Deepak Lal: Economic atavism

While labour laws protect some in the organised sector, financial repression has maintained the wealth and power of a few.

The economic liberalisation which has led to India's current growth splurge has largely been based on removing the distortions in product markets created by the licence-permit raj. The reformers have so far failed to remove the distortions that past policies have created in the markets for factors of production""labour and capital. The limited spread of the benefits of growth to the aam admi is in large part due to this failure. The reluctance to reform is not due to lack of knowledge but the political constraints that have been imposed not only by the UPA coalition's Communist partners, but also by their fellow travellers in the Congress party. Much worse, the UPA is about to introduce measures, or failed (to date) to accept the reforms recommended by expert committees. This will either worsen or stall the necessary reforms of Indian factor markets. This failure reflects the continuing hold of atavistic economic ideas on the minds of the Indian political and intellectual classes, and is the subject of this column.

First take the market for labour. It is well-known that the rapid growth in employment of about 2.5 per cent a year between 1999-2000 and 2004-05 was entirely in the unorganised sector, while organised sector employment has hardly risen since the liberalisation of 1991. The reason for this is clearly the colonial labour laws, which raise the price of labour to the organised sector above its true cost, and create a bias against the use of India's most abundant factor of production""labour""in industrialisation. As this column has pointed out on numerous occasions, the rescinding of these colonial labour laws is essential for both efficient industrialisation and to spread its benefits more widely among the labour force.

But instead of undertaking this essential reform what is the UPA proposing? A minimum wage to be enforced on the 422-million-strong unorganised workforce! The chairman of the National Commission for the Enterprises in the Unorganised Sector (NCEUS), Dr Arjun Sengupta, (the Commission is currently formulating draft bills to legislate this policy) in a recent article in Hindustan Times (April 5, 2007) while rightly bemoaning the lack of increase in organised sector employment did not analyse its cause (the restrictive labour laws) but instead sought to justify introducing similar cost-raising measures like minimum wages in the unorganised sector, whose net effect will be to raise the cost of labour and hence reduce its use and thence employment in the unorganised sector. It may be (as he writes) that "workers (in the unorganised sector) seek employment there because the alternative would be starvation", but the measures he proposes by artificially raising the price of unorganised labour will reduce its employment and in fact force some into starvation!

This is an example of the continuing economic illiteracy of the Left, which continues to argue for well-intentioned government interventions (like minimum wages, rent controls, price controls) to aid some purportedly needy groups, which often end up by damaging them the most. No doubt, they will cite the burgeoning research initiated by two young US economists who studied the market for hamburger flippers in two towns and found that a rise in the minimum wage did not affect their employment levels, with subsequent studies even claiming that raising the minimum wage raised employment! But, a recent survey of these numerous studies of the effects of minimum wages in many countries (D Neumark and W Wascher: "Minimum Wages and Employment," NBER Working Paper No. 12663, Nov. 2006) found that the studies with "the most credible evidence, almost all point to negative employment effects, both for the United States as well as for many other countries", while "the studies that focus on the least-skilled groups provide overwhelming evidence of stronger disemployment effects for these groups". The surest way of ensuring an end to whatever benefits the aam admi has received from the current surge in growth is to accept the NCEUS's proposals for regulating the unorganised sector.

Turning to capital, Indian capital markets, despite considerable financial liberalisation, continue to be repressed largely because of the resistance from the public sector banks (PSBs) to their privatisation and the RBI's continuing resistance to full convertibility of the rupee. The Percy Mistry Committee on transforming Mumbai into an international financial sector rightly argued for full convertibility of the rupee by the end of 2008, and for the adoption of inflation targeting by the RBI""issues to be discussed in my next column""as well as the gradual reduction of the government's equity in PSBs. It was the reluctance of the committee members from the PSBs to fully endorse the latter recommendation which reportedly led the Chairman not to sign the report. This points to the important reasons why there is such reluctance to end financial repression in India.

Financial repression was a necessary feature of the failed Nehruvian model of capital-intensive, heavy industry-biased development strategy. It requires government monopolisation of the mobilisation and deployment of the economy's savings, which was achieved by Indira Gandhi's nationalisation of banks. A reversal of this policy (which effectively lowered the price of capital to those favoured by the government) is needed, along with the rescinding of the labour laws that have raised the price of labour, to allow India to develop labour-intensive industries in line with its comparative advantage. But any such reversal to get the correct pricing of factors of production needed for equitable and efficient development is hindered by the rent-seeking vested interests created by this past failed strategy. Hence the reaction of the PSBs to the Mistry report.

But reforming these policy-induced distortions in the workings of Indian factor markets is essential for equitable growth.

While it may be obvious that the labour laws protect an aristocracy of a minority of labour in the organised sector, it is less often noted that, as Rajan and Zingales argue in their Saving Capitalism from Capitalists, financial repression has been a powerful means of maintaining the wealth and power of the few. A fully liberalised capital market allows greater access to those without inherited wealth or powerful connections whereas the monopolisation of access to finance by financiers, through implicit or explicit collusion with the state, prevents outsiders from challenging insiders in financially repressed economies. Thus both for reasons of efficiency and equity to serve the interests of the aam admi, it is essential to eschew the current economic atavism and to fully liberalise both Indian labour and capital markets.