The Locomotive and the Camel

The conventional wisdom in India has long been that the public sector is the locomotive of the economy, pulling the private sector along with it, so if public investment falters, so will private investment.

Liberals like me disagree on the ground that (a) public investment is generally more inefficient, and so squanders scarce resources (b) public investment pre-empts scarce domestic savings, and hence ‘crowds out’ private investment. Recall the old fable in which the camel was invited by the Arab into his tent, and soon pushed the Arab out altogether. According to liberals, the public sector has been a camel rather than a locomotive.

However, the conventional wisdom, enunciated by heavyweights like Sukhamoy Chakravarty, claims that public investment ‘crowds in’ private investment – that is, it makes fresh private investment feasible in places where it earlier was not. No private investor will invest in an area without roads, electricity, or credit facilities. If public investment provides infrastructure, this will spark private investment which would not otherwise have occurred.

The conventional wisdom says that only the government can provide infrastructure and basic goods – the private sector has neither the money nor inclination. This is clearly wrong – the Tatas produced steel and electricity long before the government did. As in Japan or the East Asian tigers, the Indian government could have channelled scarce funds to big business. Instead it chose to channel funds to itself, a special form of crowding out.

Look at the accompanying chart. It shows that from 1950 to 1986, public and private fixed investment both rose. Private fixed investment went from 6.9 per cent of GDP in 1950-51 to 10.2 percent in 1986-87, and public investment from 2.4 per cent to 11.4 per cent of GDP.

Supporters of the conventional wisdom say this close correlation proves their locomotive thesis – heavy public investment crowded in private investment, and so total investment more than doubled between 1950 and 1986.

Liberals like me, however, have had a different interpretation. We agree that public investment in infrastructure would have had some crowding in effect, but to the extent its pre-empts funds would have a crowding-out effect too. Had the crowding-in effect been strong, private investment should have risen as fast as public investment, and this has not been the case. In 1950-51, private investment (6.9 per cent) was almost thrice as high as public investment 92.4 per cent). But by 1986-87, private investment (9.8 per cent) was lower than public investment (11.4 per cent). In these 36 years, the share of public fixed investment in GDP rose 375 per cent, but that of private investment rose only 42 per cent. Thus the two are not correlated at all and this looks like crowding out.

Till the mid-1980s, the debate was in-conclusive. However, trends after 1986 have settled the argument in favour of the liberals. As the chart shows, the share of public investment in GDP fell from 11.4 per cent in 1986-87 to 8.7 percent in 1993-94.

Had the locomotive theory been correct, private investment should have slumped too. In fact private investment rose rapidly in this period, from 9.8 per cent to 13.9 per cent of GDP. Clearly the public sector has not been a locomotive. On the contrary, it stands exposed as a camel, whose gradual withdrawal has left more space for the Arab.

Additional evidence comes from improving productivity. If liberals are right in thinking that private investment is more efficient, a rise in the private sector’s share after the mid-1980s should have led to accelerated growth and higher productivity. This in fact is what has happened. GDP growth accelerated in both the seventh and Eighth plans to almost 6 per cent per year. Productivity, reflected in the capital-output ratio, has also improved.

Why, despite its plausibility, has the crowding-in thesis proved false? A major reason, I believe, lies in the Nehru-Indira grab for the commanding heights of the economy. The 1944 Bombay Plan of Indian industrialists called for large public investment in a planned economy, since they saw this would help private business too. This was the original invitation extended by the Arab to the camel. However, Nehru and Indira Gandhi resorted to not just massive public investment but nationalisation (especially of the financial sector), reservation of the core sector for the government, confiscatoy taxation, licensing controls and price controls.

In other words, crowding out did not take place just through a premption of savings, but through administrative actions and controls. But itself, the crowding-in effect of public investment may conceivably have offset the crowding-out effect. But with controls thrown in, crowding-out predominated.

As the chart shows, the change in the trend came not with Mr Rao in 1991 but much earlier, from 1986. By then the central and state governments had borrowed so much for expansion that interest charges were piling up fast, a fiscal crisis was brewing, and there was simply not enough cash to sustain public sector dominance.

Fortunately, in the 1980s there was some relaxation of administrative controls. And the high interest payments signified a return of money from the government to households, reducing pre-emption. After 199L the fiscal deficit fell further, and the slashing of controls created more space in the tent for the Arab.

We have a long way to go. Many controls remain, especially in infrastructure, and the fiscal deficit is still high. So there is still much crowding out. Within government spending, subsidies are crowding out investment. One study (Gulati and Katula, 1992) shows that the ratio of agricultural subsidies to plan allocations rose from 34 per cent in 1980-81 to 87 per cent by 1989-90. This must be reversed, and will facilitate public investment that does not crowd out private investment.

Even with new procedures to expedite private investment in infrastructure, there will always remain important areas where private investment will not suffice-major irrigation and drainage, rural roads, primary education, urban infrastructure. In all these areas we need not less public spending, but better spending and efficient operation. That, together with a lifting of controls, will ensure that public and private investment rise together. As in Japan or the East Asian tigers, we will then have enough space in the tent for both the Arab and the camel. Or to use the other analogy, we will have two locomotives, one public and one private, pulling an express train.

What do you think?