Why Economy melt down !!!

The Economic Base Theory (EBT), owing its origins to the debate between Charles Tiebout and Douglass North, provides a useful framework to understand the Indian growth story and predict future growth prospects. North argued that an exogenous world demand creates direct, indirect, and induced effects and leads to local political, economic, and social growth. Moreover, government decisions, investment decisions (e.g., housing) at least in the short-run, and export decisions may lead to the outside demand.

The direct effect is the initial immediate effect of the demand on output, employment, or income. For instance, output in the manufacturing sector will increase by, say, $5 million to meet the increased export demand of $5 million. To meet this additional output the manufacturing sector has to buy additional inputs from other industries, pay additional salaries to households, or import additional goods and these changes in output, employment, and income that occur as a result of the direct effect are called the indirect effect. Another round is the induced effect and measures the increase in household incomes and spending caused by the direct and indirect effects.


Moreover, the direct effect stimulates the economic base, or export sector; in contrast, the indirect and induced effects exist only to serve the basic sector. The EBT and the simple Keynesian model differ slightly. In the EBT the endogenous flow remains consumption, redefined now as “domestic expenditures”, which ignores savings and hides investment expenditures within it. Furthermore, external demand, the driver of the economy, assumes the function of investment in the Keynesian model.

Positive, high correlation between foreign direct investment inflows and India’s GDP growth provide some evidence for the operation of the EBT. During the last five years the aggregate FDI inflows have increased nearly seven times from Rs 95,639 crore in 2003 to Rs 6,54,949 crore in 2007. The service sector has the largest share (22%) followed by the software industry accounting for 15.6%. GDP growth rates show a corresponding increase — an average of 9.3% during the three years ending March 2008, compared with an average of 6.6% and 6%, respectively, in the preceding three and five years.


India’s rise as a dominant actor in the service outsourcing sector is partly explained by the Theory of the New International Division of Labour, associated with Frobel. Technological advances permitted splitting of production processes and China became a manufacturing centre, followed by the spread of information technology, during the 1990s, and the main beneficiary was India. Additionally, India was well placed to derive the full benefits of globalisation due to an unintended convergence of events.


First, India was fortuitously placed twelve hours away — while the west slept, India worked. Second, the Y2K scare focused research attention on IT and led to the creation of tools that accelerated services outsourcing. Third, privatisation of higher technical education during the 1990s fulfilled the desire of Indian parents to make their children engineers, ensuring that sufficient numbers of willing technical personnel were available to work in the IT sector.
When will the world demand revive again? Analysis of the depth and duration of 14 ‘severe’ meltdowns by Kenneth Rogoff and Carmen Reinhart provides some insights into the possible timeline for demand regeneration. The sample includes the depression, the recent ‘big five’ crises in the developed world (e.g., Norway — 1987, Japan — 1990s); and crises in emerging-market economies. Generally, financial crises are long-drawn out affairs.