4.8. The balance between markets and intervention

Task 1: Market-oriented policies vs Interventionist policies

Using the symbols M (Market-oriented policies) or I (Interventionist policies) identify which type of policy the strategies in the table are

Policies for Economic Development

1. Macro-economic Stability

Macro-economic stability would involve a commitment to low inflation. Low inflation creates a climate where foreign investors have more confidence to invest in that country. High inflation can lead to devaluation in currency and discourage foreign investment. To create a low inflationary framework, it requires:

• Effective monetary policy. E.g. given a Central Bank independence to control inflation through using monetary policy. This could involve the use of an inflation target.

• Disciplined Fiscal Policy – i.e. avoid large budget deficits.

• For example, if you look at current situation of China and India – they both have high rates of economic growth, but the concern is that their economies could easily ‘overheat’ and cause inflationary pressures. Therefore, to keep a lid on inflation is an important underlying factor in sustainable economic development.

Thus it is important that fiscal and monetary policy is counter-cyclical.

A potential problem of macro-economic stability is that in the pursuit of low inflation, higher interest rates can conflict with lower economic growth – at least in the short term. Sometimes, countries have pursued low inflation with great vigor, but at a cost of recession and higher unemployment. This creates a constraint to economic development. The ideal is to pursue a combination of low inflation and sustainable economic growth.

It depends on the economic situation; some countries may be in a situation where there is a fundamental lack of demand due to overvalued exchange rate and tight monetary policy. Therefore, economic development may require demand side policies, which boost aggregate demand.

Macro-economic stabilization may involve policies to reduce government budget deficits. However, this may involve spending cuts on social welfare programs.

2. Less Restrictive Regulation and Tackle Corruption

Some developing countries are held back by over-restrictive regulation, corruption and high costs of doing business. To attract both domestic and inward investment, it is necessary to remove these costs and create a climate, which is conducive to business. To tackle corruption may not be easy, but it is often one of the biggest constraints to economic development.

Also, in the effort to reduce levels of regulation, it is important that useful regulations such as protection of environment aren’t discarded in efforts to attract inward investment. Otherwise economic growth may come at the expense of sustainable development.

So some regulations, particularly in the area of environmental protection is suitable.

3. Privatization and Deregulation

An important aspect of China’s rapid economic development was the decision to move from a Communist economy to a mixed economy. Several state owned industries were privatized. This gives firms a profit incentive to cut costs and aim for greater efficiency. De-regulation involves making state owned monopolies face competition. This greater competitive pressure can help to create incentives to cut costs. Greater competitive pressures may also be gained through liberalizing trade and opening markets to international competition.

A potential problem of privatization is that it can exacerbate inequality in society. In Russia, privatization enabled a small number of oligarchs to gain control of key industries at low cost. Arguably, this does little for economic development because the nations resources become owned by a small number of very rich individuals, and there is little ‘trickle down’ to poorer members of society(Oligarchy).

4. Effective Tax Structure and Tax Collection

One of the challenges developing economies often face is to effectively tax and collect what they are supposed to. If the government is unable to collect sufficient tax from the richest aspect of the economy (e.g. production of natural resources) there will be little funds to finance necessary public sector investment in services with a high social benefit. For example, the average tax rate in Sub-Saharan Africa is only 15% of GDP – compared to an average of 40% of GDP in developed world.

But average revenue collection rates in Sub-Saharan African countries stood at only 13.3 percent of GDP during 1990 to 1994. They increased very slightly to 15.6 percent during 2000 to 2006…. And the researchers found that – and this is even more alarming – most of this slight increase came from sources such as value added taxes, which tend to burden the poor more heavily than the wealthy. Oxfam blog.

Thus it is important to both broaden the tax base (try to bring as many potential tax-payers into the tax net, but also to have an equitable allocation of tax policies between direct (usually progressive income tax system) and indirect (tax on consumption that is regressive).

5. Investment in Public Services

In areas such as education, health care and transport, there is often market failure – the free market doesn’t provide sufficient levels of education i.e. positive consumption externalities. A key factor in improving economic development is to increase levels of literacy and numeracy. Without basic levels of education and training, it is very difficult for economy to develop into higher value added industries.

Evidence on returns from investing in education are mixed. Often investment takes a long time to feed through into directly higher rates of economic growth.

6. Diversification away from agriculture

A constraint developing economies may face is that their current comparative advantage is in the production of primary products. However, these limit economic development due to volatile prices, low-income elasticity of demand and finite nature. Therefore, economic development may require government encouragement of new industries in different sectors, such as manufacturing. This may require a temporary commitment to tariffs (see: infant industry argument)

Attempts to diversify away from agriculture can have mixed results. Sometimes, countries with a poor basic level of infrastructure struggle to make effective use of capital investment in manufacturing. Some argue government attempts to encourage manufacturing industry is misplaced because they tend to have poor information about best kinds of industries to promote. It is better to allow free market to decide to which industries to invest in.

Governments must take into account the implications of the Prebisch-Singer Hypothesis – price of primary commodities declines relative to the price of manufactured good over the long-term; Terms of Trade deterioration.

7. Role of IMF in Economic Development

The IMF can play a role in dealing with economic crisis. The IMF can give a country a loan to meet a temporary fiscal or balance of payments problem. This loan can be vital for helping the economy to deal with an unexpected crisis. Without the loan, the economy may have to experience a bigger fall in living standards to meet the creditors.

However, the role of the IMF is often criticized. In return for a loan, the IMF have often insisted on certain free market reforms in return for the loan i.e. conditionality. This has included

• Privatization

• Tax reform

• Cuts in government spending (often on welfare payments)

These free market supply side policies have arguably often harmed economic development, e.g. reducing access to basic necessities and lower government spending on the poor.

However, the IMF often point out that they are usually asked to help only in crisis so there is often a difficult choice to make

See more on: criticisms of the IMF

World Bank and Economic Development

• The World Bank is a financial body committed to the reduction of poverty in developing countries. It offers long-term loans for capital programs.

• The World Bank is committed to achieving its aims through the promotion of international trade, capital investment and foreign investment.

• The World Bank has often been criticized for its promotion of structural adjustment policies. These free market oriented policies have often caused, at least temporary, upheaval in the economy.

• In particular structural adjustment policies implement in sub-Saharan Africa arguably failed to alleviate poverty when introduced in the 1980s. (Criticism of S.A.)

• In response to these criticisms the World Bank has sought to change its policies of structural adjustment placing greater emphasis on maintaining social spending and improving education.

Other Issues in economic development

• Role of foreign aid Foreign aid can help boost capital investment in schemes, which improve economic development. However, it depends on the type of foreign aid. Does Aid increase economic welfare?

• Harod Domar – model of economic growth – the role of savings and capital in promoting economic development

• Economic development and tourism

• The role of MNCs in developing economies

Source: http://www.economicshelp.org/blog/4998/development/policies-for-economic-development/, accessed Wednesday 2^nd of December 2015

Market Approaches to Development

· Liberal economists argue a free market economy ‘works’ because it offers incentives for self-generating growth. In particular:

· Household are encouraged to work and sell their labour to the firm of their choice and choose what products to buy with their resultant income. More work means more income and, as a reward more opportunities for consumption

· Firms are encouraged to produce goods. Risk taking entrepreneurs hire labour and capital to produce goods and services that consumers want, Successful firms earn a profit; unsuccessful firms become insolvent releasing resources for alternative uses

· The profit motive encourages firms to produce at lowest unit cost (productive efficiency) and to enter industries in pursuit of abnormal profit or leave where abnormal losses are made.

· Price changes reallocate resources Changes in price act a signal to influence the amount bought and produced, hence the amount of resources used in an industry. Market systems are flexible and direct resources to the best use

· A trickle down of income. The initial benefits of growth go to the rich, but eventually trickle down to the poor e.g. rich families buy local produce and employ servants.

The Washington Consensus

The Washington Consensus is a set of polices advocated by free market economists to encourage growth and is at the heart of IMF, World Bank and DC thinking on development policies. The overwhelming consensus amongst rich countries is that markets work and government planning fails to deliver growth.

Markets are not perfect and government has a major role to play in correcting market failure. But essentially LDC governments wanting growth must abandon intervention, ‘get out of the way’ and ‘establish the rule of the market’ by:

1) Getting prices right by:

· Removing price controls and subsides

· Encouraging competition through privatization

· Deregulation to remove barriers to free movement of resources between industries

2) Ensuring macroeconomic stability through:

· Balanced government budgets through tight fiscal policy (G=T) and

· Tight monetary policy to achieve low inflation

3) Liberalizing (open up) trade through:

· Abandoning fixed exchange rates,

· Removal of restrictions on imports e.g. quotas and tariffs,

allowing unrestricted capital flows e.g. FDI

Criticisms of the Washington Consensus

1. Infrastructure is unlikely to created or be present in sufficient quantity for the market-led policies to have optimal effect.

2. Hypocrisy of developed countries in relation to pushing trade liberalization policies on developing countries yet engaging in trade protection policies in their home markets i.e. agriculture

3. Export-led success of the ‘Asian Tigers’ (Hong Kong, Taiwan, South Korea & Singapore) was facilitated through a mixture of both market-led and government interventionist policies.

4. Short-term costs (lower national output, higher unemployment & increased poverty levels) due to economic shock therapy (tight economic policy) is too great to wait for its purported long-run pay off.

5. Industrialization policies can often exacerbate an increasing flight from rural to urban areas – can lead to a decline in agriculture output and creation of slums in urban areas

6. Lack of political stability for liberalization of capital markets – can lead to destabilizing effects of ‘hot money flows’. In addition, extent of possible FDI may not be realized.

Interventionist Approaches

In many countries, active state interventions have been at the forefront of growth and development strategies.

Brazil

The Brazilian government has established development programmes where active state intervention is seen as crucial for inclusive growth. In 2009 the former President Lula da Silva was quoted as saying:

“If the global financial crisis put any development model on trial, it was the free-market or neoliberal model, which emphasizes a small state, deregulation, private ownership, and low taxes. Few developing countries consider themselves to have fully adopted that model.”

Some elements of their programme include:

• Direct intervention in the currency markets to prevent the Brazilian Real from appreciating and making Brazilian industries uncompetitive in world markets
• Strong regulatory control of their banking system + controls on capital flows in and out of Brazil
• A targeted industrial policy picking likely winners in emerging industries and subsidising them)
• Conditional cash transfer policies as part of their state welfare system

South Korea

Ha Joon Chang

“Development used to be about the transformation of the productive structure and the capabilities that support it, and the resulting transformation of social structure (e.g., oil-rich countries, Germany after WWII). Now, development is about poverty reduction, provision of basic needs, individual betterment, and the sustenance of the existing production structure”

South Korea is one of the most notable development success stories of recent times – it has made impressive progress in escaping the middle-income trap and becoming a successful member of the OECD. Their development policies have moved away from the standard Washington Consensus model.

Ha Joon Chang from Cambridge University has written extensively about the South Korean development model.

Ha Joon Chang is a heterodox economist who challenges conventional views on policy for example in the areas of trade, macro policy and industrial policies.

His main argument is that the South Korean development miracle was achieved under policies that combined the market with a high degree of government involvement. He argues that there is no such thing as the free market and that most countries – including the USA and the UK – relief heavily on active state intervention and industrial policies when they were in their fast-development stages.

From South Korea’s experience he picks out some of the following features:

• Extensive use of selective industrial policy – actively looking for growth potential industries
• Combining protectionism with export subsidies especially in the early stages of growth
• Tough regulations on foreign direct investment – moving away from the free flow of capital
• Active but selective use of state-owned enterprises

Bolivia

Bolivia has chosen a development path that involves partial re-nationalization of businesses / industries that had formerly been privatized. The aim is to keep in government hands the revenues and profits from extracting natural resources. Nationalization has taken place in hydrocarbons, electricity generation and transmission, telecommunications and smelting.

In 2012 for example, Bolivia nationalized two electricity distribution companies owned by Spanish utility Iberdrola. The danger is that ad hoc nationalization of assets will frighten off future private sector foreign investment because of the high risks of state appropriation of private wealth.

Source - https://www.tutor2u.net/economics/reference/state-intervention-growth-and-development

Arguments Against Market Approaches to Development/in favour of state intervention

Microeconomic theory reminds us that markets both work and fail. The process of establishing a market system often involves radical reform that produces both winners and losers. Often the burden of adjustment falls unequally on society. For example:

I. Getting prices right means:

· Abolishing price controls and subsides on essentials. Higher prices that deny the very poor access to essentials such as clean water and electricity.

· Privatization that can result in potential windfall profits to wealthy domestic and foreign speculators

· Deregulation that weakens the rules that protect consumers and workers from abuse and causes environmental by unchecked negative externalities damage

II. Macroeconomic stability means:

· Tight fiscal policy (balanced government budgets) and reduced health and education budgets. Public sector workers may be made unemployed to ensure G=T

· Tight monetary policy to achieve low inflation which raises the costs of borrowing to firms

III. Liberalize (open up) trade means:

· Abandoning fixed exchange rates and removal of restrictions on imports e.g. quotas and tariffs. Formerly protected industries may be unable to compete and need short term protection to

· Allowing unrestricted capital flows e.g. FDI distorts the economy of an LDC e.g. resources are allocated to meet the needs of transnationals and not domestic consumers and producers; speculative capital inflows create unstable exchange rates

· An erosion of traditional community values and adoption of an ‘alien’ western culture that values the maximization of profits and consumerism (maximization of individual consumer welfare)

· Greater disparities in income and wealth when the benefits of growth are unevenly distributed. Increased income inequalities can cause social exclusion and alienation

· Short run growth may be unsustainable in the long run

Summary of conditions economists believe will be necessary for both growth and development to be achieved:

1. Trade justice

2. Debt relief – help to leverage investment in human & physical capital

3. Free workings of domestic markets but only once the markets have a competitive size and support from infrastructure.

4. Encouragement of political stability is key to elimination of corruption.

5. Effective targeted aid leads to pro-poor growth.

• Task 2: The case of Rwanda: how many of the five conditions listed above to you see evidence of in the four videos on Rwanda?

View that economic development may best be achieved through a complementary approach, involving a balance of market oriented and government intervention

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