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Once Again, Democracy Versus Capitalism: The Political Economy of Reform

Submitted by admin on Sun, 05/18/2003 - 13:27

In India Unbound I wrote about how India embraced democracy first and capitalism afterwards and this had made all the difference.1 India became a full-fledged democracy in 1950, with universal suffrage and extensive human rights, but it was not until 1991 that it opened up to a freer play of capitalist forces. This unique reversal, I think, explains a great deal about Indian society today, and particularly why the pace of reforms is so painfully slow.

In the past half-century, Indians have been avid pupils in the school of democracy. They have learned to change their governments periodically and peacefully; they have given free reign to their litigious natures and have pushed the courts to the limit; they have created a vigorous free press and more recently a lively electronic media; and they have begun to internalise the rule of law. As a result, diverse voices have risen, backward castes have come forward, a more pluralistic middle class has developed, and there is a greater balance of opportunity.If Indians went to the school of political liberty, they gradually lost their economic liberty to a domineering socialist state in the four decades after Independence. Fortunately, that state did not nationalise our bazaar or our agriculture (although it did try to nationalise agricultural trade), but it did hobble our industry with controls from which it has still not recovered. Hence, we failed to create an industrial revolution, although our farmers managed to create a green revolution. Finally, in 1991 we began to open the doors to economic freedom and the market system. Banias and bazaars have been around for thousands of years, ever since there was an agricultural surplus. Historians tell us that this happened between 8,000 BC and 10,000 BC when the first towns emerged as centres of exchange. But markets are not the same as the market system.2 For one thing, the market system requires that money making become respectable, and we know from history that commerce has had a bad odour in many societies, especially in India.

At the best of times it is difficult to appreciate the market system. Over the centuries human beings have dealt with the problem of survival through tradition or command. They organised society around custom and usage, the son following the occupation of his father from generation to generation. Adam Smith tells us that in ancient Egypt, every man was bound by a principle of religion to follow the occupation of his father. In India, as we well know, our caste system assigned us occupations in the same way. The whip of authority has been the other method of organising the jobs of society. The pyramids of Egypt and the temples of India were built by the command of pharaohs and maharajas. More recently, the Five-Year Plans of the Soviet Union were carried out by the command of the Politburo in the same manner.

It is only in recent times that human beings invented a third solution to the problem of making a living. Called the market system or capitalism, it gives individuals the freedom to follow their inclination to do what is in their best interest. And the lure of gain (not tradition or authority) steers a person to his task or occupation. And yet in this interplay of self-interested individuals, an invisible hand does the tasks of society, as Adam Smith tells us. Because it is invisible, this system is more difficult to grasp. It lacks the simplicity of custom or command, which are visible for everyone to see. It is harder to understand how a society can function or how the dirty jobs in society get done--cleaning toilets, for example—if there is neither a ruler nor tradition to command it. Although we see today the wondrous spectacle of thousands of young Indians starting new business ventures all around us, the idea that their struggle for personal gain might actually promote the good of the whole society is too bizarre for most people. Even the most sophisticated Indians distrust the market—perhaps, because no one is in charge. Hence, politicians find it difficult to win votes by appealing to economic reforms. No wonder, Samuel Johnson said, “There is nothing which requires more to be illustrated by philosophy than trade does.” 3 Democracy, in contrast, is easier to understand, but it is more difficult to achieve. Capitalism is easier to achieve (because exchange is natural to human beings) but more difficult to understand. The irony is that in India we established the more difficult political institutions of democracy fifty years ago, but it is the younger institutions of capitalism that are currently more successful. Sadly, it is our democratic institutions of governance that are letting us down. Governance at all levels is appalling, all our states are bankrupt, the central government is paralysed by coalitions, and our confidence in government institutions is at its lowest. The lesson in all this is that we cannot take democracy or capitalism for granted. Both need to be continuously nourished. Neither do they necessarily go together even though they have human freedom in common. There are only two nations, as far as I know, where democracy preceded capitalism—the United States and India. America is the oldest modern nation, and India is one of the oldest civilisations. The U.S. got democracy in 1776 but it did not embrace full-blooded capitalism until the early 19th century with the Industrial Revolution. For the rest of the world it has been the other way around. Suffrage and rights were gradually extended in Europe and slowly they altered the capitalist institutions that had come up after the industrial revolution. This historic inversion has made all the difference, and it goes a long way to explain the noisy American and Indian democracies. India's democracy, however, has an overwhelming majority of poor voters, this makes a difference to the way things work here. The journalist, T. C. A. Srinivasa-Raghavan, points out that in the long run the forces that drive markets and democracy will converge; in the short run, these forces often tend to pull in opposite directions.4 Since politics is a short run game and growth is a long run one there will never be a situation that is completely optimal, with the result that at every point in time most of the people will be disappointed.

Like many Indian liberals, I make the mistake in thinking that change can be achieved by brute sanity. Many of us are guilty of the liberal fallacy—that is, to naively assume that reasoning will prevail over interests. For the opposite happens too often in the real world, whether in democracies or autocracies. The road to power is through satisfying interests, Jeremy Bentham reminds us. It is not enough to point out what the wrong policies are, as liberals tend to, but one has to go beyond the irrational policies and trace them to the interests—both economic and political. The agenda of the state is set by interest equations and the discourse of knowledge is effective only to the extent that it is congruent with the discourse of power. Reasoning about right and wrong policies, while not entirely irrelevant, is of limited use if one's agenda is, in fact, to shape a new reality. For this, one has to come to grips with the daily reality of elections.

When a politician promises rice for two rupees a kilo (12 cents a pound) when it costs five rupees in the market, he wins the election. N. T. Rama Rao did that precisely in the 1994 and won the Andhra election, became the chief minister, and nearly bankrupted the state treasury. He also sent a sobering message to Prime Minister Narasimha Rao in Delhi, who slowed India's reforms because he realised that votes resided in populist measures and not in doing what is right for the long term. Since the 1980s our politicians have vigorously competed in giving away free goods and services to voters. When politicians do that, where is the money to come from for creating new schools or improving old ones?

It was a depressing day in February 1997 when Punjab Chief Minister, Prakash Singh Badal gave away free electricity and water to farmers. He had lived up to his electoral promise, but twelve months later the state's fragile finances were destroyed and there was no money to pay salaries to civil servants. It was a poignant moment in Punjab's history because peace had returned after more than a decade of Hindu-Sikh troubles and terrorist violence. Investors were ready and waiting to come in, but when this largesse was announced, they turned shy. Competitive politics had again failed us, and it taught us that the demand for publicly provided goods and services is insatiable in a democracy. Mancur Olson, the social scientist, makes the point that the behaviour of individuals and interests in stable democracies inevitably leads to collusive lobbies that make their economies less dynamic and efficient and their politics less governable.5 Democratic societies tend to foster special interest groups, which subvert the dynamism of capitalism. Writing in 1982, Olson compared the experiences of post-war Britain with Germany and Japan. Narrow interest groups were destroyed by the war in Germany and Japan and they had to begin from scratch; in Britain, however, a powerful and dense network of trade unions and professional associations created “institutional sclerosis” that dragged down the economy. Germany and Japan created miracles of economic growth in the post-war decade, while the British economy remained slow, and even sick in some years. Olson hoped that a public educated to the harmful effects of special interests might begin to resist such behaviour. This is what eventually happened in Britain: sick and tired of its unions, high taxes, and over-regulation, the English voter brought in Margaret Thatcher to right the balance.

Many Indian intellectuals do not like Thatcher. Conditioned by years of socialism, they are wary of capitalism and are afraid that it may, in fact, subvert democracy rather than the other way around. They think like John Stuart Mill that existing property systems are unjust and the free market is destructively competitive—aesthetically and morally repugnant—and its excesses have to be controlled. They worry that the large corporation creates a new upper class with an excessively loud voice. In their eyes, executives of large multinational corporations are the contemporary counterpart of our zamindars of the feudal era, except that their voice is amplified by the technology of mass communication. In short, they think modern global capitalism, powered by multinational corporations, threatens democracy.

Indian intellectuals, I think, need to remember that modern democratic institutions have existed only in countries with privately owned market economies. Socialist countries always had command economies with centrally directed economic orders and were ruled by authoritarian dictatorships. The market economy seems to be a necessary condition for democracy, although, of course, it is not a sufficient condition.6 Empirical research also suggests that there is a positive relationship between capitalist and democratic institutions. In a major investigation of the social psychology of industrialisation and modernisation, a research team led by the sociologist, Alex Inkeles, interviewed several thousand workers in the modern industrial and the traditional economic sectors of six countries of differing culture. Inkeles found a far greater propensity to participate among modern capitalist workers than among workers in the traditional sector in each one of these countries regardless of cultural differences.7 ¼br /> Historically, as I have mentioned, modern democracy came after capitalism in most countries. As mass political parties and trade unions developed, democracy began to impinge on capitalist institutions and practices. The democratic propensity for redistribution and regulation and leftist parties and unions started to constrain the productivity and risk-taking spirit of entrepreneurs. This process culminated after World War II in the welfare state in the western world and Japan, with social insurance and health care and extensive regulatory frameworks designed to militate against the shortfalls of capitalism. It is probable that had capitalism not been so modified by democracy, it may not have survived.8 In India, on the other hand, democratic institutions came up before we had the chance to create an industrial revolution. Even today, two thirds of our people continue live in rural areas, organised labour constitutes less than 10 per cent of total labour, and the middle class, despite tripling in the last two decades, is less than 20 per cent of the population. Because of the inversion populist pressures for redistributing the pie built up before it was baked. We set up intricate regulatory networks before the private economy had transformed a rural into an industrial society. We began to think in terms of “welfare” before there were welfare-generating jobs. The result, as we have seen, has been throttling of enterprise, slow growth, missed opportunities, huge subsidies and a rapacious bureaucracy. It is the price we have paid for having democracy before capitalism—or rather too much democracy and not enough capitalism.

We are used to thinking in terms of dualisms in India—the rich versus the poor, urban versus rural, upper versus lower castes, and so on. The most striking dualism of today's India is, however, the contrast between our vibrant private space and the impoverished public space. What could stop our future is the latter—our governance. Obviously, we need both economic growth and robust political institutions to be successful. Although we may rely more on markets now, we still need clean and efficient civil servants to regulate them. Some economists, I know, secretly hope that the states would become completely bankrupt because this will force the pace of market oriented reform. However, one does wish that Indians would begin to trust the market a little bit more. As with everything in India, this too will take time, I expect.

We tend to forget that liberal democracy based on free markets is a relatively new idea in human history. In 1776 there was one liberal democracy—the United States; in 1790, there were three, including France; in 1848 there were only five; in 1975 there were still only 31. Today 120 of the world's 200 or so states claim to be democracies, with more than 50 percent of the world's population residing in them (although Freedom House, an American think tank, counts only 86 countries as properly free).9 Clearly, there has been a liberal revolution around the globe, accelerated in part by communism's collapse. More than fifty countries are engaged in economic reform as they transition from inward looking, autarchic economies to open, market driven ones. India is one of these, and among the best placed to make a quick and successful transition to capitalism. Unlike Russia, it has had a highly developed national market, going back to the days before the British came in the 17th century, and this was integrated further when the railways came in the 19th century. Unlike China, it has had a robust, indigenous financial system, which was upgraded into a modern banking system in the early 20th century. Despite Nehruvian socialism, three fourths of the economy has been in private hands, including all of agriculture. (However, one must not underestimate the massive controls that exist in Indian agriculture and continue to bind it.) Roads, ports, irrigation, power, banking, insurance, airlines, railways were government monopolies, but the public sector accounted for less than a quarter of the domestic product. Unlike Russia and China, India also has clearly defined property rights, well-developed commercial law, and English speaking entrepreneurial class. With all these advantages, why does India remain half reformed. Why doesn't it quickly become an attractive place for private investment?

The answer partly is that we underestimate the difficulty of transforming an autarchic, centrally planned economy into a market oriented one. The state cannot merely withdraw from market activities by privatising them. Liberals think that markets are natural and they spring up on their own. Their belief is based on what Adam Smith called “man's prosperity to barter, truck and exchange one thing for another.” However, markets do not work in a vacuum. To function smoothly they need a network of regulations and institutions; they need umpires to settle disputes. These institutions do not just happen; they take time to develop. Thus, reform is not an easy path. For example, with the decision to allow private investment in telecom, electricity and insurance we have set up regulatory agencies, but we are still learning how to make them work. The experience in many countries over the last two decades teaches us that markets generate perverse results in the absence of good institutions.10

Another reason for our slow pace is that the reform agenda is constantly derailed by vested interests. Politicians lack the courage to privatise the huge, loss-making public sector because they are afraid to lose the vote of organised labour. They resist dismantling subsidies for power, fertilisers, and water because they fear the crucial farm vote. They won't touch food subsidies because of the massive poor vote. They will not remove thousands of inspectors in the state governments, who continuously harass private businesses, because they don't want to alienate government servants' vote bank. Meanwhile, these give-aways play havoc with state finances and add to our disgraceful fiscal deficit. Unless the deficit comes under control, the nation will not become competitive; nor will the growth rate rise further to 8 and 9 percent, which is what is needed to create the jobs and improve the chances of the majority of our people to actualise their capabilities in a reasonably short time.

“Collective action” is a problem in all democracies, and to that extent we have to be resigned to a slower pace of reform. But India's problems of governance go far beyond the need to appease interests. The weakening of our democratic institutions since the 1970s has caused widespread corruption, political violence, populist giveaways, and a paralysis of problem solving. Conspicuously absent is intra-party democracy, disciplined party organisations, which help leaders in other democracies to mobilise support for specific programs. Hence, there is an excessive reliance on the personal appeal of individual leaders to win elections. When in power leaders find it difficult to push through programs or when opposition mounts, they find few supporters, and tend to take the easy way out, which is not to act at all. For this reason, the Indian state is sometimes called a “soft state”.

In a perceptive analysis, the political scientist, Atul Kohli, explains that political institutions are weak because India's democracy came from above and not from below.11 It was a “gift from the elite to the masses”, and the masses are comfortable adoring an all powerful leader. He shows, however, that even a powerful leader like Rajiv Gandhi, with a vast electoral support in the mid-80s, could not implement major economic reforms. After a good start in 1985, when he introduced modest fiscal and industrial liberalisation, Rajiv Gandhi got scared by vested interests and abandoned these initiatives after two years. Professor James Manor of the University of Sussex does not agree. He thinks that Rajiv Gandhi was not a political leader and the problem lay “in the former Prime Minister's confusion and his chronic, indeed radical inconstancy.”12 The truth, I expect, lies somewhere in between. Opposition from public sector workers and middle peasants did, in part, force him to back down.

But how was Narasimha Rao able to produce such spectacular results between 1991-1993? Why didn't vested interests stop him? There are several reasons. First, all his reforms were “soft reforms”; they did not really mean job losses for organised labour or an attack on subsidies. In fact, after opposition from the farmers lobby to a reduction in fertiliser subsidy in the July 1991 budget, he backed down. Second, he was able to reform by stealth, as it were, because the nation's attention was diverted by communal passions generated by the demolition of the Ayodhya mosque. Ashutosh Varshney, the political scientist, says that this “gave the reformers room to push the reforms.”13 Third, of course, there was the fiscal crisis, and there's nothing like a crisis to concentrate the mind--even a politician's mind. Narasimha Rao deserves credit for his deft handling of the reform process, especially in sequencing the acts in a politically shrewd manner. Hence, India has avoided the political damage—or even collapse, as in Russia's case—that many countries have suffered after the economic reforms. The succeeding governments after Rao's have followed the same strategy—they have continued to reform the “softer areas” and they have not confronted the five main interest groups--prosperous farmers, industrial bourgeoisie, the middle class professionals (including government employees), unionised workers, and the poor (both urban and rural.)14 They have trodden gingerly, either skirting them or given them pain in a slow incremental manner. This, of course, does not hark well for the future of reform in India. Who is going to bell the cat? The present BJP led government appears to be serious—it has an ambitious privatisation program and has announced labour and agricultural reforms in the 2001 budget—but people remain unconvinced about its ability to deliver the results.

Will capitalism and its cousin globalisation succeed in establishing a comfortable place for themselves in India? The answer depends on their ability to deliver prosperity broadly. It also depends on leaders in the government and in business to champion the classic liberal premises of free trade and competition. It needs leaders to come out and openly educate the people about the fact that some people will not fare as well in the competitive market place; but the winners in the end will far outnumber the losers; that capitalist democracy with all its flaws is the best arrangement that we have found; that globalisation is not only a good thing, it is the best hope, for all our people. My fear is that capitalism's success in India is threatened not so much by the leftists or protectionists but by the timidity of its defenders.
The triumph of the market economy and the continued spread of democratic governance through panchayati raj or village self government are reasons for optimism. However, twentieth century history teaches us not to be too enthusiastic about any ideology. Instead of celebrating, our energies should go into figuring out how to make these arrangements more sustainable and stable propositions. How to change the mindset of politicians from territory to trade? Economic integration between India and Pakistan, for example, will do more to diffuse political conflict. It is economic integration of the European Union that has ruled out war between Germany and France. South Asian economic integration can do the same for India and its neighbours. India's politicians can learn a great deal from Clinton's battles over NAFTA—it required huge political skills to win that victory.

Who then will save India's capitalist democracy from its enemies? The job usually falls on politicians and business people. But neither seems an ideal steward. Business people are too busy making money and politicians too busy serving vested interests. Meanwhile, capitalism is socially disruptive. Democracy, on the other hand, is messy. But capitalism can succeed if it has the consent of the governed. It requires taking into account the needs and fears of ordinary Indian citizens. Economic growth is the easy part of the equation. Gaining consent from voters is more difficult because there will be stark disparities in wealth. Many Indian politicians recognise that democracy and capitalism are inseparable but binding them will be crucial if the nation is to succeed.

The hope of regaining governance and saving our democracy could lie in decentralisation. This is beginning to happen as governments in Delhi have weakened during the past decade. Since no party has been able to gain a majority in Parliament; leaders have depended more and more on regional parties to survive; neither have there been charismatic and over-bearing leaders like Nehru and Indira Gandhi. Hence, the states have grown stronger by default. With liberalisation, competition has also grown among the states for private investment. This competition in turn forces them to reform, which is a good thing as the behaviour of the state government has a bigger impact on the average citizen's day to day life than the centre.

The unique inversion between democracy and capitalism in India means that our future will not be a creation of unbridled capitalism, but will evolve through a daily dialogue between three sets of political actors: the conservative forces of caste, religion and the village, the leftist and Nehruvian socialist forces which have dominated the intellectual life of country since Independence, and the new forces of the market and of global capitalism. This daily dialogue entails a million negotiations of democracy between these three forces. Hence, the pace of economic reforms is frustratingly slow. It also means that India will not grow as rapidly as China or the Asian Tigers, nor will it wipe out poverty and ignorance as quickly as it potentially could. The historic reversal between capitalism and democracy suggests that we might have a more stable, peaceful and negotiated transition into the future than, say China; that we might avoid some of the deleterious side-effects of big-bang economic reforms, such as an unprepared society like Russia; but we are more likely to preserve our way of life and our civilisation of diversity, tolerance and spirituality against the onslaught of the phoney and fictitious global culture.Democracy and capitalism have emerged as the dominant, problem solving institutions of human society. India too is a part of this great adventure of modern civilisation. Each nation is trying to adapt these two institutions to find an acceptable mix of market competition, political pluralism, participation and welfare. With all its flaws of special interests, populism and indecisiveness, more and more Indians have begun to believe that democratic capitalism is worth fighting for, because it offers the promise of preserving and enlarging human freedoms, creating prosperity, diminishing poverty, and upholding the dignity of a human being, and it does it better than any other system that human beings have tried so far.


1. This essay grows out of my recent book, India Unbound (Viking, Delhi, 2000 and Knopf, New York, 2001). I have unashamedly borrowed from both editions of the book, and for this I seek the reader's indulgence.

2. Robert L. Heilbroner, The Worldly Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers, Simon & Schuster, New York, 1953, pp. 19-27. The subsequent quote from Adam Smith in the following paragraph is also from the same chapter.

3. I owe these wise words of Dr. Johnson to Robert Heibroner (1953), The Worldly Philosophers: The Lives, Times, and Ideas of the Great Economic Thinkers, Simon & Schuster, New York, p. 24.

4. T.C.A. Srinivas-Raghavan, “Growth versus Politics in Democracies,” Business Standard, May 13, 2000. This was in a book review of the first edition of India Unbound. Although I initially reacted petulantly to this review (by shooting off a letter the next day), I am grateful to him for pointing out the divergence between growth and politics, which has partially led to my writing a new chapter for the American (Knopf) edition of the book.

5. Mancur Olson, The Rise and Decline of Nations, Yale University Press, Haven, 1982

6. I have benefited from Gabriel Almond's discussion on this subject in his article, “Capitalism and Democracy,” in American Political Science Association's PS: Political Science and Politics, Sept. 1991, pp. 467-474

7. Alex Inkeles and David Smith, Becoming Modern: Individual Change in Six Developing Countries, Harvard University Press, Cambridge, MA. 1974

8. In the United States, manhood suffrage came quite early, and later the bargaining process emphasized free land and free education to the secondary level, an equality of opportunity version of the welfare state. With Disraeli, Britain had relatively early manhood suffrage and full parliamentary government, while the Lloyd George on the eve of World War I brought the beginnings of a welfare system to Britain. Bismarck in Germany produced an early welfare state, but postponed electoral equality and parliamentary government. While there were differences in historical encounters with democratization and “welfarization,” a century after the process began all the advanced capitalist democracies had similar versions of the welfare state--smaller in the case of United States and Japan, more substantial in Europe. Democracy has been supportive of capitalism in this sense. Without this welfare adaptation it is possible that capitalism might not have survived. ¼

9. Economist, June 24, 2000, p.21.

10. See Justin Lin and Jeffrey Nugent, “Institutions and Economic Development” in J. Behrman and T.N. Srinivasan, eds., Handbook of Economic Development, North-Holland, Amsterdam 1995, vol. 3A. It provides an excellent review of the huge literature on institutions and economic development. Robert Hall and Charles Jones offer insights into “social infrastructure” in “Why Do Some Countries Produce So Much More Output per Worker Than Others?” Quarterly Journal of Economics, Feb.(1999), pp.83-116. On bureaucratic quality and social capital, see Stephen Knack and Philip Keefer, “Institutions and Economic Performance”, Economics and Politics, November 1995, pp 207-228.
11. Atul Kohli, Democracy and Discontents India's Growing Crisis of Governability, Cambridge University Press, 1991, p.390

12. James Manor, “The Political Sustainability of Economic Liberalization in India,” Robert Cassen and Vijay Joshi, eds. India: The Future of Economic Reform, Oxford University Press, New Delhi, 1995, p. 354.

13. Ashutosh Varshney, “Mass Politics or Elite Politics? India's Economic Reforms in Comparative Perspective” in Jeffrey D. Sachs and others, India in the Era of Economic Reforms, Oxford University Press, New Delhi, 1999, p. 225

14. To Pranab Bardhan's three “dominant proprietary classes” I have added James Manor's latter two groups. Pranab Bardhan, The Political Economy of Development in India, Oxford University Press, New Delhi. James Manor, “The Political Sustainability of Economic Liberalization in India,” Robert Cassen and Vijay Joshi, eds. India: The Future of Economic Reform, Oxford University Press, New Delhi, 1995