## Tuesday, August 15, 2006

### Economic aspects of nation building

Happy 59th birthday to all of us!

The idea of India is the notion that the shared spirit of a nation, founded on the liberal notions of freedom of individuals, can hold together the world's greatest diversity of language, religion, ethnicity, caste and skin colour. We in India live this project: we tend to be aware that the idea has not been seen to fruition in full measure, but it has worked very substantially. We tend to sometimes lose sight of how hard the task is. Today, I saw an article in New York Times which revisits the traditional wisdom that ethnic diversity leads to ethnic warfare; this made me think once again about what are the forces at work in India.

In a famous book India: the most dangerous decades published in 1960, Selig Harisson argued that the Republic of India would come apart, leaving a situation more like Africa or East Europe. This was not an extremist position. Particularly after the rise of the Shiv Sena and the breakup of the Bombay Presidency, in the 1960s and 1970s, my father used to think this was a scenario worth taking seriously.

Matters were made worse by socialist economic policy, which (a) gave a low-growth environment, and (b) converted the political process into a game where groups of citizens organised themselves to grab a bigger slice of the pie through the aegis of a tax-and-transfer State. It was a natural development for these coalitions to get organised around language, religion, caste or ethnicity, each trying to grab a bigger slice of the resources taken by the State from citizens through taxation, the inflation tax and seignorage.

For many years, things used to look bleak. As an example, see this note by Shyam Kamath which was written in 1991.

What changed after that? I think three factors have been at work:

1. Greater competition in many sectors of the economy has helped shift focus away from sectarian considerations towards meritocracy. As Gary Becker observed in 1971, in a competitive environment, the firm comes under pressure to hire the best man for the job, or to contract with the lowest-cost supplier. Considerations like caste or ethnic origins are luxuries which matter less when there is fierce competition. Discrimination against Harijans is not an upper-caste conspiracy to keep Harijans down; rather it's a luxury that upper caste can allow themselves when competition is weak. The increase in levels of competition after 1991, both in product markets and in removing the role of the government in finance, has taken us closer to a meritocratic society. In areas with competition, and areas where firms compete to obtain resource access from a private sector financial sector, what matters is the output of a person or a firm. Considerations like religion or ethnicity fade away in decision making. In India today, religion or caste or ethnicity are a bigger issue in the public sector than in the private sector, since the revenue stream there is not under competitive pressure. This gives the decision maker the luxury of bringing religion or ethnic origins into decision making. I find it interesting to see that with a public sector that is unremitingly sectarian and a private sector that is meritocratic (in the areas with competition), the Indian nation building project is assisted by a small State. Right now, public sector employment in India is small (roughly 3 crore workers in all), so the outlook for meritocracy and for the Republic of India is good. However, this perspective reiterates the importance of public policy effort on maintaining a small State, on competition and the financial sector.
2. The second factor is the cost/benefit analysis for a faction to be in the Republic of India. The Indian nation-building project - whether it is about highways or about stock market trading - has grown deep roots across the land, particularly with the greater resources and greater sophistication that has come about in the last 20 years. Improvements in infrastructure are delivering `internal gains from trade' [link] [link] and weave the national economy together, though a lot of work is still needed on the impediments against India as a single market. A person sitting in Srinagar or Guwahati benefits by participating in Indian national systems such as computerised railway reservation, HDFC Bank branches, NSDL depository participant outlets or NSE brokerage firms. If a faction chose to break away from the republic, they'd have to do all this hard work by themselves. Last year, when I worked on the paper Improving governance using IT systems which has appeared in S. Narayan's edited book Documenting reforms: Case studies from India (not yet at Amazon), the phrase which repeatedly came to my mind was "nation building".
3. Finally, the system of fiscal transfers is sending huge money back into state capitals. Indian GDP growth, coupled with a flat tax/GDP ratio, means that the resources that go into the Finance Commission sharing formulas are growing by leaps and bounds. This mechanism for sending resources into the provinces delivers rents to the local elite, and removes the incentive for them to to break away from the union. The best talent in each province gets tempted to think "make PWD roads, not war", and gets drawn away from separatist movements into collaborating with the Indian nation-building project. I recall a one-kilometre stretch of road at Dehra Dun, which used to be an open-air retail market for Basmati rice under the old boundaries of Uttar Pradesh. After Dehra Dun became capital of Uttaranchal, that stretch of road has become a market for cars, ranging from small cars all the way up to the best cars available in India. I can't help thinking that the fiscal transfers which used to be captured by the Lucknow elite have now shifted to the Dehra Dun elite. High Indian GDP growth plus the system of fiscal transfers gives people with intelligence and organisation skills the incentives to become CPI(M) (i.e., to seek to control provincial expenditures) instead of CPI(ML) (i.e. to rail against the Republic of India).

Punjab has been the biggest success story for the project of Indian nation-building, where a province that went to the brink in the early 1980s has come back whole-heartedly into the Indian mainstream. Now the problem areas are J&K and the North-East states. Apart from that, there are numerous districts where the lumpen engages in banditry, but there is no organised effort at establishing an alternative nation-state. My view is that the banditry will be successfully overcome by the growing resources of the State which can go back into law & order, and the growing appeal of participation in the economy owing to improvements in infrastructure. This does require a State that is more interested in law & order, and less oriented towards tax-and-transfer.

1. Dr shah,

Your posts are wonderful and with keen acumen.

Happy I-day to you too.

Cheers
Navin

2. loved the differentiation between CPI (M) and CPI (ML)!!

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