The State and Economic Development

Paul Jasper Student ID: 548084 MSc Development Economics Department of Economics School of Oriental and African Studies, London January 11, 2012

Course: 15PEC007: Growth and Development Tutor : Mushtaq Khan Assignment:

Does the framework of market failure and binding constraints provide an adequate guide for determining the functions of the state in sustaining growth?

Introduction: The Puzzles of Economic Growth

One of the central questions development economics has been concerned with in the past decades, is what accounts for the dierences in economic growth between countries and how policies can be devised to accelerate it. Clearly, these dierences in growth patterns exist. For example, in the 1990s, Sub-Saharan Africa experienced only slight growth as opposed to e.g. East Asia. (See Figure 1) Similar results can be shown when looking at longer time horizons or more segregated and detailed data. (World-Bank, 2005) Hence, divergence in relative productivity levels (. . . ) is the dominant feature of modern economic history. (Pritchett, 1997, p.32)

Figure 1: Growth in the 1990s. Source: World-Bank (2005)

In addition, few countries have shown stable growth paths over time, 2

but instead alternating phases of growth, stagnation and decline. (Pritchett, 2000) In fact, achieving rapid growth for a limited period of time has not been uncommon for many countries. As Hausmann et al. (2005) show, this suggests that achieving rapid growth over the medium term is not something that is tremendously dicult and it is well within most countries reach. (Hausmann et al. , 2005, p.316)

The main issue concerning economic growth in developing countries hence is how to sustain it at suciently high levels over a signicant period of time. In fact, the group of todays advanced capitalist economies consists of countries that have shown a narrow range of moderately low and stable growth rates over long periods of time. (Pritchett, 1997)

As the above evidence suggests, however, few economies have achieved this exercise of catching-up so far: Out of 117 countries with populations of more than half a million people, only 18 have been able to sustain growth rates exceeding industrialized countries growth . . . (World-Bank, 2005, p.5) To reduce dierences in income sustainably, developing countries therefore need to solve two puzzles: First, how to kick-start growth and create economic dynamism that exceeds developed countries levels. Second, how to sustain this dynamism so that a transition can happen towards an advanced capitalist economy with stable and continuos per capita growth and technological progress. 3

The Washington Consensus

The most prominent answer to the above challenge for developing countries was, propagated during the 1990s and early 2000s, a set of policies termed the Washington Consensus. Originally formulated by Williamson (1990), it can be summarized as promulgating the following to poor countries: get your macro balances in order, take the state out of business, give markets free rein. (Rodrik, 2006, p.973) Table 1 provides a more detailed overview of these prescriptions.

Hence, during the 1990s, a variety of states adopted related policies. However, due to unsatisfactory results in many countries, the consensus after this decade of reform is that the Washington Consensus has failed in promoting growth. (World-Bank, 2005) Yet, not everywhere stagnation reigned. As shown in gure 1, East and South Asian economies experienced rapid growth throughout the 1990s. However, these countries did not implement the Washington Consensus: . . . , their policies remained highly unconventional (. . . ), these two economies hardly looked like exemplars of the Washington Consensus. (Rodrik, 2006, p.975) In sum, the 90s showed bad outcomes for Washington Consensus policies, and good outcomes for unconventional policies implemented by countries mainly in East and South-East Asia. This led 4

Table 1: The Washington Consensus. Source: Williamson (2000) Fiscal discipline A redirection of public expenditure priorities toward elds offering both high economic returns and the potential to improve income distribution, such as primary health care, primary education, and infrastructure Tax reform (to lower marginal rates and broaden the tax base) Interest rate liberalization A competitive exchange rate Trade liberalization Liberalization of inows of foreign direct investment Privatization Deregulation (to abolish barriers to entry and exit) Secure property rights

economists to explore alternative explanations for sustainable growth and eective economic policies.

The First Alternative: Institutions

One of the main responses to the failing of development policy in the 1990s was the idea that the Washington Consensus was in principle right, but its implementation faulty. Basically, according to this approach, governments in developing countries meant well, tried little, failed much.(Krueger, 2004) 5

This led to two conclusions: First, policy-makers in developing countries were not committed enough to the reform package. (Rodrik, 2006) Second, commitment alone was not enough for the reforms to be successful. Even if the above mentioned policy package was implemented, it might still not work because background institutions were performing poorly: Regulatory and supervisory institutions in product and nancial markets proved too weak. Poor governance and corruption remained a problem. (. . . ) Sound policies needed to be embedded in solid institutions. (Rodrik, 2006, p.976 .)

In the empirical literature, two ndings tried to provide evidence for such institutions. First, Kaufmann et al. (1999) and the Governance Matters papers showed a strong positive relationship between income and their governance indicators.1 (See Figure 2.) According to the authors, this implied that there is a large payo in terms of per capita income to improvements in governance. (Kaufmann et al. , 1999, p.15) Second, Acemoglu et al. (2000) found that, in the long-term, dierences in institutions, mainly dened as security over property rights and constraints on the executive, account for a mayor part of cross-country dierences in income.2

The central conclusion following this argumentation therefore is that the

Note that Kaufmann et al. (1999) dene Governance as the traditions and institutions by which authority in a country is exercised.(Kaufmann et al. , 1999, p.1) 2 See also Acemoglu et al. (2002).
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Figure 2: Governance and Per Capita Incomes. Source: Kaufmann et al. (1999)

Washington Consensus needs to be replaced by an enhanced version of itself. Hence, developing countries should try to provide the right environment for economic activity, basically the one existing in the developed nations of the world, and continue to pursue liberal and market friendly reforms. The result would be accelerated and stable growth.3
Note that another alternative view on how to achieve growth and development is the Big Push approach, advanced by Jerey Sachs and the U.N. Millennium Project. See Rodrik (2006, p.980 .) for an overview.
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The Second Alternative: Market Failures, Most Binding Constraints and Growth Diagnostics

Besides problems with the empirics of the above approach, the main criticism brought forward against it is its laundry-list view on policies states should implement. In the extreme, the list of institutional preconditions is open ended and could lead to policy prescriptions that are dysfunctional.(Rodrik, 2006) To avoid this pitfall and to provide an alternative, Hausmann et al. (2007) develop a concept that tries to focus reforms on specic market failures in developing countries, so as to get the biggest pay-o of feasible reforms.

4.1

Market Failures

Hausmann et al. (2007) base their analysis on the assumption that the main reason for low growth and underdevelopment are market imperfections.The identication of market failures as a severe problem for underdevelopment is not new. Historically, and from an allocative perspective, Economists dened market failures as situations where a market does not provide for the ecient allocation of goods and services. (Bator, 1958) Besides this allocative failure 8

of markets, other authors have pointed possibility of creative market failures that constrain the creative dynamism of an economy. In the extreme, market failures can lead to the nonexistence of markets.

What causes market failures? Generally, markets fail to produce ecient outcomes when the costs of participating in this market, i.e. the transaction costs, are too high. (Arrow, 1969) Transaction costs can take dierent forms, such as costs of gathering information, enforcing contracts, excluding freeriders, etc. More specically, dierent transaction costs can be too high for individual agents, in diering circumstances and in very dierent markets. Stiglitz (1989) provides some theoretical perspectives on this heterogeneity.

Market failures exist both in developing and developed economies. However, the general consensus in the literature is that markets work even less well, and institutions that might help to solve these failures are less successful, in developing countries. (Stiglitz, 1989; Arndt, 1988) Therefore, the problem of market failures is more severe there.

4.2

Most Binding Constraints and Reforms

Hausmann et al. (2007) assume such a relationship between market failures and growth in order to develop their approach to policy reform. In their model, market failures drive a wedge between private and social valuations of specic economic activities. (Hausmann et al. , 2007, p.5) This leads 9

to underinvestment, economic underperfomance and a distorted economy. These distortions constrain policy-makers in their eort to maximize social welfare: in a general equilibrium environment, any distortion in one activity also aects all other economic activities in the economy.

This therefore translates into a second-best complication for reforms. If a social planner wants to remove one distortion, i.e. tackle a market imperfection, the result on the social welfare consists of two eects: First, the direct unambiguous positive eect of the reformed distortion. Second, an interaction eect of the reform with all other distorted economic activities:

Change in Social Welfare = Direct Eect + Interaction Term.

The problem for policy making is ambiguous interaction term. It might be positive, but might also be negative. Clearly, if it is negative and larger than the direct eect, the economy is worse o after removing the initial market imperfection. (Hausmann et al. , 2007)

In such an environment, choosing the right reform strategy is dicult. Hausmann et al. (2007) suggest to prioritize reforms on the biggest direct eect that will result from the reform. This strategy has two obvious advantages: First, policy makers get the biggest direct positive pay-o from the reform. Second, since the direct eect is likely to be big, the relative 10

importance of the interaction term diminishes and reformers need to worry less about it.

4.3

Growth Diagnostics

How can these most binding constraints be identied? Hausmann et al. (2007) develop a diagnostic approach, to show that it is possible to identify the most binding constraint in an economy.4 They start with a simplied growth model which assumes that growth depends on two main factors: high expected return to private capital and low cost of nance.

Hence, if an economy is underperforming, this must be either because the expected private return of asset accumulation is low (. . . ) or because the cost of funds (. . . ) is high.(Hausmann et al. , 2008, p.19) These broad constraints, when identied, can then be further split into more precise constraints. If in the rst case the problem were low expected returns to asset accumulation, the question would be whether this was due to low appropriability of returns or low social returns. Again, this could be split into more precise causes, moving down a diagnostic tree as depicted in gure 3.

As a result, after cautious analysis of the current state of the economy, policy makers could identify the most binding constraint and target reforms
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See also Rodrik (2006, 2007) and Hausmann et al. (2008) for this approach.

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Figure 3: The Growth Diagnostics Tree. Source: Hausmann et al. (2008)

accordingly. (Rodrik, 2006)

Critique: Is this the adequate response to the Washington Consensus?

On the rst sight, the Growth Diagnostics approach has some promising features for the analysis of developing economies and for the formulation of policy prescriptions. It avoids, rst, the spray-gun procedure of both the Washington Consensus and the Institutions approach. Second, the approach builds on a solid theoretical backing from the market failure literature and on the empirical nding that growth accelerations 12

among developing countries are not extremely rare. It is plausible that market failures inhibit economic dynamism and that removing them can have potentially large short-term positive eects on growth. Third, the approach induces both policy-makers and academics to think harder and in a more contextual manner about economic development and policies for growth. As opposed to the Washington Consensus or the Institutions approach, the diagnostics procedure asks for a detailed and customized analysis of the situation of each single economy.5

However, criticism has also ensued over several problems. In this regard, Felipe & Usui (2008) provide a comprehensive list of critical points. First, the approach focuses solely on economic growth and no other important policy objectives, such as e.g. environmental protection. Second, it is unclear wether capital accumulation and private investment are the only factors driving growth and development. Both ideas have been have been challenged both theoretically and empirically. (Felipe & Usui, 2008, p. 7 .)

Third, although the approach is very clear and straight-forward on a theoretical level, nding the most binding constraint in practice is complicated. Both price and non-price signals need to be analyzed and interpreted. In fact, prices might not necessarily reect constraints on growth. For examSee for example the twelve World Bank pilot studies of 2005. (Leipziger & Zagha, 2006)
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ple, as shown by Aghion & Durlauf (2007), low interest rates might exist in situations with tight credit supply. In addition, prices reect the current situation of the economy, but do not show what growth dynamics might ensue when a constraint is removed, i.e. the size of the direct eect on welfare of a reform. (Aghion & Durlauf, 2007) Non-price signals, in turn, are heavily dependent on the socio-political context of the economy. In-depth knowledge is necessary to interpret them. From my point of view, this implies two problems: First, the replicability of results is inhibited. Researchers might reach dierent conclusions dependent on their interpretation of the signals, a point also made by Felipe & Usui (2008). Second, the identication of the most binding constraint turns out to be a highly complex process that requires much ex ante knowledge and that inherently holds a high degree of uncertainty.

Fourth, as Felipe & Usui (2008) rightly point out, the approach rests on the assumption that the branches of the decision tree (Figure 3) are independent. However, growth and development are complex processes where many factors interact. The identication of one most binding constraint might not be the correct procedure. Therefore, while the Washington Consensus suffered from its generality, the Growth Diagnostics approach might suer from too much singularity. Besides these methodological problems, two more fundamental critiques need to be made. 14

Sustainability As mentioned above, one of the central problems developing countries need to solve in order to reach higher income levels is to sustain economic dynamism and growth over longer period of times. Rodrik (2006) acknowledges this, saying that the nature of binding constraints changes over time, and in particular after reforms have been implemented. Hence, institutions are needed to respond to this and to sustain growth. However, according to the author, economic science typically provides very little guidance on how to proceed. (Rodrik, 2006, p.986) The problem is that the Growth Diagnostics approach does not provide any answer either. It does not give details on how the transition from an initial reform to an institutionalization of economic governance which sustains growth could be designed. The Role of the State Roughly, from a growth diagnostics perspective, the states role in developing countries is to to identify the most binding market failure, to deliver a policy that tackles this failure, e.g. strengthen the rule of law, and let the market do the rest to kick-start growth. Institutions should then be put into place that keep the economy growing. Khan (2004) denes this view on the role of the state as the service delivery model, where the state delivers public goods such as law and order, social security, and market regulation, and relies on competitive markets to deliver all other goods and services. (Khan, 2004, p.165) Essentially, this view of the service delivery 15

state is also shared by the Washington Consensus and its augmented version.

However, it is not clear whether such a role of the state is sucient for a sustainable growth path of developing countries. In fact, the successful stories of rapid and sustained growth, such as e.g. China, Taiwan, Vietnam, and Korea, suggest a far more active role of the state in shaping economic development and the transition to high-income and dynamic economies. Khan (2004) argues that in order to achieve sustained growth, the state must be able to reallocate property rights and to manage rents, through e.g. conditionality schemes, in ways that promote growth. In addition, in order to maintain political stability in the process of economic growth, states must be able to transfer rents in ways so as to compensate losers and to incentivize the creation of productive capitalism.

According to Khan (2004), in particular the political dimension of the economic transition needs emphasis. The distribution of power between different societal groups that participate in the economy and the state is pivotal for the capacity of the state to enforce policies and implement institutions that enhance growth. Khan (2004) supports this argumentation by giving empirical evidence from successful examples of recently growing economies, such as e.g. Thailand, Korea, and China.

The view that tackling binding constraints is enough to sustain economic 16

growth might therefore be misleading. It ignores the active role states have played in the past in shaping development transitions of successful economies and does not take into account the political dimension of this process. By doing so, it commits the same mistake as the Washington Consensus (see section 2) and the institutional approach (section 3).

Conclusion

The dominant feature of growth patterns of economies in the past 300 years has been divergence and variability. However, to increase income and reduce poverty, developing economies need to grow sustainably over a significant period of time. Hence, accelerating the process of economic growth in a sustained manner is just about the most important policy issue in economics.(Hausmann et al. , 2005, p.303)

Yet, economic policies that have been promoted by international organizations and mainstream economic theory have failed in doing so. Countries that followed their advice, did not experience sustainable economic development. Instead, states that followed unconventional economic policies, in particular in East Asia, have impressively succeeded in promoting growth.

The framework promoted by Hausmann et al. (2007) suggests that the main problem of past policy prescriptions was their spray-gun approach.

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Instead, they suggest that developing countries should focus their reform efforts on the most binding constraint, i.e. market failure, that constrains economic activity. By tackling it, markets will work more eciently and hence promote growth.

As I have shown, however, this approach suers from serious shortcomings. First, there are methodological and practical problems with the application of this approach. Second, and more severely, it does not satisfactorily answer the question of sustainability. After tackling a binding constraint, how should economic dynamism be kept alive? Third, and nally, the approach suers from the same blindness towards a more active role of the state in economic development as did previous policy prescriptions. Successful stories of growth suggest that the state must play an active role in designing the transition of developing countries towards developed economies. In failing to incorporate this issue, the framework of binding constraints and market failures does not provide an adequate guide for determining the functions of the state in sustaining growth.

(2969 words)

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