More government, more growth?

Given the fetish for good governance in the current political discourse, a question worth answering is, what difference does governance make to growth, rues Abheek Barua

'Good governance' falls in the 'motherhood and apple pie' category.

Who could argue against less corruption in the bureaucracy, fewer inspections by pesky factory inspectors and an end to the 'sifarish-firman' raj that politicians have ruled over?

However, given the fetish for good governance in the current political discourse, a question worth answering is, what difference does governance make to growth? Economists have been examining this for decades.

Most mainstream researchers agree that good governance is a necessary condition for growth.

This, by extension, means that differences in growth across countries can be explained at least partly by differences in the quality of governance.

But first things first.

What exactly is this governance?

Daniel Kauffman (in “Growth without governance”, a World Bank discussion paper from 2002) defines a measure of governance that considers a basket of six things: voice and accountability; political stability and the absence of violence; government effectiveness; regulatory quality; rule of law; and control of corruption.

This has emerged as the gold standard of governance measures, and most researchers use a variant of this.

While there appears to be a consensus in the mainstream, there are notable voices of dissent on the necessity of governance for growth.

Jeffrey Sachs and his collaborators (in “Ending Africa’s growth trap”, a Brookings paper from 2004) argue that differences in growth across Africa have nothing to do with governance.

Instead, they can be explained by levels of old-fashioned aid-financed investments.

The least 'governed' states have actually produced spectacular growth rates.

Recent work on India throws up some interesting results.

Maitreesh Ghatak’s and Sanchari Roy’s somewhat controversial article in the Economic and Political Weekly (“Did Gujarat’s growth rate accelerate under Modi?” in April 2014) does not find any significant acceleration in Gujarat’s growth rate (relative to the national average; this is important) for the 2000s decade (the Modi years) compared to the 1990s.

If I were to assume (and I am sure that many would agree) that the regime quickly ushered in a substantially improved governance structure, then one clear implication is that the growth-governance link is weak.

Analysis of state-level data by Sudipto Mundle and his colleagues at the National Institute of Public Finance and Policy (“The quality of governance: how have Indian states performed?” in July 2012) finds a positive but statistically weak relationship between the “quality” of governance (again gauged by Kauffman-type measures).

This perhaps is a rigorous way of stating the obvious -- that a whole lot of things other than governance determine growth.

However, it is worth highlighting in the current political context.

The research on governance is not just about these somewhat sterile statistical links.

There are many other insights that our policymakers who think about governance could take cues from.

A paper by Rafael La Porta and three co-authors (“The quality of government”, National Bureau of Economic Research, 1998) analyses the experience of a large sample of economies over a long period and arrives at a number of powerful insights.

Of particular interest to India is their assertion that government intervention and efficiency are not mirror images.

Let me quote them: “We have consistently found that better performing governments are also larger and collect larger taxes.

"Poorly performing governments, in contrast, are smaller and collect fewer taxes.”

The authors are quick to point out that this is not an endorsement of bigger government of any quality. Instead, they assert that 'identifying big government with bad government can be highly misleading'.

This might give us reason to rethink the “less government, more governance” mantra that is so much in vogue these days.

The proposition that big government is not necessarily a bad thing is linked to the question of what governments should be doing in the first place.

Traditionally, the role of governments was to address market failure through non-market institutions, and this drove the governance agenda in between the 1950s and the 1980s.

The most extreme form of this non-market intervention was central planning that relied on mechanisms such as industrial licensing.

India, like others, botched this up completely; the result was a combination of severe macroeconomic problems and the proliferation of rent-seeking activities and rampant corruption.

In short, market failure was replaced by government failure.

The backlash against the failure of this model came from mainstream economists whose prescriptions were administered by agencies like the International Monetary Fund and World Bank touting a model of 'market enhancing governance' that would jettison the planning approach and instead replicate the conditions of an efficient market.

This would be implemented through a combination of things: stable property rights; low transaction costs; and minimising rent seeking and corruption. An extreme but popular view was that since government intervention breeds corruption and rent seeking, an obvious solution would be to have a small government.

What this agenda misses is the entire business of state capacity. Government intervention failed because the government simply did not have the capacity to do the things it was trying to do.

Mushtaq Khan, an economist at London’s School of Oriental and African Studies (in “Governance, development and economic growth since the 1960s”, a working paper from 2007) argues that while one cannot argue with the objective of creating efficient markets, developing countries might not have the capacity to do this either.

Markets in developing countries, he argues, are inherently inefficient and the kind of improvement in state capacity required is difficult to achieve.

The second proposition that Mr Khan and others make is that recent history shows that efforts to 'enhance markets'? haven’t quite paid off (take Latin America in the 1990s, for instance).

What appears to have worked very well, instead, has been the kind of governance structures -- 'growth enhancing governance' he calls it -- that led to a boom in East Asia.

These experiments – the creation of the chaebols in South Korea using public resources; the setting up of the town and village Enterprises in China and their subsequent privatisation; the channelling of credit in South Korea to priority industries – all made a substantial contribution to contribution.

Some of them appear to go against the principle of the 'market enhancing school' since they involve state intervention to correct for market failure.

Be that as it may, the bottom line is that they have worked well.

India has learnt to 'look East' in many domains of our economic and international relations strategy.

Perhaps we should look East when it comes to deciding on a model of governance as well.

Abheek Barua is with the ICRIER. These views are his own