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Sunday, March 25, 2007

Interpreting and contemplating the European growth experience

Barry Eichengreen has a new book titled The European Economy since 1945. Sheri Berman has written a great book review in the New York Times. Greg Mankiw points to Chapter 1 of the book on the NYT website.

It is a fascinating story. After World War II, Europe bounced back on a foundation of great human capital, institutional mechanisms and State capacity. In the first three decades, the story was one of pouring capital into a near-ideal setting, which gave very high GDP growth. Eichengreen says that European institutions comprising trade unions, employer organisations, and corporatist arrangements evolved to support this phase of `extensive' growth where the information processing required in deploying capital was relatively easy, and the game was primarily about quickly getting the top quality labour force up to the production possibility frontier.

I believe there was one more reason why European institutions evolved the way they did in the post-war years: Appeasement. In the early 20th century, communism was a genuine alternative to democracy both at the level of ideas and in terms of realpolitik. My sense is that for wise people like Keynes, who knew and loved the ideals of classical liberalism, a pragmatic path of buying off the `working class' was taken, so that there would be no fertile ground for a communist revolution. We know today that communism was hopelessly broken, that there was never any threat; the perceived fertile ground would have rapidly evaporated the moment workers in the West learned more about the plight of workers in the USSR. But at the time this was not obvious.

My sense is that people like Keynes, with a heavy heart, supported the rise of a big State thinking that it was the only way to stave off the takeover of totalitarian ideas as had happened in Russia in 1917 and Germany in 1933. The thinkers of that age, who knew and loved individualism and freedom the best, thought that it is better to have a big State, and hang on to an attenuated form of personal freedom, rather than collapse into brutality as Germany and Russia did. This rationale, founded on appeasement, lost relevance after the collapse of the USSR. This may have set the stage for dismantling the European welfare state, which has now outlived its original purpose of staving off totalitarianism.

Extensive growth is an important part of development economics also. Some countries, like China, have done very well by marshalling a vast pool of labour and capital, and obtaining growth by deploying these factors of production. Paul Krugman famously reminded all of us over a decade ago that East Asian growth was quite `unmiraculous' in that it mostly reflected a boring accumulation of labour and capital into the production process, often with poor technology and productivity.

In Eichengreen's story, by roughly 1975, the potential for `extensive' growth in Europe was exhausted, and from that point onwards, the `European model' has looked bad. Margaret Thatcher and Ronald Reagan helped to radically turn the US and the UK away towards the Anglo-Saxon model. This experiment has been running for a while, and continental policy regimes like Germany and France have inferior growth and worse unemployment when compared with the US and the UK.

In the post 1975 period, what Europe - at the frontiers - needed was "flexible and mobile work relationships, technological novelty and the financing of risky ventures" (as Eichengreen puts it). The UK and the US economic policy framework worked much better with a flexible labour market, market-oriented finance, and powerful incentives for hard work, risk-taking, innovation and entrepreneurship.

What does this say for economic development in the third world? Sometimes the argument is made for more Statist growth in the early decades of catch-up, as was done in the first 30 years in Europe. In my view, there is a fundamental difference between post-war Europe and the typical third-world context: this lies in institutional sophistication and State capacity. The competence and lack of corruption of the State in Germany is something which we just do not possess in India. The Indian State tried to lead, particularly over 1966-1976, and we saw how bad that was. There is no one road to serfdom, but in places with weaker political and institutional capacity, a large State is more vulnerable to cancer.

In India, we don't seem to be walking down a phase of State-led extensive growth which is then followed by a withering away of the State. India is walking on a sui generis path, where we seem to be jumping out of poverty into a world of "flexible and mobile work relationships, technological novelty and the financing of risky ventures". We seem to be developing what Vijay Kelkar's October 2005 Gadgil Memorial Lecture calls a new model of `Indo-Saxon Capitalism', where the primitive accumulation is taking place alongside the huge technological catch-up.

The private sector, which is driving growth, is working within a market-oriented financial system which is able to supply risk capital. However, my sense is that this `extensive' growth is not simple-minded. Highly novel mechanisms are often required for plugging India into globalisation, which require creativity, intelligence, risk-taking and entrepreneurship. The private sector operates in a framework of flexible and mobile work relationships. I believe this path is scalable for many decades, and involves a virtuous cycle between widening personal freedom and high economic growth.

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