Lessons from India's fiscal policy management

It has become a feature of economic policymaking to define thresholds for fiscal prudence and macroeconomic stability. Accordingly, it is held that fiscal deficits should not exceed 3% of GDP, public debt should not exceed 60% of GDP, inflation should not exceed 2% (or 4%), etc. 

I have blogged earlier here and here about the problems with the uniform adoption of such targets. 

This post will examine India’s macroeconomic record over the last fifty years against these benchmarks. It will use data for 1975-2024 from the World Bank’s WDI to assess the impacts of CPI inflation, central government debt (% of GDP), fiscal deficit, and gross fixed capital formation (GFCF) on GDP growth rates. 

The table below captures the five-year averages on each of the above parameters. 

This is the same table with ten-year averages.

This is a ChatGPT summary which broadly conforms to the economic orthodoxy on macroeconomic stability. 

A five- and ten-year view of India’s macrofiscal indicators highlights a clear structural shift after the mid-1990s, marked by lower inflation, higher investment, and improved growth outcomes. The FRBM period stands out as the most balanced macro regime. However, major shocks since 2008—particularly the COVID-19 pandemic—have resulted in persistently higher fiscal deficits and public debt, underscoring the importance of restoring fiscal space while protecting capital expenditure.

We get broadly similar conclusions from models with different specifications (lagged multivariate growth regression, structural break regression, and reduced-form VAR).

India’s growth experience shows that fiscal deficits support growth only in the short run and only when macro-credibility is intact. Sustained growth is driven far more by investment and macro-stability than by deficit expansion, while rising public debt increasingly constrains long-term growth.

However, if we disaggregate the fifty years into identifiable macroeconomic regimes and perform lagged GDP growth regressions against each parameter separately, the shorter-term trends become less clear and regime-dependent. It provides some useful takeaways. 

There are some distinct takeaways. The strongest relationship is that between GFCF and growth. It holds in both short and long-run time frames. 

The short-run relationship with fiscal deficits is generally positive. However, the magnitude of this relationship depends on the regime. As can be expected, the three periods with the greatest perceived thrust on macroeconomic stability - post-liberalisation decade, FRBM era (2003-08), and post-Covid 19 years - are also associated with the highest positive impulse from fiscal deficits. 

The trends on fiscal deficit show a distinct shift towards a higher deficit. Interestingly, though the post-pandemic period has had the highest deficits, it has also been associated with the highest economic growth rates. 

In fact, since 2010, the economy has shifted to a regime with fiscal deficits that are much above the 3% of GDP threshold. But it does not appear to have adversely impacted growth rates, nor market perceptions. An obvious reason is the quality of fiscal deficits, which have shifted sharply towards capital expenditures. 

Overall, as the graphic below shows, there’s a very weak correlation between growth and fiscal deficit. At least, there’s nothing to suggest a fiscal deficit threshold around 3% of GDP. 

Since around 1995, successive governments in India have generally exercised fiscal prudence in terms of the public debt to GDP ratio being range-bound in the 45-50% range. However, unlike fiscal deficit, there’s a strong inverse correlation between the stock of public debt and GDP growth rates. Therefore, the rise in the public debt ratio in the post-pandemic period should be a matter of concern. When the state government debt is added, the gross public debt is inching towards 100%, easily the highest among all major developing countries. 

Similar to fiscal deficit, inflation higher than the target rates has been found to co-exist with high growth rates. There’s little relationship between an inflation rate of 2%, or even 4%, and GDP growth rates. In general, inflation effects tend to weaken once macro stability is achieved. 

Over the last decade, India has significantly improved its economic attractiveness. This has come about through a combination of political stability, large infrastructure investments, expansion in the IT services market (GCCs), the emergence of e-commerce and startups with the resultant job creation, gradual but consistent pursuit of economic reforms, interspersed with some critical reforms, and generally good macroeconomic governance through fiscal discipline, quality of public expenditures, and transparency. It has also helped that the country has been growing at steady high rates, and has emerged as the fourth biggest economy in the world and is one of the few big growth markets. 

All this has provided the fiscal credibility to run a higher level of deficits. In fact, the Indian economy has benefited from the free lunch of an additional 2-3 percentage points of GDP of fiscal space for the last decade or so, which was unavailable in the FRBM-constrained regime. This fiscal boost has been central to the high growth rates of recent years. 

This is a good case study for at least two reasons. One, while such quantitative targets do play a fiscal disciplining role, there’s nothing sacrosanct or objective about arbitrarily defined thresholds. In fact, a rigid adherence to such targets is counter-productive and growth-squeezing. Second, in a world where these targets have become accepted norms, market perceptions about reform commitment and fiscal prudence can significantly expand the fiscal space available for governments. Market credibility provides the flexibility for fiscal expansion. 

So what does this all say? Here is the summary from ChatGPT

Over the last five decades, India’s growth experience shows no stable linear relationship between fiscal deficits and growth. Periods of high growth have occurred under both fiscal expansion and consolidation. Inflation control appears growth-enhancing primarily in high-inflation regimes, while capital formation is largely pro-cyclical. The results underscore that fiscal quality, institutional credibility, and macro stability matter more than headline fiscal aggregates.

A major macroeconomic challenge for India going forward will be the management of its fiscal balance. It must pursue fiscal consolidation to significantly reduce its current high flows and stock of debt, while also significantly raising GFCF. And it must do all these at a time when private investment remains caught in a low equilibrium trap with no signs of a breakout, and when global headwinds are likely to squeeze capital inflows and export growth. This is especially daunting since, as the figures show, economic growth since the GFC, and more so since the pandemic, has been largely propped up by public investment, which is now hitting hard fiscal constraints. 

Weekend reading links

1. While the US tariffs are undoubtedly reducing US imports from China, the imports are substituting towards other developing countries. See this about the trends with mobile phone imports.

And, this about imports of wooden furniture.

The moot point is how much of these imports are merely repackaging and re-routing of supply chains. 

2. Has Spain reached peak solar generation?

The country has become a solar champion thanks to abundant sunshine and the government’s pro-renewables policies. But a surge in power production has outpaced demand, depressing electricity prices and profits for generators. Some power producers are struggling to offload plants whose valuations have plunged as executives talk of solar “saturation”... Operational solar plants were valued at an average of €916,000 per megawatt in early 2024, but have now dropped to €648,000 per megawatt, according to nTeaser.

... the gloom is even greater over so-called ready-to-build projects, where land, permits and grid access have all been secured, but construction has not begun. A senior executive at an owner of Spanish solar plants said: “The market is flooded with ready-to-build projects that developers want to sell since they’re no longer good enough in the current market.” Some projects were up for sale for just €1, the executive said, reflecting developers’ desperation to avoid further spending, and potential government penalties for not executing agreed construction plans. The least attractive ready-to-build projects are often far from power grid nodes, requiring investment in expensive power lines.

... low prices are painful for producers. When they fall below zero, as they have for more than 500 hours in Spain this year, producers can end up having to choose between paying wholesale customers to take excess power off their hands or switching off. Many producers insulate themselves by selling electricity through long-term power purchase agreements (PPAs), which they sign at fixed prices with corporate clients for 10-20 years... Adding battery storage to solar plants helps to limit price plunges by enabling generators to store electricity when prices drop during the day, then sell it in the evening when demand and prices are higher.

3. John Burn-Murdoch points to a rising inflation in reported children with "special needs" in US and UK, with some distortions. 

38 per cent of undergraduates at Stanford this year are registered as having a disability, as are 21 per cent at Harvard — both up from 5 per cent in 2009... The bulk of the rise in special support for youngsters is cases of non-profound autism spectrum disorder (ASD), attention deficit hyperactivity disorder (ADHD) plus anxiety and mental health, all of which have flexible diagnostic criteria… we consistently see mild, not severe, cases driving the rise... As the number of more mild cases receiving support has climbed over the past decade, average funding per child (including the most severe cases) has fallen by a third in real terms… In 2010, 1 per cent of American young people from the poorest school districts were on plans that provide special support, and today that figure is unchanged. But among those in the richest areas, it has tripled from 2 to 6 per cent.

4. The Big 5 Indian IT firms have added just 17 net workers in the first three quarters of Fy26!

5. This is what industrialisation success looks like, the example of Hosur in Tamil Nadu, the leading EV and electronics manufacturing cluster in India.

6. India's industrial power prices are the highest.

7. Consumption's share of China's GDP is lowest among all major economies.

China’s decline in private final consumption expenditure is in sharp contrast to consumption-dependent economies like the United States (US) and India, with their share of private final consumption reaching 68.39 per cent (in 2022) and 61.38 per cent (in 2024) of their GDP, respectively. Among the top five economies of the world, China has the least share of private final consumption in its GDP. On the contrary, China has the highest share of fixed investment in its GDP – almost 10 percentage points higher than India’s share. Further, China has the largest share of net exports, after the EU.

8. The biggest trade promotion policy ever? The shipping container.

Nothing has done more to juice global trade than a simple receptacle—spanning about 40 feet on the long side and eight on the other two. It could be stuffed with cargo and hoisted onto lorries, trains, ships or planes with equal ease. That humble steel box—the standard shipping container—did “more than all trade agreements in the past 50 years put together” to boost globalisation

9. The US government has announced a $1.6 billion investment in USA Rare Earth, a listed Oklahoma-based miner that controls significant US deposits of heavy rare earths. 

One person said the government would get 16.1m shares in USA Rare Earth and warrants for another 17.6m, both at a price of $17.17. The government agreed to pay $277mn for the equity, giving it an implied gain of $490mn for the equity and warrants based on the current share price of $24.77. USA Rare Earth will also receive $1.3bn in senior secured debt financing at market rates from the government. The money will come from a finance facility created for the commerce department as part of the CHIPS and Science Act passed in 2022... A condition of the government investment in USA Rare Earth was that the company raise at least an additional $500mn from investors. It is on track to raise more than $1bn because of high demand for the financing deal, which uses a mechanism known as a private investment into a public equity, often called a “Pipe”...

USA Rare Earth, which has a market value of $3.7bn, is developing a huge mine in Sierra Blanca, Texas that it says contains 15 of the 17 rare earth elements underpinning production of cell phones, missiles and fighter jets. It also plans to open a magnet production facility in Stillwater, Oklahoma... Last year, the Trump administration invested in at least six minerals companies, including MP Materials, Trilogy Metals and Lithium Americas. Some of the investments overlapped with the financial interests of people associated with the administration. The government did a funding deal with Vulcan Elements, a rare earths start-up three months after the president’s son Donald Trump Jr’s venture capital group invested in the company... USA Rare Earth has separately tapped Cantor Fitzgerald, the Wall Street firm previously owned by commerce secretary Howard Lutnick and now run by his sons, to raise more than $1bn in fresh equity financing, the people said.

10. President Trump has announced his intention to cap credit card interest rates at 10% and has enlisted the services of an unlikely partner, Elizabeth Warren, to draft legislation in this regard. 

But a study by Liberty Street Economics found that spreads are high across all levels of credit ratings measured by so-called Fico scores and that default losses cannot explain the huge spreads above FFR... A recent Vanderbilt study concludes that at a 10 per cent cap, banks could continue profitably serving the vast majority of their customers... Americans pay about $160bn a year in credit card interest.

Sheila Bair, the former FDIC Chair, has this alternative proposal.

A better approach would be a permanent cap expressed as a spread over the FFR, say 10 per cent. This would be consistent with pre-crisis spreads. It would ensure that banks pass on the benefits when the Fed lowers rates but also allow them to raise rates when the FFR goes up. At the current FFR, it would bring credit card rates to just under 14 per cent.

11. Debashis Basu on the challenges with tripling exports by 2035, a CAGR of 13%. From history, South Korea increased its exports by a CAGR of around 18% between 1965-85, Taiwan by 16% in the 1965-80 period, Thailand by 14% in 1986-96, Malaysia by 14% in the 1987-2000 period, and Vietnam by 14% from 2005-24. 

History suggests that sustaining export growth of around 13 per cent for a decade requires these conditions: Cheap currency, strong central coordination and disciplined policy execution, a large surplus of labour at low wages, assured access to large and open markets, and a willingness to tolerate overcapacity and frequent failures. India currently possesses none of these in sufficient measure. Instead, it faces headwinds from rising protectionism, aggressive dumping by China, and reforms that are often procedural rather than outcome-oriented.

12. The non-profit only mandate for schools in India is among the biggest charades. 

India’s rules continue to insist that most private schools are “charities”. The result is a system that makes it hard to bring capital in openly or take returns out transparently. Founders instead resort to legal gymnastics. A single school is often split into three entities: a trust to hold recognition and collect fees; a land company to own the campus; and a services firm to run everything from transport to maintenance. Three entities mean three sets of books, audits, and compliance calendars. Even routine decisions, like paying salaries or upgrading infrastructure, require cross-entity coordination that adds weeks of delay. Hanging over all this is the lingering uncertainty of the government suddenly cracking down on the school or changing a rule about the trust... Every rupee that leaves the account must be defensible on paper. Salaries are routed as lease payments to a land-owning entity and as service fees to an operating company. Each transaction is vetted by his chartered accountant, ensuring no regulator can later accuse the school of making a profit—before it has even run payroll.

The arrangement is captured nicely here.

13. Tamal Bandopadhyay has an interesting article on the trends with central and state government borrowings.

In the current year, the central government’s gross borrowing is pegged at Rs 14.72 trillion, and net of redemptions, the net borrowings, at Rs 11.54 trillion... The gross SDL in the current year is Rs 11.83 trillion... Will there be demand for such a large borrowing programme? That’s the challenge before the RBI. In the current year, it has managed this by buying bonds from the market, popularly known as open market operations, or OMO. In FY26, a record Rs 6.45 trillion (till February 12) is being raised through this route, more than double of what the RBI had bought in FY25. The highest OMO before this was in FY21 – a little over Rs 3.13 trillion... 

Until the global financial crisis of 2008, the central government’s gross borrowing never crossed Rs 2 trillion. And SDLs were much lower – in thousands (for instance, Rs 20,825 crore in FY07). In FY09, the central government’s gross borrowing crossed Rs 2 trillion for the first time. The following year, it jumped to over Rs 4 trillion. The next big jump came in the Covid-hit FY21. From a little over Rs 7 trillion in the previous fiscal year, it rose to Rs 13.7 trillion that year. It crossed Rs 15 trillion in FY24, and is now set to cross Rs 16 trillion in FY27. Though the size of borrowing has increased over the years, as a percentage to GDP, it has remained largely in range... But SDL is becoming a burden. Before the global financial crisis, state loans were just 15-20 per cent of central borrowing every year. In FY27, these could be 75-80 per cent; and over the next few years, SDL may even exceed the centre’s annual borrowing. The oversupply of SDL has widened the spread between the yield of 10-year central government and state government papers to 85 basis points. Typically, it is about 40-50 basis points.

14. China is enhancing state capability by recruiting more tax officers to strengthen enforcement amid widening budget deficits. 

Central and local government tax departments plan to recruit 25,004 staff in 2026, accounting for two-thirds of the new bureaucrats to be appointed from among the millions taking part in fiercely competitive national exams, according to the state civil service administration. The plans mark a fourth successive year of heavy recruitment of tax officials, with the number of appointments set to marginally exceed a previous peak of 24,985 in 2023 to reach the highest level since at least 2012… Tax authorities have also announced moves to tighten tax enforcement and to scale back the use of corporate tax breaks by local governments… Authorities are also broadening the tax base by capturing more high-income earners, including those making capital gains on offshore equity investments… China’s tax revenues have fluctuated in recent years and fell 3.4 per cent year on year to Rmb17.5tn ($2.5tn) in 2024.

15. The rise and rise of Gold.

16. India mortgage housing market facts.

Housing accounts for 18 per cent of employment, making it the second-largest generator of jobs. It has deep linkages with more than 250 ancillary industries, creating powerful multiplier effects. Every investment in a housing unit generates 1.54 direct and indirect jobs and 4.05 induced jobs — much higher than employment multipliers in agriculture (0.8 and 1.2)... The average loan-to-value (LTV) ratio is a mere 65 per cent, compelling homebuyers to rely on other expensive borrowing sources for interiors and registration... less than 8 per cent of loan originations have an LTV greater than 80 per cent... even in a relatively safe asset class like mortgages, more than 75 per cent of lending is still to “prime” borrowers (bureau scores of 730 and above). The likelihood of a “near-prime” borrower (bureau score 650-700) getting a loan approval is just 40 per cent... housing finance to GDP ratio at 11-12 per cent is much lower than comparable economies.

17. What explains the weakness in East Asian currencies despite these countries running large surpluses, the general weakening of the US Dollar, and the smallest interest rate spread with the US in years?

Heavy buying of US assets, and concerns on how to fulfil the pledges from Japan, South Korea and Taiwan to invest $550bn, $350bn and $250bn in the US, and Sanae Takaichi's large spending plans are contributors. 

18. On the historic India-EU FTA deal.

Under the deal, Indian levies on EU cars will be gradually reduced from 110 per cent to 10 per cent, with a quota of 250,000 vehicles a year. Tariffs of up to 44 per cent on machinery, 22 per cent on chemicals and 11 per cent on pharmaceuticals will be mostly eliminated. Steel and iron levies of up to 22 per cent will also be phased out over a 10-year period... Tariffs of more than 36 per cent on EU food products will be reduced or removed, the bloc said, while those on wine will be slashed from 150 per cent to 75 per cent and eventually to levels as low as 20 per cent. Olive oil tariffs will also fall from 45 per cent to zero over five years. Those on processed agricultural products, such as bread and confectionery, of up to 50 per cent will be eliminated. In exchange, more than 99 per cent of Indian exports, worth about $75bn, will gain preferential entry status to the EU... The Indian dairy industry, a politically important constituency that New Delhi has sought to protect in the past, was excluded from the deal. Sensitive EU agricultural sectors, such as beef, chicken, rice, sugar and ethanol, were also carved out.

Individuals matter, and more so in public bureaucracies

I blogged here about the importance of strong public oversight and in-house expertise for the successful execution and management of infrastructure projects. 

Mainstream development discourse focuses disproportionately on institutional and systemic challenges, and overlooks the important role played by individual officials in effective public services delivery and the realisation of policy outcomes. 

Specifically, I am referring to the commitment and expertise of individual public servants in important positions at all levels of the government. By important, I’m not confining to leadership positions, but any position where they can make significant contributions to influence the agenda. 

The importance of individual officials in the success of development interventions is generally overlooked amidst systemic and institutional factors. This also comes from the belief that the success of development interventions is determined by good ideas, comprehensive planning, and rigorous monitoring. This theory of change overlooks the reality that successful development interventions tend to emerge iteratively over the course of their implementation. Such iteration, in turn, requires capable and committed leadership, especially important given weak state capabilities. 

In fact, it is no exaggeration to argue that capable, proficient, and committed officials are perhaps the most important ingredient of state capability. 

The importance of capable individual officials is also borne out by academic research. I blogged here, drawing attention to the work of Philipp Barteska and Jay Euijung Lee, who examined the impact of the bureaucratic capabilities (of export promotion officers) on the effectiveness of industrial policy in terms of export performance in South Korea. They found the following:

We exploit the three-yearly rotation of managers of South Korea’s export promotion offices in 87 countries between 1965 and 2000 to show that a one standard deviation increase in bureaucrat ability boosts exports by 37%. Under higher-ability bureaucrats, South Korean exports respond more strongly to a country’s import demand, suggesting a more effective transmission of market information.

An increase in exports by nearly two-fifths with just one standard deviation increase in bureaucratic capability tells us that the quality of officials might matter more than (or at least as much as) fiscal incentives and regulatory changes in trade promotion efforts. 

Alessandra Fenizia studied the impacts of managers in the public sector in Italy using a dataset containing an output-based measure of productivity. 

Exploiting the rotation of managers across sites, I find that a one standard deviation increase in managerial talent raises office productivity by 10%. These gains are driven primarily by the exit of older workers who retire when more productive managers take over. I use these estimates to evaluate the optimal allocation of managers to offices. I find that assigning better managers to the largest and most productive offices would increase output by at least 6.9%.

Cristobal Otero and Pablo Munoz study government managers in public health provision in Chile. 

Using novel data from public hospitals in Chile, we document that top managers (CEOs) account for a significant amount of variation in hospital mortality. We then use a staggered difference-in-differences design, and show that a reform which introduced a competitive selection system for recruiting CEOs in public hospitals reduced hospital mortality by approximately 8%. The effect is not explained by a change in patient composition and is robust to several alternative explanations. The financial incentives included in the reform—performance pay and higher wages—do not explain our findings. Instead, we show that the policy changed the pool of CEOs by displacing older doctors with no management training in favor of younger CEOs who had studied management. The mortality effects were driven by hospitals in which the new CEOs had managerial qualifications. These CEOs improved operating room efficiency and reduced staff turnover.

Michael Carlos Best, Jonas Hjort, and David Szakonyi analyse data on public procurements in Russia and find the value of bureaucratic effectiveness. 

Using data on 16 million public purchases in Russia, we show that 39 percent of the variation in prices paid for narrowly defined items is due to the individual bureaucrats and organizations who manage procurement. Low-price buyers also display higher spending quality. Theory suggests that such differences in effectiveness can be pivotal for policy design.

R D Metcalfe, A B Sollaci, and C Syverson

In this setting, managers move between stores but management practices are set by firm policy and largely fixed, allowing us to hone in on managers’ personal roles in determining store performance. We find: (i) managers affect and explain a large share of the variance of store-level productivity; (ii) negative assortative matching between managers and stores, which may reflect both firms’ decisions and a selection-driven bias that we characterize and argue might apply in other settings using movers designs; (iii) managers who move do so on average from less productive to more productive stores; (iv) female managers are less likely to move stores than male managers; (v) manager quality is generally hard to explain with the observables in our data, but is correlated with the ratio of full-time to part-time workers; (vi) managers who obtain high labor productivity also tend to obtain high energy productivity, revealing some breadth in managers’ skills applicability; (vii) high-performing managers in stable growth times are also high-performing during turbulent times; and (viii) exogenous productivity shocks improve the quality of initially low quality managers, suggesting managers can learn. We explain implications of these findings for productivity research.

Ricardo Dahis, Laura Schiavon, and Thiago Scot investigated the performance of state judges in Brazil. 

We investigate this question focusing on state judges in Brazil. Exploring monthly data on judicial output and cross-court movement, we estimate that judges account for at least 23% of the observed variation in number of cases disposed. With novel data on admission examinations, we show that judges with higher grades perform better than lower-ranked peers. Our results suggest competitive examinations can be an effective way to screen candidates.

On a slightly different note, Kevin Hawickhorst shows how technical expertise built up within public systems in the US allowed for the nurturing and flourishing of capable officials, created public confidence, and thereby enhanced the credibility of governments. 

However, over time, expertise has come to be crowded out due to the conscious shift in the way government bureaucracies came to be organised. 

At the turn of the twentieth century, agencies followed a distinct blueprint: they were organized by subject matter, not by abstract function. Each bureau focused on a single domain—such as soils, mines, or forests—and combined research, regulation, and grants under one roof. In the U.S. Department of Agriculture (USDA), the Bureau of Entomology, for example, studied insect-borne diseases, issued rules to contain them, and funded farmers to protect their crops, all as part of a single mission. This structure helped agencies recruit experts by offering broader, more meaningful work than corporations could, and it built a shared sense of mission rooted in a vocational community.

Today’s agencies look very different. After World War II, reformers dismantled the integrated subject matter bureaus and reorganized government along what they called “functional” lines. In this system, regulation is one bureau, research another, and grant administration still another; each bureau covers a wide range of subjects and is defined by its activity rather than its mission. It is the model we now take for granted. The Bureau of Entomology is gone, and USDA now houses all agricultural research in a single unit. New agencies were built this way from the outset: the Department of Housing and Urban Development, created in 1965, was designed as a grantmaking machine, never a vocational community.

The shift was a well-intentioned one and backed by a wide coalition of reformers, businessmen, and interest groups. Functional departments looked modern, rational, and efficient: they simplified charts, tightened chains of command, and promised to reduce duplication. But what seemed like sensible reform gradually hollowed out the structures that had made expertise durable. Once government agencies lost their vocational missions, they stopped drawing on networks of expertise and started looking like paper mills, less able to command political respect, and more vulnerable to capture and drift… logic of the Progressive-era model: that research and administration had to remain intertwined within a unified mission if expertise was to thrive.

However, this wealth of internal technical expertise has, over time, given way to the tribe of generalist managers. 

The core mistake was a shift in what we thought expertise was. The Progressive reformers built vocations that were tied to missions, visible to the public, and legible to politicians. Their successors redefined expertise as a credential: the knowledge of process rather than mastery of a craft. To businessmen and academic reformers alike, competence meant general managerial skill, not professional vocation. As this view took hold within the bureaucracy, “expertise” came to mean knowing the procedures rather than knowing the work. We have traded the civil engineer and the entomologist for the program analyst, the management consultant, and the diversity officer—experts who know how to manage the process but not how to do the work.

This redefinition of expertise hollowed out our idea of representation. We now equate representation with participation and diversity, as if the state were legitimate only when citizens can see themselves in its officials. The Progressives, by contrast, recruited from the country’s varied vocations and made that work visible to the nation. Expertise was representative not because it resembled the public but because it served the public, visibly and competently… Their institutions were built to make expertise endure, by recruiting promising candidates from vocational schools and professional societies, dressing them in uniform, and sending them to work alongside state engineers, agricultural agents, and university researchers…

The Navy cannot build ships. In 1940, faced with the same problem, Congress did the obvious: it created a Bureau of Ships, put engineers in charge, and got ships built. That bureau is gone, and we treat its return as unthinkable. Yet the remedy remains the same. If we want ships, we should once again have a Bureau of Ships to build them… Repairing our institutions will ultimately require returning to the vocational conception of expertise… We have built institutions that valorize process in place of vocation, producing a bureaucracy that neither embodies skill nor commands respect. What matters now is not saving “expertise” in the abstract but rebuilding the institutions where it can serve visibly and credibly.

Hawickhorst’s essay points to several individual public leaders in the US who built institutions and brought credibility and confidence in public agencies through their careers - George Uhler (headed Steamboat Inspection Service for 20 years from 1903), Logan Page (Office of Public Roads, founded in 1905), Joseph Kinyoun (headed the Hygienic Laboratory, a precursor to the National Institutes of Health), and Gifford Pinchot (founded the Forest Service). Every country has such leaders across levels. 

In their search for better outcomes in public policy, governments tend to expend effort and resources on interventions involving financial support, regulatory enablers, and technology adoption, while overlooking personnel choices. This bias is also reflected in public commentary and academic research that shapes public narratives. 

However, as the case of the South Korean export promotion officers starkly demonstrates, for governments intent on reform and impact, personnel choice decisions may be the lowest-hanging fruit. In most policy areas, the range between the opportunity cost of a bad personnel choice and that of a capable personnel choice may be much greater than that for any other policy intervention.

The private sector addresses the issue of the importance of capable individuals by incentivising them with extrinsic material motivations like financial rewards and fast-tracked promotions. While neither of these instruments is available to governments, it can appeal to the intrinsic motivation of public-spirited officials. 

This would require acknowledging capabilities and merit (as borne out strictly by performance track record, not merely in some narrow quantitative sense). This requires differentiating capable bureaucratic leaders from their larger peer group by entrusting them with higher responsibilities, appointing them to identified important positions, drawing on their expertise in various forms, recognising their work through different non-financial channels, and generally signalling their differentiation. 

An explicitly professed intent, let alone a rigorously implemented process, that seeks to differentiate among officials at all levels, can be a powerful force to shape expectations and align incentives within public systems.

Market failures in deep tech markets

There’s a fundamental competition problem in markets where network effects (e.g., the platforms offered byAmazon, Google, and Meta) and/or technological path dependencies (e.g. Nvidia’s constantly evolving versions of ever more sophisticated GPUs) create rising entry barriers and confer ever-widening competitive advantage, and where accordingly companies are incentivised to deepen their moats and keep expanding their market shares.

As an illustration, the Dutch lithography behemoth, ASML, may have the deepest and broadest moat among firms in any industry. 

Even in an industry with dominant or near-monopolistic firms - Nvidia in the design of chips that run AI applications, TSMC in the fabrication of processing chips, and Samsung and SK Hynix in high bandwidth memory (HBM) chips - ASML stands out. Consider the extent of its monopoly.

ASML sells just over 40 of its most advanced chipmaking machines each year. For over a decade, investors questioned whether such limited volumes could ever add up to a viable business. Those doubts have aged badly. After an 80 per cent rise in its share price over the past six months, ASML is now valued at more than $500bn... It is the only company that can make the extreme ultraviolet lithography machines required to produce those advanced chips. Each one has a starting price of $220mn and there is no commercially credible alternative supplier... In most industries, a monopoly this profitable — ASML’s gross profit margins were 52 per cent in the third quarter — would attract competition, especially from regions that already lead in related technologies.

What explains this monopoly?

The technology behind EUV machines is a chain of almost impossible steps, all of which have to work at the same time. Modern chips are made by printing patterns, layer by layer, on to silicon using light. To do this, engineers first need to create a form of light that does not occur naturally. Powerful lasers are fired at microscopic droplets of molten tin, turning them into plasma hotter than the surface of the Sun. That creates a pulse of extreme ultraviolet light, which is then reflected off a series of mirrors, each made with atomic-level precision and taking months to make, before the pattern is finally transferred to the silicon wafer. The hardest part to replicate is the optics. EUV-grade mirrors are produced by a single supplier: Carl Zeiss SMT. They are the product of decades of tightly integrated development between Zeiss and ASML.

Even if a peer could replicate that technology, the economics do not work. Any new entrant would sell too few machines each year to recover development costs, yet those machines would still be expected to deliver near-perfect reliability from day one. Chip fabrication plants operate continuously… As a result, chipmakers are unwilling to experiment with unproven EUV tools in volume production. That means a rival would never accumulate the field data required to improve. 

ASML shipped its first EUV machine in 2006 and its first production capable system in 2013. Because chip factories run around the clock, cumulative operating hours now run into the millions. That gap in real world operating data explains why Nikon and Canon, once ASML’s peers in lithography, ultimately withdrew from pursuing EUV lithography systems over a decade before it became commercially viable, and why no successor has emerged since their exit… ASML shows how, beyond a certain technological threshold, markets no longer correct monopolies.

ASML may be the most egregious illustration of a pervasive market failure in deep technology markets, arising from innovation-induced moats. 

This moat is a result of the structural characteristics of the technology that creates a dynamic natural monopoly, arising from a combination of a long period of co-evolution with suppliers and customers, unmatchable accumulated R&D and tacit knowledge, high capital intensity and irreversibility (once invested, exit is costly and entry is irrational), and very long time horizons. In fact, the entire semiconductor chip design-to-fabrication value chain, including the equipment used, can be considered a stack of interlocking monopolies. 

It is therefore unsurprising that this is the only major market where China has struggled to make a breakthrough. All the dominant firms are either US, European, or Japanese. 

Such market failures are true across deep technology markets - commercial aircraft (Boeing/Airbus), jet engines (GE Aerospace, Rolls-Royce, Pratt & Whitney), electron microscope (Thermo Fisher Scientific, JEOL), industrial automation (Siemens, Rockwell Automation), etc. 

Traditional anti-trust measures are unlikely to be effective in addressing market failures arising from the structural characteristics of the technologies involved. As the Chinese are finding out, even throwing massive amounts of money can do little to cross the moats.

In addition to the moats created by the structural characteristics of the technology itself in these deep tech products, the manufacturing of major components for these products is also protected by daunting entry barriers arising from the market structure. 

Take semiconductor chip design, say, for a market for System on Chips (SoC) for various digital equipment (laptops, cameras, mobile phones, telecom equipment, etc.). This market is dominated by the likes of American (Qualcomm and Broadcom) and Taiwanese (Mediatek and Realtek) SoC designers. The OEMs in this market, themselves large multinational incumbents, are locked into close long-term partnerships with one or other of these companies. 

Even if a new chip design startup assembles a solid team and does tapeouts of an SoC that can be readily deployed in a device, it would still need an OEM to deploy the same. However, the OEM, which has a well-established supply chain, would have limited incentive to risk the experiment of trying out a brand-new supplier for any component, much less a critical one like the SoC. The OEM’s concerns are understandable given that it would require deep and mature institutional capabilities for the supplier to respond swiftly to rapidly evolving technologies and standards (for example, in telecommunications, a new 3GPP release happens every 6-12 months) and the resultant demands of the OEM. 

This is a problem not just to SoC but to any chip, or any other sophisticated electronic component, where moats are high. The net result is that breaking into this market becomes almost impossible. Since component manufacturing is generally an essential requirement to catalyse product manufacturing, barriers to the former end up further entrenching incumbents in the latter. 

It is relevant here that Chinese firms have made some headway in these markets. Their breakthroughs have come by riding on a wide base of domestic OEMs. In their quest to diversify away from the Western chip firms and lower their costs by leveraging their massive volumes (also from their ever-expanding export volumes), they had the incentive to bet long-term on domestic chip design firms. As a practice, starting with a small share of their overall requirement, they gradually increase the share of their sourcing from domestic chip firms. The massive subsidies and the strong push by the Chinese state to nurture indigenous firms have facilitated this process. 

The chip design firms, too, have generally started with a less sophisticated version of chips, developed capabilities and moved up the value chain into more sophisticated versions. 

As an example, by privileging a Chinese 3G standard, Beijing forced carriers and vendors to adopt equipment and handsets that supported it — creating immediate, captive volume for domestic baseband suppliers. That is a strong example where a regulatory mandate (a standard) directly created market share for local firms.

So what can be done to lower the moats and enable entry in some of these markets?

In these markets, where moats are so deep and wide, industrial policy actions by way of financial incentives (subsidies) to lower entry barriers may struggle. How much incentive is adequate to bridge the disability faced by domestic chip firms? How will it help open up the platforms of OEMs to the new chip design firms? There are hard limits to how much support can be given by fiscally constrained governments.

Therefore, in some of these markets, notwithstanding their distortionary risks, hard constraints by way of mandates may be required to break the entrenched market equilibrium of dominant foreign OEMs and their suppliers. These mandates can take the form of domestic content rules, public procurement preferences, and standards.

These mandates must be carefully designed and implemented to minimise market distortions and inefficiencies. It may be advisable to start the domestic mandate with a small percentage of sourcing, and that too in components where local capability is plausible, and by allowing tradeable compliance credits (firms unable to source locally can buy credits that fund supplier development). There should also be sufficient safeguards in terms of waivers and emergency provisions that allow temporary exceptions. Most importantly, the mandates should be administered transparently and closely monitored to make course corrections if required.

For sure, these mandates can only create some initial market access and cannot work on their own. They must be complemented with industrial policy incentives, patient risk capital, supply-chain development, and commercial incentives for OEMs. And even with all these, it can be effective in facilitating entry only to a few deep tech market segments.

Alliances and coalitions in the new world order

Mark Carney delivered the speech for the times at Davos. It is a brilliant description of the challenges facing the international order in times of intensifying great-power rivalry, due to a declining hegemon and a rising superpower, and articulates a prudent yet values-based way forward. 

It is highly relevant to middle powers like India. 

The speech hangs on Vaclav Havel’s analogy of the greengrocer’s myth to explain how the communist system sustained itself, and how the rules-based international order has sustained itself so far despite its obvious observed deficiencies.

Every morning, this shopkeeper places a sign in his window: ‘Workers of the world unite’. He doesn’t believe it, no-one does, but he places a sign anyway to avoid trouble, to signal compliance, to get along. And because every shopkeeper on every street does the same, the system persist – not through violence alone, but through the participation of ordinary people in rituals they privately know to be false.

Havel called this “living within a lie”.

The system’s power comes not from its truth, but from everyone’s willingness to perform as if it were true, and its fragility comes from the same source. When even one person stops performing, when the greengrocer removes his sign, the illusion begins to crack. Friends, it is time for companies and countries to take their signs down.

Carney describes the rules-based international order as a similar lie, a fig-leaf for countries to “pursue values-based foreign policy”, though they knew that the “strongest would exempt themselves when convenient”, “trade rules were enforced asymmetrically”, and “international law applied with varying rigour depending on the identity of the accused or the victim”. 

This fiction was useful, and American hegemony, in particular, helped provide public goods, open sea lanes, a stable financial system, collective security and support for frameworks for resolving disputes. So, we placed the sign in the window. We participated in the rituals, and we largely avoided calling out the gaps between rhetoric and reality. This bargain no longer works. Let me be direct. We are in the midst of a rupture, not a transition.

Over the past two decades, a series of crises in finance, health, energy and geopolitics have laid bare the risks of extreme global integration. But more recently, great powers have begun using economic integration as weapons, tariffs as leverage, financial infrastructure as coercion, supply chains as vulnerabilities to be exploited. You cannot live within the lie of mutual benefit through integration, when integration becomes the source of your subordination.

The speech makes the case for building alliances to preserve strategic autonomy and sovereignty, but one underpinned by shared values. 

Collective investments in resilience are cheaper than everyone building their own fortresses. Shared standards reduce fragmentations. Complementarities are positive sum. And the question for middle powers like Canada is not whether to adapt to the new reality – we must. The question is whether we adapt by simply building higher walls, or whether we can do something more ambitious… And our new approach rests on what Alexander Stubb, the President of Finland, has termed “value-based realism”.

Or, to put another way, we aim to be both principled and pragmatic – principled in our commitment to fundamental values, sovereignty, territorial integrity, the prohibition of the use of force, except when consistent with the UN Charter, and respect for human rights, and pragmatic and recognizing that progress is often incremental, that interests diverge, that not every partner will share all of our values.

So, we’re engaging broadly, strategically with open eyes. We actively take on the world as it is, not wait around for a world we wish to be. We are calibrating our relationships, so their depth reflects our values, and we’re prioritizing broad engagement to maximize our influence, given and given the fluidity of the world at the moment, the risks that this poses and the stakes for what comes next. And we are no longer just relying on the strength of our values, but also the value of our strength. We are building that strength at home… 

To help solve global problems, we’re pursuing variable geometry, in other words, different coalitions for different issues based on common values and interests… This is not naive multilateralism, nor is it relying on their institutions. It’s building coalitions that work – issues by issue, with partners who share enough common ground to act together… What it’s doing is creating a dense web of connections across trade, investment, culture, on which we can draw for future challenges and opportunities. Argue, the middle powers must act together, because if we’re not at the table, we’re on the menu.

This is a summary of the way forward

This is not sovereignty. It’s the performance of sovereignty while accepting subordination. In a world of great-power rivalry, the countries in between have a choice – compete with each other for favour, or combine to create a third path with impact… It means acting consistently, applying the same standards to allies and rivals. When middle powers criticize economic intimidation from one direction, but stay silent when it comes from another, we are keeping the sign in the window… And it means reducing the leverage that enables coercion – that’s building a strong domestic economy. It should be every government’s immediate priority. And diversification internationally is not just economic prudence, it’s a material foundation for honest foreign policy, because countries earn the right to principled stands by reducing their vulnerability to retaliation.

There is no disputing the need for middle-powers to build alliances and coalitions. Apart from the innate coordination problems with building such alliances, there are at least three other challenges with the pursuit of such a foreign policy. 

First, there’s a difference between the pursuit of such policies that are built predominantly on opportunism and less on shared values. Therefore, for example, it should not be about embracing principles on anti-terrorism, or the inviolability of national borders, or the promotion of free trade, or the protection of human rights, but only when convenient, and condoning their egregious violation otherwise. There’s a difference between realpolitik and values-based realism. The big powers can pursue the former (they are expected to), but when practised by the middle-powers, the hypocrisy becomes too evident. And in the repeat game of international politics, it erodes national credibility. Non-alignment may have been a good example of values-based realism.

Second, such alliances and coalitions are built on accommodation involving mutual give and take. It’s about “shared sovereignty”. Core interests cannot be compromised, but secondary interests can be. Compromise is also not a binary choice, but in shades of grey and white. In any case, a country cannot share in the benefits of an alliance without a willingness to assume its costs. China’s hypocrisy on international trade becomes egregious since it only wants a one-way street - access to export markets while systemically restricting and disincentivising imports. 

Finally, such values-based accommodation becomes impossible when foreign policy becomes another instrument for projecting nationalism and populism. A fundamental tension envelopes when this genie is out of the bottle. Populist rhetoric constrains an already limited policy choice space available for diplomats and makes any kind of accommodation an acknowledgement of weakness, provoking accusations of being a traitor. There’s a reason why foreign policy has traditionally been pursued outside the glare of publicity. However, if the genie is out of the bottle, it might well be impossible to put it back in for some time.

Middle powers must take cognisance of these challenges and tailor foreign policies and their contexts accordingly. 

In a more realpolitik sense, it is also prudent for middle powers, for generally everyone other than the big powers, to follow Chinese President Jiang Zemin’s dictum that China adhered to for a long time, “hide your strength, bide your time” (Taoguang Yanghui). 

PS: While Mark Carney was statesmanly and his extraordinary speech rightly went viral, Belgian Prime Minister Bart De Wever was equally forthright and brave:

“So many red lines have been crossed [by Trump] . . . Being a happy vassal is one thing. Being a miserable slave is another. If you back down now, you are going to lose your dignity and that is probably the most valuable thing you can have in a democracy.”