The importance of human capital investment and the account of its delivery

From a Policy Note made for the Government of India in 1955 by Milton Friedman (HT: Sanjaya Baru)

In any economy, the major source of productive power is not machinery, equipment, buildings and other physical capital; it is the productive capacity of the human beings who compose the society. Yet what we call investment refers only to expenditures on physical capital; expenditures that improve the productive capacity of human beings are generally left entirely out of account. In the United States, for example, only about one-fifth of the total income is return to physical capital, four-fifths to human capital. By this writer's estimate similarly, only about one fifth of the annual rate of growth in the United States can be attributed to the direct effects of investment in the usual sense; four-fifths must be attributed to the growth in the productivity of human beings. Annual expenditures on improving the quality and quantity of human resources are at least as large as and perhaps much larger than investment as usually defined. Destroy the physical plant of the United States and leave the skills of the people and it would take but a few years to restore the initial position. Destroy the skills and leave the plant and the level of output would sink irretrievably. The cathedrals of medieval Europe, the pyramids of Egypt, the monuments of the Moghul empire in India are all testimony to the possibility of a high rate of investment in physical capital without a growth in the standard of living of the masses of the people. These considerations are especially important for India, precisely because its frontier is the frontier of technical knowledge and skill.

This is not to deny in any way the desirability of investment in physical capital. It is certainly highly important and is to some measure an indispensable concomitant of the development of human capital. But it is not the whole or even the most important part of the story. The danger is that concentration on it may lead to policies that increase physical investment at the expense of investment in human capital; and even within the area of physical investment, may lead to increases in the kind of physical investment that we can measure at the expense of kinds that we cannot measure. We must be aware lest we become the victims of our statistical creations.

This is brilliant writing. Clear and elegant articulation of one of the most important overlooked realities of macroeconomic policy making globally.  

And it's perhaps even more relevant as a policy brief for India today than it was then. 

Investments in human capital suffer from problems at least three levels, thereby making it less attractive for all stakeholders concerned. All of them have to do with the qualitative and long-drawn nature of investments in human capital.

On the political side, while the physical components of investments in human capacity are a political good, the same cannot be said about the quality of the service delivered. So for, example, have we come across villagers complaining that the quality of instruction in their schools is poor? Or that the doctor does not ask enough or relevant questions or spend enough time to do the right diagnosis and provide the correct treatment?

On the bureaucratic side, while the physical components of buildings, equipment, personnel, and other inputs are measured using the standard accounting system, the same cannot be done for quality of service delivery on education, skilling, health care, sanitation, nutrition etc. Even when they focus on quality, it becomes confined to the accounting of quality, which in all these cases suffers from several limitations. So both the politician and the bureaucrat gloss over the quality side and focus on the inputs. 

The citizen (or customer of the public service) struggles for various reasons to go beyond the physical components. In most cases, there are no easily comprehensible measures of the quality that are quantifiable, connected to some practical desirable benchmarks, and credibly measured. In these circumstances, the citizen's expectations are left anchored around inputs. Compounding matters, there are some distracting measures of perceived quality that generate perverse incentives - perception of English fluency, excess use of diagnostics and medications, doing IT skilling courses etc.

It's for this reason that I'm increasingly convinced that any meaningful reform efforts in sectors that are human engagement intensive, and involve quality or behaviour change necessarily require systemic efforts. The traditional accounting based implementation has to be complemented by the building of a narrative around the account. Without this, all accounting efforts, using the best of technologies and most intense monitoring will merely be a band-aid on the gangrene.