Economists need to re-evaluate the role of the state in driving growth and development
In the immediate aftermath of the great financial crash of 2008, both fiscal and monetary stimulus packages were viewed as important drivers of global growth. But soon after, monetary policy took centre stage as central bankers did most of the heavy lifting to revive their economies. Several years of such experiments have not been able to revive the global economy, as private investments have failed to respond to lower interest rates.
Amid rising fears that central banks are stretching the limits of unconventional monetary policies, and threatening competitive currency devaluations, there are now growing calls for fiscal authorities to take over the responsibility of stimulating demand. As the major economies of the world met at the G-20 conference in Shanghai, there were growing calls for a coordinated and sustained fiscal stimulus by the major economies of the world.
In India, too, the run-up to Budget 2016 witnessed a debate on whether the country needs a fiscal stimulus at this stage, and if the fiscal consolidation targets could be relaxed to provide such a stimulus.
The finance ministry’s
mid-year economic review argued that in the absence of robust private investments, public investments might have to play an important role in supporting economic growth. The ministry has stuck to the fiscal consolidation targets, but given that many of the assumptions used to arrive at the fiscal balance are optimistic, there might be an implicit fiscal stimulus in the upcoming financial year.
The debate on the role of the state in economics is, however, much broader than current concerns about fiscal stimulus packages and the form they should take. In a forthcoming research paper in theJournal of Economic Literature, Pranab Bardhan, emeritus professor of economics at the University of California, Berkeley, argues that economists have not paid enough attention to the role of the state in coordinating economic decisions of individuals and firms, which has played a key role in the development of many newly industrialized economies.
Bardhan acknowledges that new institutional economists such as Douglass North and Daren Acemoglu have helped focus attention on state institutions in growth and development, but contends that their theories provide partial truths and do not fully explain the varieties of development experiences across the world.
The institutional economists emphasize that the “state has to be strong enough to provide a solid minimum framework of law and order, enforcement of contracts and other basic institutions underpinning the market, while at the same time, the state executive has to be constrained not to interfere with security of property rights”.
But Bardhan points out that many of the “inclusive institutions” that the institutional economics literature emphasizes may not always go hand-in-hand with each other.
For instance, while institutional economists underline the need for pluralism and democratic accountability to lend legitimacy and sustainability to the development process, they do not pay adequate attention to the problems of political clientelism that may arise in a democracy, leading political parties to focus on narrow short-term interests rather than broad-based, long-term development goals.
Similarly, political inclusion, with its pluralistic distribution of political power and broad popular participation, may not always secure the property rights of the few against the numerous encroachers and squatters or against high taxes.
The focus on security of property rights and market institutions has diverted attention from the important issue of developing state capacity in resolving coordination failures, contends Bardhan. “Beyond being a ‘nightwatchman’ of property rights and markets, the state often needs to be a guide, coordinator, stimulator and a catalytic agent for economic activities in situations where for various historical and structural reasons the development process has been atrophied and the path forward is darkened by all kinds of missing information and incomplete markets,” he writes.
The state can build a political coalition among different interest or identity groups in order to steer the economy towards a particular direction. For example, in East Asian economies like South Korea’s, the state helped coordination in the early phase of industrialization by reportedly facilitating interdependent investment decisions in orchestrated networks of producers and suppliers.
As explained in a 2002 paper by Chung H. Lee of the University of Hawaii, developing countries are often afflicted by “coordination failures” which cause under-investment in areas where investments are complementary to each other and need to be coordinated. For example, a steel mill will not be built unless there is a power plant to supply electricity for the steel mill and the power plant will not be built unless there is demand for power.
Asia’s “miracle” economies—Japan, Hong Kong, South Korea, Singapore, Taiwan, Indonesia, Malaysia and Thailand—largely relied on three tools to solve the coordination problem: promotion of specific industries, directed-credit programmes and promotion of exports. These economies not only forced people to save more, but also set up development finance institutions to channel savings into long-term investments.
The success of East Asian economies suggests that the state can successfully coordinate the activities of various groups for the goal of economic development, even without itself occupying the commanding heights of the economy or having to erect a large public sector.
However, it is important to keep in mind that some of the tools and tactics used by these “developmentalist” states are unlikely to work in a pluralistic and competitive democracy.
The absence of strong democratic institutions allowed autocratic rulers such as former president Park Chung-hee of South Korea to adopt a carrot-and-stick policy to discipline industrial conglomerates. The manner in which top businessmen were arm-twisted in these economies to follow state diktats while making investments, and the manner in which their losses were socialized when the bets turned wrong, are unimaginable in most democracies today.
Nonetheless, most economists agree today that there are some vital functions a state can perform, which markets left to themselves fail to achieve. As an earlier
Economics Express column
pointed out, even early institutional economists such as North recognized the coordinating role of the state, even if in a more limited way than Bardhan does.
Going against the grain of mainstream economics of his time, North refused to see the state primarily as a rent-seeking extortionist. Rather, he considered the state a pivotal coordinating body, which, if it functioned well, could lower transaction costs meaningfully and raise economy-wide efficiency levels.
A “coordination” role for the state might seem enticing as it precludes the potential problem of a bloated and inefficient public sector. Nevertheless, the East Asian model of state-led development has led to some unintended consequences because of its emphasis on forced savings to boost domestic investment rates.
Reserve Bank of India governor Raghuram Rajan argues in his bookFault Lines that countries such as Japan and Germany, which cultivated a highly competitive export sector, ended up with low competitiveness in the industries catering to domestic consumption demand—banks, retailers, restaurants and construction companies.
Rajan points out that while Japan has created a number of very efficient export-oriented manufacturing firms like Canon and Toyota, it does not boast of any retailers “that approach Walmart in size or cost competitiveness” or any Japanese restaurant chains that “rival McDonald’s in its number of franchises”.
The reason for an under-developed domestic sector lies in the fact that these countries encouraged a high rate of household savings in order to limit consumption and hence imports. Also, high savings enabled the export-oriented sector of the economy to access funds required for capital expenditure.
Thus, we must be cautious in emulating the “East Asian experience” even though it may have valuable lessons on how the state can promote growth and development. Both the Indian model of a large public sector and the East Asian model of coordinating economic activity and channelizing savings come with their own set of potential problems—inefficient public enterprises versus lopsided development.
This is not to deny that states can and do play an important role in economic development, but to point out that we need to look carefully at the contextual factors that lead to the successes and failures of particular forms of state interventions in an economy.
Bardhan argues that “industrial policy should have less to do with the impossible task of ‘picking winners’—the usual argument against industrial policy—but more with a way of ‘discovering’ a country’s range of potential comparative advantages in a coherent way in a world of uncertainties and missing information”.
Meanwhile, policymakers also need to contend with the question of whether the powers and functions of the state be centralized or decentralized. The recent trend in India has been towards gradual decentralization, at least in terms of budgetary allocation, with the view that greater autonomy for states can improve efficiency and is also more democratic.
However, decentralization can have its own failings, as noted by Bardhan. To begin with, decentralization can often undermine democracy if power is captured by the local elite, which might be more true for agrarian or feudal societies. Meanwhile, decentralization can also trigger a “race to bottom”, with regions competing against each other to relax tax or environmental regulation in order to attract private capital.
Sometimes, de facto decentralization can also exacerbate inequality, especially in cases when the responsibility for education spending (or any social spending) is devolved to lower levels of government without the commensurate transfer of government resources or without addressing the differences in state capacities across local governments.
However, decentralization can also often be successful in reducing inequality—in Bolivia and South Africa, for example, where decentralization improved the criteria of allocation of federal transfers to regions, according to Bardhan. Moreover, the case of China reminds us that decentralization and regional decision-making can lead to fast economic growth.
However, China might have been a unique case in the sense that it was able to avoid local political power being captured by the local elite owing to initial land redistribution. Nevertheless, decentralization, especially combined with the lack of democracy, has not always worked well for China, and led to corruption and misallocation of resources. Much of its current economic troubles, for instance, have been fostered by excessive levels of municipal debt.
Thus, not only do policymakers need to determine the appropriate role for the state in the economy, they also need to determine how the state will function—whether in a centralized or a decentralized set-up—as that may have repercussions for growth and equality.
As Bardhan points out, economists have so far been able to come up with only partial answers to the role of the state and the kind of state institutions that can foster fast economic development. A closer examination of economic history and more intensive studies of state institutions might yield better understanding of what kind of state institutions work, and to what extent, in different societies.
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