Economics of Development - States and Markets

States and Markets

• Who is it that makes economic development happen?

  • Individuals pursuing their goals through the market.

  • Government playing a central role.

• Debate over the proper role for government has been ongoing for over two centuries.

• Adam Smith argued against the conventional wisdom of government-led development in The Wealth of Nations (1776).

  • He proposed individuals working through the market to specialize and exchange products.

  • Example: Manufacture of pins.

• In England, Smith’s view dominated development thinking in the 1800s.

  • Leaders promoted free trade and minimal government intervention.

• Elsewhere, the state played a major role in developing new industries.

  • Government role steadily increased eastward from England to France, Germany, and Russia in the 19th century.

  • Basic thesis of Alexander Gerschenkron in Economic Backwardness in Historical Perspective.

• After David Ricardo and Karl Marx, economists focused on understanding how markets worked.

  • Economic growth was more or less taken for granted in Europe and North America.

• This focus changed dramatically after World War II, which devastated much of Europe and Japan.

  • The challenge was how to achieve economic recovery before wartime devastation brought to power new totalitarian regimes and further warfare.

  • Former colonies were becoming independent states and wanted to catch up with industrialized nations.

  • The United States, not devastated by war, stood ready to help.

• The first decades after World War II witnessed a major effort to achieve modern economic growth throughout the world.

  • There were some successes, mainly the rapid recovery of western Europe, but also many failures.

  • At the center of this debate is the question of the proper role for government in development.

• Thinking about the role of the state has been a learning process because successes and failures have helped develop a more sophisticated understanding of the role of government and government-created institutions in the development process.

• Despite all of the development thinking since the 1950s, there are still a great many poor countries and poor people in the world.

• The evolution of ideas since the end of World War II about the proper role of the state in economic development will be traced.

Development Thinking After World War II

• Key influences on development thinking after World War II:

  • Economists' ideas about growth dated back a century or more.

    • Adam Smith stressed markets and technological progress.

    • David Ricardo stressed saving, investment, and capital accumulation.

    • Karl Marx also focused on capital accumulation.

    • The Harrod-Domar model put investment and capital at the center of growth.

  • One influential book published in 1960 argued that the key to growth was to raise the rate of investment and capital formation to a level above 15 percent of gross domestic product (GDP).

• If capital is central to growth, then raising the saving rate is key to increasing investment.

  • Poor countries were seen to be in a vicious circle of poverty: too poor to save, therefore unable to invest and grow.

  • The solution: Rich countries should contribute savings to poor countries to break the cycle.

• In the 1960s, Hollis Chenery’s two-gap model refined the idea:

  • Not just a saving gap, but also a foreign exchange gap.

  • The foreign exchange gap was the major constraint on development in most countries.

  • Emphasis was placed on rich countries providing aid (dollars or another convertible currency) to fill both gaps.

• This view was reinforced by the experience of the Marshall Plan.

  • Marshall Plan supplied 25 billion to rebuild Western Europe, with immediate and dramatic results.

  • Europe recovered rapidly and caught up to pre-war income levels.

  • Much the same experience occurred in Japan.

  • By the 1950s, the nation was well launched on two decades of unprecedented 10 percent a year GDP growth.

  • Large injections of capital, mostly from the United States, had done the trick, or so it seemed.

• What was missing from the analysis of these success stories was the role of the supporting institutions required for economic development.

  • Western Europe had fully developed legal systems designed for a modern industrial economy; had education systems capable of providing required training; and despite the enormous loss of life, had large numbers of people who knew how to organize a company (and a government) and who understood modern technology.

  • Much of the physical infrastructure was gone, but many of the key institutions were embodied in people, and all that was needed was a little help to get started.

  • When the same emphasis on foreign aid, capital, and foreign exchange was applied a decade later to developing countries, many of the critical institutions were missing.

  • Developing poor and underdeveloped nations proved to be a very different process from reconstructing already developed economies destroyed by war.

• Most developing countries did not start with the Smith view that well- functioning markets were the key to successful development.

  • Markets were associated with capitalism, which was associated with colonialism and being kept poor by colonial powers.

Market Failures and Government Intervention

• Leaders in developing countries sought alternative paths, supported by people and events elsewhere.

  • Markets had not functioned well before the war, as seen in the Great Depression of the 1930s.

  • Economists were aware that all economies suffer market failures.

• The question was not whether these market failures existed but how prevalent they were and thus what (if anything) the government should do about them.

• Fabian socialists in Britain believed market failures were common and called for government intervention.

  • The British Labour government supported government takeover of businesses.

  • Many leaders of former British colonies were educated in Britain and exposed to Fabian socialist views.

  • Jawaharlal Nehru and other leaders of the Indian Congress Party were examples.

• Development economists argued that developing countries required broad government intervention.

  • Paul Rosenstein-Rodan's big push idea:

    • It was difficult for one modern industry to start up in a developing country (his example was shoes) because there would not be enough people with the money to buy the products of one shoe factory.

    • One needed to develop a wide range of industries simultaneously so that workers in each factory would have income to buy products from other factories.

    • A government plan was needed to guide producers and guarantee demand.

  • Albert Hirschman countered this with the idea of emphasizing industries with strong linkages.

    • The creation of one industry (e.g., machinery) would create demand for others (e.g., steel).

    • He called backward linkages.

  • The big push theory assumed exporting new products was not realistic (Rosenstein-Rodan wrote during/after WWII).