"Public Investment Can Transform The Economy", 'The Hindu Business Line', May 5, 2014
Public Investment Can Transform the Economy
A new government will take over within a month. And this will not be too soon as the country faces some serious challenges ahead with respect to the economy. Many of these are long-term in nature and require long-term solutions. These include environmental degradation and the woeful state of public services. The people of India are, and recognize that these are unlikely to be sorted out soon. But they are no longer as patient as they used to be, especially those of the younger generation, and would expect a newly-elected government to tackle some of the problems with alacrity and resourcefulness. Of these the most visible are growth and inflation. The expectation is compounded by the fact that the populace is aware that a reversal has occurred over the past decade whereby high growth with low inflation has been replaced by low growth with high inflation. They can also see that this is related to the functioning of government and can therefore be reversed at least in part.
It goes without saying that with productivity given in the short run increasing the investment rate is absolutely essential for returning India to the high rates of growth achieved half a decade ago. Actually, investment in the right quarters is also essential for maintaining stable prices. Thus observers are right to emphasise the investment climate as crucial, and to be conscious of the incentives of the private investor. We are after all in a market economy. The question, though, is how to alter the investment climate favourably. In fact, this is the challenge for government. A ready answer to the question, often encountered in the business press, is “more reforms”, but it is not clear what is meant by this. After all, beyond the proposal for a Goods and Services Tax there is no pending macroeconomic policy reform with potential to reverse the slide in the growth rate. For instance, the tariff rate and corporate tax rate are by now quite low in an international comparison, and a round of private bank licenses has only just been completed. Sector-specific liberalisation that increases profits and maybe even the profitability of some private players can be imagined of course, particularly in the financial sector. It is difficult to imagine though that this would have the effect of raising the private investment rate permanently. Something more than sector-specific reforms are needed for that.
It has not been sufficiently well-known that in the virtual stagnation of economy-wide investment for the past five years, it is fixed capital formation in the public sector that has actually declined since 2008. Household investment has actually grown faster than before. Private investment may have declined in a couple of years since but has on average grown, though feebly. On the other hand, public investment has actually collapsed, recording in 2012-13 a level less than half of what it was in 2007-08. It is this collapse in public investment that has led the growth slowdown in India, exactly as its steady rise had led the fast growth in the five years from 2003-04. Once it is recognized that much public investment had gone into infrastructure, and that the public sector invests more in infrastructure than the private, it is easy to see why public investment is so important to the growth dynamic in the India of today. At some stage in the future, when we have all the infrastructure that an economy needs, the situation could be different.
The investment climate for the private sector is defined by the expectation of profits to be realised entirely in the future. A firm’s forecast revenues are related to the demand for its product, which in turn depends upon the expected state of the economy. The state of the economy itself, we can see from the experience of the past decade, is at least partly dependent upon public capital formation. Public capital formation has a dual role. It both enhances aggregate demand and transforms the supply side. Private investment too adds to aggregate demand but it is relatively less transformational. This is because of public investment, at least in principle, creates, public goods which are open to other producers – think “bridges and roads”, or just pavements which are in so short a supply in Indian cities that they hold back economic activity. Therefore, the investment climate for the private sector is in some part determined by public capital formation. Further, the private investor is fully aware of this impact on her own prospects of public capital formation. Thus when demand is sluggish public capital formation stimulates private investment, perhaps more than anything else does.
So, from a macroeconomic point of view, the first task of the new government would be to step-up public investment substantially given the extent of its decline in the past half-decade. Since the fiscal deficit is quite large as it is, space would have to be made by cutting subsidies to the same extent. The slide in the rate of growth as subsidies have billowed in recent years is an indication that the reduction in some subsidies is unlikely to have an adverse impact on growth. On the other hand, increasing subsidies may well have crowded out investment by government in the past. And so the proposed increase in investment to be made possible now may be expected to speed up growth.
In the agendas suggested for the new government the central role of public investment is unappreciated. For the right wing of the political spectrum growth must be led by the private sector. This is mere ideology, and harbours a flawed understanding of the way economies work. Note here that a plan for enhancing public investment does not in any way mean restraining the private sector. It is actually worth repeating that public investment enables the private in two ways. It generates demand for the latter’s products and enables the expansion of private production by providing the necessary physical infrastructure. The reality here is that much of this infrastructure is in the nature of public goods and the private sector has no incentive to produce them, as it cannot ration their use by the public. On the left of the political spectrum, heavily invested in the language of rights and the practice of distributivism, there is inadequate recognition of the importance of public infrastructure for any meaningful empowerment of the poor, leave alone the ultimate elimination of poverty. In fact, the poor are left seriously disempowered by the absence of infrastructure that they have access to. One might add, “infrastructure that they have use for”. After all, they are empowered less by airports than by producer services such as rural roads and urban water supply.
What has been set out here is a programme of fiscal action that makes up for the deflationary stance of monetary policy in the recent past. The RBI claims that it is motivated by ‘anchoring inflationary expectations’. This it has done by raising interest rates. The result has been declining manufacturing output with inflation having yielded little. Private investors cannot but remain pessimistic of the future in such a situation. Unless the government steps in to invest, by its inaction it would have ended up ‘anchoring stagflationary expectations’.