Revised excerpts from the 16th JRD Tata lecture, delivered in New Delhi, 19 August 2013.
This is a difficult time for the Indian economy. Growth has slowed, with industry shrinking over the last two successive months, wholesale price inflation has risen to 5.8%, and the rupee has been losing value sharply. There is reason to be upset about this and to demand more from policy makers. Yet, as I argue in this lecture, this is not India's biggest problem. The nation's biggest challenge at this critical juncture is a moral and an ethical one. This, for India, is a moment of moral churning. Skullduggery and corruption, cutting across party lines, have been rampant, eating into the moral fabric of the nation, leaving ordinary people befuddled and in despair. This is breeding a corrosive cynicism, leading people to believe that maybe this is the only way to be, that petty corruption and harassment is simply the new normal, whereby we should complain when we are left out of the gravy train and merrily join in if and when we get a foothold on that train. Yes, the economy has not done well over the last year or two. But once we look beyond the proximate causes we will realize that one important factor for the economy not doing well is the corrosion of values like trust and trustworthiness and their concomitant, poor governance.
As far as the current economic situation goes, conditions are grim, with a growth slowdown and a sharp depreciation of the Indian rupee. Nevertheless, the gloom and the pessimism spiral we see in India is disproportionate. It is driven in large part by the disenchantment with politics and is not borne out in reality. Let us look at the numbers. Some commentators have compared the current predicament with 1991; but in truth there is no basis for this. The growth now is around 5%, then it was around 1%; India's foreign exchange reserves are now enough for 7 months of imports, then it was enough for 13 days of imports; in absolute terms, in the early 1990s India used to have on average a forex reserve of approximately 4 billion dollars, now it carries approximately 280 billion dollars. And, importantly, now it has a floating exchange rate; in the early 1990s it had a fixed exchange rate. Conducting international trade with a fixed exchange rate is like driving a car without shock absorbers. In a fixed exchange rate regime a large current account deficit can cause a sudden shock to the economy, whereas now it is likely to be absorbed, in large part, by a depreciating currency. And that is what has happened.
Another factor contributing to the excessive gloom in India is a failure to recognize that the entire global scenario is grim. Indeed, in relative terms, India's performance measured by GDP growth is not poor at all. If one takes the list of over 40 nations--almost all the important ones in the world--for which the Economist magazine presents data and forecasts in its back pages, in the first quarter of this calendar year India was the 6th fastest growing economy. And in 2013 India is expected to be among the top three performers, behind China, and lock-step with Indonesia.
Given what is happening on the trade front and the sharp slowdown in manufacturing, it is possible, even likely, that growth will slow down further during the course of this year. But that is the short run prognosis. With its very rapid growth from 2003 to 2011, averaging over 8%, the nation has enough internal resilience to get back to a rapid growth path in two years, unless there is major policy bungling.
Let me turn to policy. Today the Indian economy is in the midst of a crisis in the foreign exchange market. The current account deficit is at a historical high and the rupee has been depreciating sharply over the past few weeks. In responding to this, ideally the emphasis should be on promoting foreign exchange inflows rather than placing restrictions on foreign exchange outflows. Curbs on outflows can, ironically, exacerbate the problem in the long run since people hesitate to bring foreign exchange into the country for fear that they will not be able to take it out again.
The right strategy is to convert the crisis into an alibi for promoting exports, boosting medical tourism, and taking steps to make India into an educational hub. All of these are foreign exchange earners and well within the realm of the possible. To boost any of these activities, the Indian government does not have to do much but rein in its bureaucratic transactions costs and improve the ethos of doing business. Given India's high quality doctors and nurses, medical tourism will flourish on its own if the visa rules and process of entering India are made more inviting for medical tourists. Visas need to be processed quickly and return visas made automatic. In addition, simple moves like creating special channels in airports for such visitors to clear immigrations and customs quickly can make a difference. When I worked as a bureaucrat in India I used to go through immigrations and customs within minutes using special channels meant for political leaders and senior bureaucrats. Why not convert those into channels for political leaders, senior bureaucrats and sick people?
India needs to think of intelligent ways to improve the culture of governance. Teach ordinary police to stop cars of VIPs--be they members of parliament or corporate leaders--that, for instance, illegally go through the traffic sign, and fine them. This would require instruction right from the top, assuring ordinary police that the top leadership will stand behind them in such cases, because currently the Indian police would not have the courage to do so. This will give police personnel dignity in their work and curb their penchant to cheat and take petty bribes. And, as a useful by-product, this will teach VIPs some much-needed humility.
On the short-term problem of foreign exchange management, I have written at length elsewhere (see my paper  with Aristomene Varoudakis). Central banks can do better than what they currently do if they are willing to use some novel ways of intervening. In the meantime one general principle is worth keeping in mind. Most central banks are wary of using their forex reserves. While such caution is useful, it can also be overdone. To understand this, consider the extreme case in which the forex reserves are never used; they are simply kept invested in some relatively liquid assets. In that case the market soon learns to ignore the reserves, because reserves that are never used are like there being no reserves. To discipline private market players it is important to occasionally buy and sell in the open market and take punitive action against those who manipulate the forex market.
Culture is a difficult thing to consciously change. But it would be wrong if for that reason we go to the other extreme and treat culture as immutable. There are recorded histories of how a nation known for its tardiness has become highly punctual over a short period of time; how a people historically known to be lazy have become models of industry. Thanks to traditional economists' propensity treat culture as irrelevant to economic functioning, there is very little research on the connection between culture and economic performance and on his cultural norms and habits can be changed. However, private firms and those marketing particular brands have long been aware that behavior and preferences can be changed, through advertising, through the creation of role models. There is no reason why the government cannot take up in earnest the effort to break the culture of corruption. Through the use of education, role modeling and even speeches, leaders can break the equilibrium of pervasive corruption and cynicism in which the nation is currently trapped.
Bureaucrats and the police do not have to behave the way traditional economics textbooks say all human beings behave, namely, making money wherever they can. Having dignity and honor in what one does can be a deterrent from taking bribes. Of course, alongside training and education, one should use intelligent law and a revision of bureaucratic and administrative procedures to improve governance. I have earlier argued that India should amend its Prevention of Corruption Act, 1988, to make bribe giving legal even while increasing the punishment for bribe taking in the case of harassment bribes. I had argued that this will cause bribery to decrease because the giver and the take would not collude to hide information about bribery once that has taken place. And knowing this, the bribe taker will be more hesitant to take a bribe in the first place. Controlled experiments, now seem, with some caveats, to confirm this theoretical claim (see paper  by Abbink, Dasgupta, Gangadharan and Jai).
What we do know about culture is that it has a propensity to become an equilibrium, so that no one wants to individually breakaway for it even when they realize that collectively they will be better off by changing their behavior (see Akerlof, G. ‘Economics of Caste, and of the Rat Race and Other Woeful Tales ,’ Quarterly Journal of Economics, 1976; Basu, K. and Weibull, J. ‘Punctuality: A Cultural Trait as Equilibrium ,' in R. Arnott, B. Greenwald, R. Kanbur and B. Nalebuff, Economics for an Imperfect World: Essays in Honor of Joseph Stiglitz, MIT Press, 2003) .
India has to make a big effort to initiate bureaucratic reform so as to make it easier for people to start, operate and even close businesses. On this front, the nation has some distance to go (see World Bank's Doing Business 2013 ), but one attractive feature of equilibrium behavior is that when it changes, the change can be large. So if India makes the effort to break the culture of corruption, cumbersome governance and accompanying cynicism, it is possible to make a vast improvement. Given that the fundamentals of the Indian economy are strong, with investment and savings as high as in the East Asian economies in the heydays of their growth, a strong engineering and management sector and long-standing entrepreneurial culture, once these facilitating social and cultural practices are put in place, the nation can grow at outstanding rates.