8. Government Failures in Development

Government Failures in Development (1990) by Anne O. Krueger

Overall Summary

Anne O. Krueger's "Government Failures in Development" critically examines the assumption prevalent in post-war development economics that governments in poor countries should manage industries, control markets, and dictate investment decisions due to perceived flaws in private markets. By 1990, evidence suggested that the outcomes of government intervention often led to worse problems than the issues it aimed to solve, yielding corruption, waste, and economic stagnation. Krueger poses four essential questions:

  1. What exactly is "the government"?

  2. What functions is the government competent at?

  3. How do policies become uncontrollable over time?

  4. What practical advice can economists offer to policymakers?

Section 1: The Original Case for Government Intervention — And Why It Failed

After World War II, many development economists believed that markets in poor countries were fundamentally dysfunctional, arguing that individuals did not respond to price signals as predicted by Western economic models, citing "structural rigidities."

The conclusion drawn was that governments needed to intervene and direct the economy, particularly in critical industries such as steel, energy, and banking, to guide investment decisions where free markets were inadequate.

Key Definitions:

  • Market failure: A situation where the free market leads to an inefficient outcome, which can occur due to monopolies, externalities like pollution, or the inability of private companies to profitably provide essential public goods such as infrastructure.

By the 1970s and 1980s, the consequences of this approach had led to significant adverse outcomes:

  • State-run enterprises that incurred losses.

  • Extensive control over businesses leading to fiscal mismanagement.

  • Large budget deficits fueling persistent inflation.

  • Inadequate maintenance of basic infrastructure.

Most observers, including the World Bank, recognized that the failures of government intervention had become more problematic than the market failures they aimed to correct. Krueger categorizes government failures into two types:

  1. Failures of commission: Actions taken by governments that caused harm, such as creating oversized state enterprises or granting monopolistic access to politically connected firms.

  2. Failures of omission: Neglect of responsibilities like maintaining infrastructure or managing currency exchanges realistically.

Both types of failures discouraged private investment, eroded savings due to inflation, and impeded economic growth.

Key Definitions:

  • Government failure: The concept parallel to market failure, indicating that government actions can lead to poor economic outcomes via corrupt or inefficient policies, bureaucratic waste, and politically driven, detrimental decisions.

Krueger argues that it was overly optimistic for economists to assume that government intervention could always ameliorate market outcomes

Section 2: What Is "The Government"?

Krueger critiques the mistaken assumption made by early development economists that "the government" operates as a singular, benevolent entity. Instead, she highlights that government is made up of individuals with self-interests, which affects decision-making.

Critical Inquiry:

  • Why do economists assume that private-sector actors act in self-interest while believing that public officials act solely for the public good?

In practice, politicians prioritize electoral success, and bureaucrats focus on job security and advancement, often succumbing to lobbying from wealthy and organized groups. This dynamic can result in extensive levels of protection that far exceed legitimate economic justification.

For instance:

  • In Turkey, some industries faced effective rates of protection exceeding 200% long after they should have ceased needing it.

  • In India, one industry had an effective rate of protection of 3,354%, indicating a severe dependency on government support.

Key Definitions:

  • Effective rate of protection (ERP): A measure of the actual protection a domestic industry receives after considering the costs of protected inputs. An ERP of 200% implies the industry operates at double the costs it would under free trade.

Administrative challenges were aggravated by political issues. Common failures included delayed arrivals of essential inputs and excessive delays in processing investment applications.

Section 3: What Is Government Actually Good At?

Krueger argues that the relevant question should not simply be whether the government should intervene, but rather which functions it can perform with comparative advantage.

Government, as a non-market, large-scale institution, is uniquely suited for tasks that require universality and are difficult to provide through private enterprise, such as:

  • Infrastructure (roads, communications).

  • Law enforcement and order.

  • Public information dissemination and agricultural research.

Key Definitions:

  • Comparative advantage: An economic principle stating that entities should specialize in tasks they can perform relatively better than others. Krueger argues that governments should specialize in activities like infrastructure maintenance rather than attempting to manage every economic aspect.

The irony lies in governments pouring resources into managing inefficient state enterprises at the expense of infrastructure and essential services. Critiques of government are often misconstrued as calls for less government, when the aim is instead for a more efficient and focused government that emphasizes critical services—thereby providing genuine public value even with reduced control over the economy.

Section 4: How Does Government Intervention Spiral Out of Control?

Krueger identifies three dynamics that contribute to the growth and distortion of government interventions:

Dynamic 1: Rent-Seeking

When the government offers allocations or benefits below their market value (such as import licenses or subsidies), it spurs individuals and organizations to engage in rent-seeking behavior.

Key Definitions:

  • Rent-seeking: The process by which individuals or businesses spend resources to acquire gains from the government without contributing to productivity. This can include lobbying and corruption aimed at capturing government benefits.

This behavior escalates the cost to society and complicates traditional economic assessments. For example, a tariff might seem like a minor inefficiency, but when considering the resources wasted on rent-seeking, the true social cost is significantly elevated.

Dynamic 2: Interest Groups Organize and Escalate

Once policies create identifiable beneficiaries and victims, these groups will commence lobbying for favorable modifications of policies. The outcomes lead to increasingly complex regulations and exceptions, resulting in tangled bureaucracies that foster corruption.

For instance, Mexico's investment system became an intricate bureaucracy with multiple criteria and zones designed to satisfy varying interests.

Dynamic 3: Different Groups Within Government Have Conflicting Interests

The government consists of different factions, each with unique goals, leading to conflicts and competition for resources, often to the detriment of overall fiscal responsibility.

In democratic states, governments often adopt policies that are publicly tolerable despite their hidden or complex costs, making transparency imperative for good governance.

Section 5: What Guidance Can Policymakers Take From This?

Krueger concludes with five lessons for developing countries:

  1. Government action is never free: Every intervention has inherent costs and administrative requirements that must be considered thoroughly.

  2. Prefer simple policies over complex ones: Simplicity aids in management and reduces manipulation opportunities by interest groups.

  3. Choose policies that minimize rent-seeking: Opt for options that create fewer corruption opportunities. For instance, tariffs are less susceptible to rent-seeking than quotas.

Key Definitions:

  • Tariff vs. quota: Tariffs tax imports while generating government revenue, whereas quotas allocate import limits, fostering bribery with no governmental gain.

  1. Make trade-offs visible: Establishing a structure where true governmental costs are presented to the budget can hold politicians accountable.

  2. Prioritize transparency: When policy costs are concealed, it invites exploitation by special interest groups.

Section 6: The Big Picture

Bates’s quote encapsulates the core tragedy of government failures in development: the initiatives intended for public good often become conduits for private enrichment. Krueger advocates for a more pragmatic understanding of government behavior, arguing against naive assumptions of omniscience.

The shift from asking how governments should intervene for market failures to designing institutions that mitigate government failures while addressing market limitations encapsulates the foundational changes in economic thought of the 1990s. Krueger emphasizes focusing government efforts on infrastructure and law, simplifying policy, reducing rent-seeking, and ensuring transparency—principles that underscore the necessity of cautious economic reforms in development.