6. Economics Notes 11

Elaborate Notes

Factors Determining the Type of Growth Model

A nation’s choice of economic growth model is contingent upon a confluence of its intrinsic characteristics and the external economic environment. The primary models are investment-led, where growth is driven by capital accumulation, and consumption-led, where growth is powered by household spending. The key determinants include:

• Strength of the Manufacturing Sector: A robust manufacturing sector is often considered the engine of economic growth, a view propounded by economists like Nicholas Kaldor in his “Kaldor’s growth laws” (1966). A strong manufacturing base can absorb surplus labor from agriculture, enhance productivity, generate exports, and foster technological innovation. Countries with a well-developed industrial base may initially pursue investment-led growth to further enhance capital stock and competitiveness (e.g., post-war Japan, South Korea). Conversely, a weak manufacturing sector may necessitate a different strategy, possibly focusing on services or agriculture initially.
• Demographics of the Country: The age structure of a population is a critical factor. A country with a large, young population, often described as having a “demographic dividend,” has a potential workforce that can fuel growth. India, for example, is projected by the UN to have one of the world’s youngest populations. Such a demographic profile supports an investment-led model, as creating jobs for the burgeoning workforce requires significant capital investment in infrastructure and industry. In contrast, an aging population with a high dependency ratio, like in Japan or parts of Europe, might naturally shift towards a consumption-led model driven by the accumulated wealth and spending of its older citizens.
• The Openness of the Economy: The degree of integration with the global economy, through trade and capital flows, influences the growth strategy. An open economy can leverage foreign direct investment (FDI) and foreign institutional investment (FII) to fund an investment-led growth model. It can also rely on exports as a primary driver of demand. However, high openness also exposes the economy to global shocks, such as the 2008 financial crisis. Economies that are more closed or face a protectionist global environment might need to rely more on domestic consumption or investment.
• Trade Balance & Economic Strength: A country’s position in international trade and its overall economic stability are paramount. A nation running a persistent trade surplus (like China for many years) has the foreign exchange reserves to fund large-scale investments and is less vulnerable to external shocks. Conversely, a country with a chronic trade deficit or a fragile Balance of Payments (BoP) position may find it difficult to sustain an investment-led model that often requires significant capital goods imports. Its economic strength, reflected in factors like GDP, fiscal health, and currency stability, determines its capacity to attract and sustain investment.

Reasons for India’s Shift to Investment-Led Growth

India’s contemporary economic strategy is increasingly oriented towards an investment-led growth model, a departure from a historically more consumption-driven path. This strategic pivot is motivated by several factors:

• Aim of Emerging as an Industrialized Country (Industry 4.0): To transition from a developing to a developed economy, India aims to build a globally competitive industrial sector. This involves preparing for “Industry 4.0,” the fourth industrial revolution characterized by automation, data exchange, Artificial Intelligence (AI), robotics, and the Internet of Things (IoT). Achieving proficiency in these areas requires massive investment in technology, R&D, and modern manufacturing facilities, aligning with national initiatives like ‘Make in India’.
• To Attract More Foreign Investment: An investment-led model creates a virtuous cycle by signaling a favorable business environment. By focusing on improving infrastructure and easing regulations, India aims to attract higher inflows of both Foreign Direct Investment (FDI), which is long-term and involves direct management, and Foreign Institutional Investment (FII), which is more portfolio-based. These capital inflows are crucial for financing the investment needs of the economy.
• Need for Fiscal & Social Infrastructure Development: India faces a significant infrastructure deficit. An investment-led strategy directly addresses this by channeling resources into building physical infrastructure (roads, ports, energy) and social infrastructure (hospitals, schools, sanitation). The National Infrastructure Pipeline (NIP) announced in 2019 is a government blueprint for this strategy, envisioning large-scale investment to boost economic activity and improve the quality of life.
• Reaping the Benefits of the Demographic Dividend: With a median age of around 28 years, India has a large and youthful workforce. To prevent this demographic potential from becoming a liability (i.e., mass unemployment), it is imperative to create sufficient jobs. An investment-led growth model, by expanding industrial and service sector capacity, is seen as the primary mechanism for generating the employment opportunities required to absorb millions of new entrants into the labor force annually.

Reasons for China’s Shift to Consumption-Led Growth

China, after decades of unprecedented growth driven by investment and exports, is actively “rebalancing” its economy towards domestic consumption. This strategic shift is a response to both internal and external pressures:

• Sub-prime Crisis and External Trade Impact: The Global Financial Crisis of 2008, originating from the US sub-prime mortgage market, led to a sharp contraction in global demand. As a major exporter to the US and Europe, China’s economy was severely impacted. This event exposed the vulnerabilities of an over-reliant export-led model and catalyzed the policy shift towards cultivating a more resilient, domestic demand-driven economy.
• Increase in Labor Cost in China: For decades, China benefited from a vast supply of cheap labor, a phenomenon explained by the Lewis Model. However, rapid industrialization led to a tightening of the labor market, causing wages to rise significantly. This erosion of its low-cost labor advantage made its exports less competitive and pushed the economy past its “Lewis Turning Point.” This necessitated a move up the value chain and a greater reliance on domestic consumption.
• Protectionist Policies and Deglobalization: The rise of protectionist sentiment globally, exemplified by the US-China trade war initiated around 2018, has created uncertainty and barriers for Chinese exports. This trend towards deglobalization has reinforced the strategic imperative for China to reduce its dependence on external markets and foster internal sources of growth.
• Change in Consumer Attitude and Technology: A burgeoning middle class has emerged in China with greater disposable income and a growing appetite for goods and services. The rapid proliferation of e-commerce platforms like Alibaba and JD.com has further fueled this consumer revolution, making it easier for domestic consumption to become a primary engine of economic activity.

Feasibility of Investment-Led Growth in India

While an investment-led model holds great promise for India, its successful implementation is contingent on overcoming several significant challenges:

• Challenges of Twin Balance Sheet Syndrome: Coined by then Chief Economic Adviser Arvind Subramanian in the Economic Survey 2016-17, this refers to the stressed balance sheets of both corporations (overleveraged and unable to invest) and public sector banks (burdened with Non-Performing Assets, or NPAs). This predicament constrains the ability of both the corporate sector to undertake new investments and the banking sector to lend, thus acting as a major impediment to an investment-led recovery.
• Infrastructure as a Prerequisite: Investment-led growth cannot take off without a robust foundation of infrastructure. Deficiencies in power, logistics, and transportation increase operational costs and reduce the efficiency of new investments. Therefore, the government’s primary task is to front-load infrastructure development while simultaneously ensuring that the benefits of growth are widely distributed (inclusive growth).
• High Rate of Inflation: A high rate of inflation erodes the real rate of return on savings. This reduces the propensity of households to save, as the value of their savings diminishes over time. Since domestic savings are the primary source of investment capital (Savings = Investment), high inflation can starve the economy of the funds needed for an investment-led model.
• Global Protectionist Policies: Protectionist measures by major economies can negatively impact India’s exports. If export markets shrink, the capacity utilization of domestic industries falls, discouraging further investment in expanding production capacity.
• High Capital Output Ratio (COR):
  • Definition: COR is the amount of capital required to produce one unit of output. For instance, a COR of 4 means that 4 units of capital are needed to produce 1 unit of output annually.
  • Implication: A higher COR indicates lower efficiency of capital; more capital is needed for the same level of output. Developing countries often have higher CORs due to infrastructural bottlenecks, technological lags, and inefficient resource allocation. A high COR makes an investment-led strategy more costly and less effective. A related concept is the Incremental Capital Output Ratio (ICOR), which measures the additional capital required to produce one additional unit of output.
• Savings-Investment Gap: The economic disruption caused by events like the COVID-19 pandemic can widen the gap between domestic savings and the required investment. Declining incomes reduce household savings, while increased uncertainty deters private investment.
• Crowding Out of Private Investment: When the government runs a high fiscal deficit, it borrows heavily from the domestic market. This increases the demand for loanable funds, pushing up interest rates. Higher interest rates make it more expensive for private companies to borrow and invest, a phenomenon known as the “crowding out” effect.

Harrod-Domar Model

The Harrod-Domar model is a seminal work in development economics that explains economic growth in terms of the level of saving and the productivity of capital.

• Origin: It was developed independently by Sir Roy Harrod in his essay “An Essay in Dynamic Theory” (1939) and Evsey Domar in his article “Capital Expansion, Rate of Growth, and Employment” (1946).
• Core Idea: The model posits that the growth rate of an economy is directly proportional to its savings rate and inversely proportional to its capital-output ratio. It emphasizes investment as the key driver of growth. The central equation is often expressed as:
  • Growth Rate (g) = Savings Rate (s) / Capital-Output Ratio (k)
  • This implies that to achieve a higher growth rate, a country must either increase its rate of savings (and thus investment) or improve the efficiency of its capital (i.e., lower its COR).
• Mechanism: The model describes a virtuous cycle: increased savings lead to increased investment. This investment enhances the nation’s capital stock, which in turn leads to higher output and economic growth. A portion of this higher output is saved, feeding back into the cycle.
• Application: The model was influential in post-World War II developed countries to analyze business cycles and prevent chronic unemployment. In the context of developing nations, it was adopted as a cornerstone of development planning, notably in India’s First Five-Year Plan (1951-56), to determine the investment required to achieve a target growth rate.
• Limitations:
  • Increasing Savings: In low-income countries, where incomes are close to subsistence levels, increasing the savings ratio is extremely difficult.
  • Weak Financial System: The model assumes that savings are efficiently channelized into productive investments. However, many developing countries lack a deep and efficient financial system, meaning household savings may not translate into investment.
  • Capital-Output Ratio (COR): The model’s assumption of a constant COR is a significant weakness. In reality, COR can change due to technological advancements, changes in the economic structure, and improvements in efficiency. Funding for the Research & Development (R&D) needed to reduce COR is often scarce in developing nations.
  • Oversimplification: The model overlooks other crucial factors for growth, such as labor quality, technological progress (treated as exogenous), and institutional structures. It implies capital investment is the sole prerequisite for growth, which is not always true.

Lewis Model

The Lewis Model, or the dual-sector model, provides a framework for understanding development in a labor-surplus economy.

• Origin: It was proposed by Nobel laureate Sir W. Arthur Lewis in his influential paper, “Economic Development with Unlimited Supplies of Labour” (1954). He was awarded the Nobel Memorial Prize in Economic Sciences in 1979 for his work on development economics.
• Dual-Sector Postulate: The model divides the economy into two sectors:
  1. Subsistence Sector: Characterized by traditional agriculture, it has a very low productivity and a large surplus of labor. Lewis defined this broadly to include agricultural workers, domestic servants, and the urban poor.
  2. Modern Sector: This is the high-productivity industrial sector, which uses reproducible capital and pays higher wages.
• Core Concept - Zero Marginal Labour Productivity: The key assumption is that the subsistence sector has so much surplus labor that its marginal productivity is negligible or even zero. This condition is also known as “disguised unemployment.” This means that labor can be withdrawn from this sector without causing a fall in total output.
• Mechanism of Growth:
  1. The modern industrial sector attracts surplus labor from the subsistence sector by offering a wage that is slightly higher than the subsistence wage.
  2. As this surplus labor moves to the industrial sector, it becomes productive, generating profits for capitalists.
  3. Lewis assumed that these capitalists have a high propensity to save and reinvest their profits. This reinvestment expands the capital stock of the modern sector.
  4. This expansion of capital creates more jobs, leading to further migration of labor from the subsistence to the modern sector. This process continues, driving economic growth.
• The Lewis Turning Point: This virtuous cycle of capital accumulation and labor migration continues until the entire labor surplus from the subsistence sector is absorbed. At this point, the labor market tightens, and wages in the modern sector begin to rise, determined by marginal productivity rather than the subsistence wage. Many economists argue that China reached its Lewis Turning Point in the late 2000s.
• Criticisms:
  • The assumption that capitalists will reinvest all their profits may not hold true; they might engage in conspicuous consumption or invest abroad.
  • Industrialists might opt for capital-intensive technologies rather than labor-intensive ones, thus absorbing less labor than the model predicts.
  • The model assumes wages in the modern sector will remain constant. In reality, pressures from trade unions, urban living costs, and government policies can cause wages to rise before the labor surplus is exhausted.
  • It oversimplifies the process of labor transfer, ignoring the costs of migration and the challenges of training unskilled agricultural labor for industrial jobs.

Planning

Economic planning involves the deliberate direction of economic activities by a central authority to achieve predefined goals.

• Rationale for Planning in Post-Independence India: After 1947, India adopted a planned economic model to:
  • Optimum Utilization of Resources: Guide scarce capital and resources towards nationally important sectors.
  • Address Structural Challenges: Tackle deep-rooted problems like poverty, unemployment, and economic inequality.
  • Achieve Self-Reliance: Build a strong, independent industrial base to reduce dependence on foreign countries, a goal heavily influenced by the colonial experience.
  • Promote Economic Growth: Accelerate the pace of GDP growth to improve living standards.
• Mahalanobis Model (Second Five-Year Plan, 1956-61):
  • Developed by Professor P.C. Mahalanobis, this model provided the intellectual framework for the Second Plan. It was a two-sector investment allocation model, later expanded to four sectors.
  • Core Idea: The model divided the economy into the Capital Goods Sector (C-sector) and the Consumer Goods Sector (K-sector). Mahalanobis argued that to achieve rapid, long-term growth, a higher proportion of investment must be allocated to the heavy industries that produce capital goods (machines, steel, etc.).
  • Logic: While this strategy would mean lower availability of consumer goods in the short run, the expanded capacity of the capital goods sector would eventually enable the country to produce more of both capital and consumer goods, leading to exponential growth and self-reliance in the long term. This strategy was heavily inspired by the Soviet Union’s Feldman model.
• Incremental Capital Output Ratio (ICOR):
  • Definition: ICOR measures the additional unit of capital or investment needed to produce an additional unit of output. It is calculated as the change in capital (investment) divided by the change in output (GDP).
  • Significance in Planning: Planners use ICOR to estimate the amount of investment required to achieve a target growth rate. A lower ICOR is desirable as it signifies greater efficiency of investment.
• First Five-Year Plan (1951-56):
  • Model: It was based on the Harrod-Domar model.
  • Focus: The primary focus was on overcoming the food crisis and building the agricultural base. Major investments were made in agriculture, irrigation (e.g., Bhakra-Nangal Dam), and community development.
  • Outcome: The plan was a success, achieving a growth rate of 3.6% per annum, which was higher than the target of 2.1%.

---

Prelims Pointers

• Harrod-Domar Model: Developed by Roy Harrod (1939) and Evsey Domar (1946).
• Lewis Model: Proposed by Sir Arthur Lewis in his 1954 paper, “Economic Development with Unlimited Supplies of Labour.”
• Mahalanobis Model: Provided the framework for India’s Second Five-Year Plan (1956-61).
• First Five-Year Plan (1951-56): Based on the Harrod-Domar model with a focus on agriculture.
• Capital Output Ratio (COR): The amount of capital required to produce one unit of output. Higher COR implies lower efficiency.
• Incremental Capital Output Ratio (ICOR): The additional capital required to produce one additional unit of output.
• Zero Marginal Labour Productivity: A key assumption of the Lewis Model, also known as disguised unemployment, where withdrawing labor from the subsistence sector does not reduce total output.
• Lewis Turning Point: The point at which a developing economy’s surplus rural labor is fully absorbed into the modern sector, causing wages to rise.
• Twin Balance Sheet Syndrome: The problem of stressed balance sheets of both public sector banks (high NPAs) and corporate firms (high debt).
• Crowding Out Effect: A situation where increased government borrowing leads to higher interest rates, thereby reducing or ‘crowding out’ private investment.
• Industry 4.0: Refers to the fourth industrial revolution involving technologies like AI, robotics, IoT, and big data.

---

Mains Insights

1. Investment-Led vs. Consumption-Led Growth: The Strategic Dilemma for India

• The Case for Investment-Led Growth (India’s Current Path):
  • Cause-Effect: Investing in infrastructure and manufacturing (e.g., National Infrastructure Pipeline, PLI schemes) is expected to create jobs, remove supply-side bottlenecks, and improve long-term productive capacity. This is crucial for absorbing India’s demographic dividend.
  • Need: India’s per capita income is still low, and consumption cannot be a sustainable driver without a corresponding increase in production and income. An investment-led push is seen as a prerequisite to creating the income base that can later fuel consumption.
• The Case for Consumption-Led Growth:
  • Argument: Proponents argue that a consumption stimulus (e.g., tax cuts, direct income support) can revive demand quickly, especially during economic slowdowns, encouraging private players to invest to meet this demand.
  • Risk of India’s Path: Over-focusing on investment without robust demand can lead to excess capacity and low returns, exacerbating the NPA problem. The Twin Balance Sheet problem itself is a legacy of an investment boom that was not sustained by adequate demand.
• Comparative Perspective (India vs. China): China is shifting to consumption after decades of high investment led to immense industrial capacity and high savings. India’s situation is different; it needs to build that capacity first. Therefore, while China rebalances away from investment, India needs to rebalance towards it. The challenge is to sequence this transition correctly, ensuring investment creates demand and incomes, which in turn sustains the investment cycle.

2. Critical Analysis of India’s Early Planning Models

• Harrod-Domar in the First Plan:
  • Relevance: It was a simple, practical model for a newly independent nation with a data deficit. It rightly identified capital scarcity as the primary constraint and focused on mobilizing savings.
  • Limitation: Its mechanical nature ignored structural and institutional realities of the Indian economy, such as the difficulty of channeling agricultural savings into industrial investment.
• Mahalanobis Model in the Second Plan:
  • Historiographical Viewpoint (Pro): Supporters argue that this ‘heavy industry’ strategy laid the foundation for India’s industrial diversification and self-reliance. It created a capital goods base (e.g., steel plants, heavy engineering) that was essential for long-term development.
  • Historiographical Viewpoint (Con): Critics like Jagdish Bhagwati and Arvind Panagariya argue that this model was flawed. It led to a highly inefficient, capital-intensive, and state-dominated industrial sector that neglected agriculture and consumer goods. This ‘inward-looking’ strategy stifled competition, created monopolies in the public sector, and resulted in a low-quality, high-cost economy for decades. The long-term consequence was a slower rate of poverty reduction compared to East Asian economies that pursued an export-oriented, labor-intensive strategy.

3. The Challenge of Implementing Investment-Led Growth Amidst Structural Weaknesses

• The Vicious Cycle: The Twin Balance Sheet problem creates a vicious cycle. Stressed banks cannot lend, and over-indebted firms cannot invest. This stalls the investment-led growth engine before it can even start. Government efforts like the Insolvency and Bankruptcy Code (IBC) and bank recapitalization are attempts to break this cycle, but progress is slow.
• The Inflation-Growth Trade-off: The government’s push for investment often involves expansionary fiscal policy (high borrowing). This can fuel inflation. The Reserve Bank of India, mandated to control inflation, might then raise interest rates, which directly counters the goal of stimulating private investment. This creates a policy conflict between the government and the central bank.
• Geopolitical Headwinds: India’s ‘Make in India’ and investment-led strategy are unfolding in a global environment of deglobalization and protectionism. This makes an export-led component of the strategy difficult. The focus must therefore be on domestic market creation, which brings back the importance of inclusive growth to raise the purchasing power of the masses.

4. Demographic Dividend: An Opportunity with a Ticking Clock

• Potential vs. Reality: The demographic dividend is not an automatic benefit. It is a window of opportunity. If the large youth population is not equipped with the right skills, education, and health, and if the economy does not create enough productive jobs, this ‘dividend’ can turn into a ‘demographic disaster’ marked by high unemployment, social unrest, and crime.
• Policy Linkage: This directly links to the necessity of investment in social infrastructure alongside physical infrastructure. The success of an investment-led model depends not just on capital but on the quality of human capital that can utilize it productively. Therefore, policies on education (NEP 2020), health (Ayushman Bharat), and skilling (Skill India Mission) are as crucial to the growth story as policies on roads and ports.