any of these three constants on shifting and changing the shapes of the three curves to define a new equilibrium state are described in The Solow-Swan Model and Where We Are Economically (3).

So where are lesser developed economies on the plot above? They are generally capital-poor countries with invested capital per capita far below their equilibrium value of κ₀. Therefore, so long as their government does not actively damage the economy, a lesser developed economy can grow and increase its GDP simply by increasing the investment rate, increasing savings and investments. It can also help matters by decreasing the rate of population growth  and/or the depreciation rate. This decreases the slope of the replacement investment line, causing it to intercept the savings curve at a larger value of invested capital per capita, which means the corresponding value on the production function curve is at a larger value. However, decreasing population growth and depreciation rates are often much harder than simply encouraging savings and investment.

Alas, as is often the case in impoverished nations, the ofttimes corrupt government frequently follows very bad economic policy. The results most usually are that total factor productivity is decreased, and/or the savings rate is decreased. If total factor productivity alone is affected, then the equilibrium value of capital investment remains unchanged, but the production function curve is scaled downwards to provide a lower GDP for the same investment. If the production function is unchanged, but savings is decreased, the savings curve is scaled downward to cause a smaller equilibrium value of invested capital where it intercepts the replacement investment line.

Once an economy becomes highly developed, merely increasing savings and investment provides little in the way of economic growth. Then the easiest way to cause more growth is to increase total factor productivity A by employing more efficient technology, technology that enables new products, and/or increasing the skill levels of the workers.

Keeping these implications in mind, let us now examine how India has managed its economy since its independence from Great Britain in 1947.

India

Immediately following its independence from Great Britain, India followed the socialist way. Influenced both by a feeling British companies had exploited India under the British Raj and by the then currently dominant Fabian socialist views in British Universities, India nationalized all its major industries. As a blueprint for their economy they adopted the planned economy of the Soviet Union, with India’s five-year plans greatly resembling those of the Soviet Union. In general the Indian government’s policies had the autarkic nature of mercantilism, favoring substitution of imported goods with new domestic industrial output. Not surprisingly, the Indian economy echoed the bad performance of the Soviet economy. In the first 30 years after independence, the Indian economic rate of growth was often ridiculed by economists as “the Hindu rate of growth” when compared with the growth of other Asian nations. In the bar chart below, the GDP per capita  of several developing Asian countries are shown as a percent of the American GDP at the displayed year. In particular, compare India (orange) with South Korea (yellow), which both started at essentially the same level in 1950.

The collapse of the Soviet Union in 1991, together with the effects of the First Gulf War of 1990-91 on oil prices, were very traumatic events for the Indian economy. Laden with international debts from industrialization, India asked the International Monetary Fund (IMF) for a $1.8 billion bailout loan. As a prerequisite for the loan, the IMF required economic deregulation. As a response to these IMF demands, the government of Narashima Rao, under the guidance of Finance Minister Manmohan Singh, initiated the economic reforms of 1991. Among their accomplishments, which started a long journey away from socialism, were the following:

• Fiscal consolidation and limited tax reforms.
• Removal of controls on industrial investments and imports to allow foreign participation.
• Reduction in import tariffs.
• Creation of a more welcoming environment for foreign capital.
• A dirty float of India’s rupee and making the rupee convertible for current account transactions
• Opening energy and telecommunication sectors for private investment, both domestic and foreign.

In 1994 a National Stock Exchange was launched to facilitate private ownership of companies. In the 1990s India began to privatize some companies, including hotels, the communications company VSNL, the car company that became Maruti Suzuki, and airports. Even now India is continuing to reduce the role of the national government in the economy through privatization of state-owned companies.

Those free-market reforms took some time to bear fruit, but by the early 2000s a remarkable increase in Indian GDP growth was undeniable.

One feature of this plot that should catch your eye is the very high volatility of the growth rate (red curve) prior to 1991, a volatility that was greatly reduced after the 1991 reforms. From 1960 to 1991, the GDP per capita grew from $83.79 to $309.33, an increase of 269% over 31 years; from 1991 to 2015, it went from $309.33 to $1598.26, an increase of 417% over 24 years. In the period 1960-1991 the GDP per capita increased $7.28 per year; from 1991 to 2015 it increased $53.71 per year.

Recall the earlier discussion of the Solow-Swan development model. The hallmark of an underdeveloped economy is that additional inputs of capital and labor will easily increase economic output. Once the economy has become mature, growth becomes much harder and can only happen if total factor productivity is increased, i.e. only if there is an increase in technology and education. In mature economies, the growth rate tends to either decrease on average or to remain constant at generally lower rates of growth than for underdeveloped countries. If you look carefully at the red curve above from 1991 to 2015, you can see a gradual increase in the growth rate, indicating (luckily for India!) the country still has room to mature.

India is currently ranked 143 out of 180 nations in the index of economic freedom with a score of 52.6, and it still has a long way to go as a developing country. If only they had not thrown away the first 44 years of their independent statehood on socialism . . .

Mexico

Mexico  provides a very different example of a developing nation. Ranked 70 in the index of economic freedom with an index of 63.6, Mexico is a lot closer to having a free-market economy than India (ranked 143, index 52.6), and the greater economic freedom shows in their GDP per capita and its growth rate.

Whereas India’s GDP per capita in 2015 was $1598.26, Mexico’s was $9005.02 and in 2014 it was $10,353.45.

Nevertheless, although Mexico finds itself a lot closer to a free-market than does India, it still has a long way to go to match even the limited freedom of the United States and most European countries. Mexico is slightly more economically free than France (ranked 72, index 63.3) and Italy (ranked79, index 62.5), and considerably more free than Greece (ranked 127, index 55.0).

The Heritage Foundation praises the Mexican government’s prudent fiscal and monetary policies, so unlike the foolish policies of the United States, which have blessed Mexico with a great deal of macroeconomic stability. Heritage also favorably cites structural reforms in parts of the economy including telecommunications and energy. While Mexico continues to monopolize the oil industry with majority ownership of the Mexican oil company Petróleos Mexicanos (Pemex), they have opened up the possibility for foreign investment, and encourage participation and investment from both domestic and foreign private companies.

Nevertheless, Mexico continues to have a large number of extremely serious problems in organized crime, corruption and in encouraging private enterprise. In the words of the Heritage Foundation,

However, lingering constraints on achieving even more dynamic economic expansion are numerous, including the lack of competition in the domestic market, labor market rigidity, institutional shortcomings within the judicial system, and limited progress in curbing high levels of crime. Corruption is a continuing problem. … The PRI regained the presidency in 2012 with the election of current President Enrique Peña Nieto, whose single six-year term of office runs through 2018. After pushing through most of his ambitious structural reform agenda in 2013–2014, Peña Nieto has focused on implementation and on boosting sluggish growth. Rising drug-related crime has resulted in homicides, and widespread corruption has increased public dissatisfaction about the effectiveness of anticorruption efforts by weak government institutions.

Yet, Mexico seems to be following the road toward free-markets in fits and starts, and if they can just get control of corruption and organized crime, especially by the drug cartels, their economic future appears bright.

There is one point of caution suggested by the Solow-Swan growth model. As economies become more mature, economic growth becomes more dependent on  a lot more than just investing more capital or by employing more of the population, Growth becomes harder at a particular technological level and growth rates will decline with time or remain constant. If you take another look at Mexico’s growth rates, the red curve in the plot above, you can see the peaks declining with time, suggesting Mexico is entering a state of economic maturity. With a large fraction of the population living in what Americans would consider a state of poverty (Mexico’s GDP per capita in 2015 was $9005.02), that would be an ominous development. An essential condition for raising everyone’s standard of living would then be to increase the country’s total factor productivity that takes every production factor other than labor and invested capital into account. At least a part of that increase in total factor productivity can be effected by decreasing crime and corruption. In addition, the more Mexico travels toward a free-economy, the more productive and efficient the allocation of scarce resources by Adam Smith’s Invisible Hand will become.

What Do We Learn From India and Mexico?

From the first four decades of India’s independence from Great Britain,  we learn that socialism equals death for economic growth. India did not begin to emerge from its zombie-like economic state until the 1991 free-market reforms of Narashima Rao and Manmohan Singh. To gain anything more than the most minimal growth, state-owned companies must be privatized and allowed maximal freedom to allocate their resources to maximize their own profits. When the Indian industrialist J.R.D. Tata suggested to India’s first prime minister, Jawaharlal Nehru, that if his companies could make a profit, it would be good for India, Nehru replied, “Never talk to me about the word profit; it is a dirty word.” That attitude was precisely what held India down for its first four decades of independence from Britain. Profits are what allow companies to pay their workers a rising wage, to pay taxes, and most of all to increase the productive capacity of the country.

Mexico reinforces that lesson from India, but it also shows just where some functions of government are absolutely necessary for the growth of a country. Government is required to enforce the rule of law, without which life would be “solitary, poor, nasty, brutish, and short” in the immortal words of Thomas Hobbes from his book Leviathan. In particular, as John Locke pointed out, government is needed not just to preserve our lives from each other, but also to insure property rights and to enforce contracts. Mexico illustrates these needs with its problems with government corruption and its war against the drug cartels.

Unfortunately, the more usual problem in the more developed countries is too much government, not too little. Politicians need power over their fellow human beings like fish need to be in water. Often, this desire for power is for the very best of reasons, to ensure (they think) social justice or to solve social and economic problems.  This was Jawaharlal Nehru’s most fundamental problem.

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