India Must Look to Its States for Salvation

Economically, things are not quite falling apart in India but it is becoming clear that the center is increasingly unable to hold. Political fragmentation and weak leadership in New Delhi are eroding federal power relative to India's states. But might decentralization offer hope for the Indian economic union even as the very opposite is seen as Europe's salvation?

If a few years ago pundits were giddy about India's growth prospects, today the gloom is universal. Fiscal populism, reflected in high subsidies, stubbornly high inflation, and large external deficits points to India's precarious macroeconomic situation. Weak macroeconomics is a double blow: It has a debilitating effect on growth because it adversely affects investor sentiment; at the same time it robs India of the macroeconomic freedom to offset the decline in growth. India, unlike China, cannot spend its way out of a downturn because of large deficits.

The roots lie in errors of omission and commission in economic policies, but two underlying weaknesses have not changed: feeble state capacity that weakens policy implementation and pervasive corruption. India has gone from becoming a "permit-quota-license Raj" to what might be called a "rents Raj."

Yet the weakness of the central government and the attendant pessimism mask the reality that there has been a considerable shift in power to the states. Indeed, most issues that critically concern investors—land, infrastructure, human capital, law and order—are largely the domain of states. So, while it is hard to see the federal government getting its act together, what happens in the states will increasingly determine India's economic fortunes.

It is not that leadership in the states is better on average than at the center, but in a decentralized India, a few visibly successful experiments can have powerful repercussions for the economy. Capital and labor can and will flow from the laggard states to the performing ones because India is broadly an economic union. The laggards will have fewer excuses for non-performance if the experience of a neighboring state is better. In the past, the southern states were the pacesetters. This is no longer the case today. There are encouraging improvements in states across India—in the north (Haryana), west (Gujarat), east (Bihar), and Central India (Madhya Pradesh).

This competitive dynamic is one cause for hope. The other is that the Indian voter is increasingly rewarding good governance. Until recently, India's political system was characterized by anti-incumbency, with identity politics trumping good governance and economic performance. As a result, politicians had little incentive to deliver essential services and enact lasting reforms. Recently, though, Indian voters have reelected many incumbents who improved economic outcomes while throwing out poor performers, as exemplified by the ousting of the Communist party in West Bengal. These trends portend reasonable rates of economic growth in India even if the scorching rates of the past decade prove elusive. Decentralization is not without risks. The governance of the economically best performing states is around "authoritarian democrats," leaders who, while democratically elected, have few checks and balances.

Decentralization has also arguably not gone far enough because the states have been very reluctant to extend its advantages to local governments, which has had a pernicious effect on urbanization. Cities in India need more autonomy and their leaders need to be held more accountable.

The contrasts between India and Europe as economic unions are striking. In Europe, centralization is becoming an existential necessity. India, in contrast, is decentralizing even as the center is weakening. In Europe, better economic performance in the periphery is seen as possible only with tough rules dictated from the core. In India, it is competition between the states that holds the prospect for unleashing dynamism. Europe is being refashioned in the image of Germany. India, in contrast, is having to reinvent itself as an economic union in a way that allows competing ideas of India to flourish.