eco paper 12pages

Development Economics States and Markets

Readings: Chapter 5 in Perkins et al.,

University of Miami Professor: Salvador Ortigueira

Problems in development process

Common experience (~before 1980): ● Heavy state intervention in economy:

– Price controls – Nationalized companies – Trade barriers

● Poor macroeconomic policies: high inflation, high budget deficits

● Exposure to external shocks, especially commodity prices

The Washington Consensus → New paradigm in the 1980s ● Backed by International Monetary Fund (IMF) and

World Bank ● Prescriptions:

– Reliance on market powers (no price controls, privatizations etc.)

– Macroeconomic stabilization: lowering inflation and budget deficits

– Reduction of trade barriers

● Builds on neoclassical economic theory

Outcomes Economic reforms towards free markets in 1980s and

1990s led to: ● High growth in some countries: China, Vietnam,

other Asian countries ● Stabilization, but low growth in other countries

(e.g. Ghana and other African countries) ● → Common view today: ● Policies prescribed by Washington Consensus

necessary but not sufficient for growth

Markets and market failures Economic theory tells us that markets are good at

allocating scarce resources: → The Welfare Theorems. ● No need for expensive central planning, decisions

are made by informed agents. ● Provide the right incentives, especially when

circumstances change ● Profit motive enhances productivity in firms ● [Ethical argument: Give economic power and

freedom to individuals.]

Market failures: overview

● Externalities: positive and negative ● Economies of scale: natural monopolies ● Imperfect information: the lemons problem ● Contracts not enforceable: institutional problems ● Missing markets: credit, insurance etc. ● Price rigidities etc. → justify macro policies ● Also: efficiency does not imply justice/equality

Market failures (1) ● Externalities

– Positive (also: “external economies”), e.g. build road, clean one's sidewalk

– Negative (“external diseconomies”), e.g. pollution, overfishing → the tragedy of the commons

– Important example: Infant industry protection → Technological spillovers as positive externality

Fix: taxes/subsidies, regulation, nationalization

Market failures (2)

● Economies of scale (=increasing returns to scale) – Natural monopolies: railroad, telecom etc. – Lead to inefficiently high prices

● Fix: government regulation (antitrust), nationalization

Market failures (3) ● Imperfect information: the lemons problem

– Example: Second-hand cars.

● Fix: quality control by government (food, e.g.) ● Contracts not enforceable: institutional problems ● Missing markets: credit, insurance etc. ● Price rigidities etc. → justify macro policies. ● Example: Central Bank intervenes to stabilize

inflation and growth.

Efficiency versus equality

● Efficient allocation may be inequitable ● Most governments pursue goal of poverty

reduction ● → Fiscal re-distribution. Trade-off between

– More equality – Less efficiency: taxation negatively affects

incentives

1950s-60s: Market pessimism ● Market failures perceived as wide-spread ● Great Depression destroyed confidence in markets

→ Keynesian ideas popular: – Active fiscal policy for stabilization – Active monetary policy

● Some successes of interventionist policies: – Soviet Union: rapid industrialization – Argentina: protectionism

→ Many developing countries embrace interventionist policies (following India).

Import substitution Trade theory of 1950s-60s (Prebisch, Singer): ● Terms of trade: price of exports compared to price

of imports ● For primary-product producers, terms of trade had

fallen for a long time ● World demand for primary products was forecast

to grow slowly ● → Export pessimism/import substitution: ● Protect local manufacturers

Means of market intervention ● Protective tariffs and import controls ● Taxes on primary exports ● Controls of prices, interest rates and exchange rate ● Minimum wage and benefit regulation ● Government ownership of key industries ● Government control over investment ● → Common in developing world until early 1970s

Shift towards markets since 1970s ● In China: after Mao's death in 1976 ● Other positive examples (1980s and 1990s):

– India, Indonesia – Bolivia, Chile – Ghana, Tanzania

● Transition to market economies after end of Soviet Union: – Eastern Europe – Central Asia...

Rise of neoclassical paradigm

Backs market-oriented, outward-looking (→ trade) development.

● Surge in neoclassical economic theory in 1970s in academia

● Success of outward-looking strategy: Hong Kong, Singapore, South Korea and Taiwan

● → Grew by exporting ● Failure of interventionist policies (see next slide)

Failure of interventionist policies ● Protective barriers supported inefficient industries ● Interest-rate controls hindered evolution of

financial sector ● Minimum wage stifled job growth ● Rent seeking and corruption: heavy regulation

favored those protected by regulation ● Inefficiencies in publicly-run companies

1980s: Debt crises Many developing countries: ● Slow growth in 1970s ● Large debt accumulated by 1980

– Failure of interventionist policies – Negative influence of oil shocks

● Large budget and trade deficits ● High inflation ● → Pressure to undertake reforms

IMF and World Bank ● Became main source of financing for poor

countries in 1980s ● IMF: Provides financing to countries with balance-

of-payment problems ● World Bank: Finances development projects ● Financing conditional on reforms

● → Washington Consensus

Main goals of reform programs ● Stabilization: Correct imbalances in

– Trade balance – Budget deficit – Money supply → inflation

● Structural adjustment: – More reliance on markets: privatization,

deregulation – Opening to trade

Macroeconomic stabilization Strong evidence that macroeconomic stability is

necessary (though not sufficient) for growth ● Inflation:

– Hurts those dependent on fixed incomes, – … especially the poor – Creates uncertainty

● Budget deficits: – Crowd out private investment – Can lead to inflation: government prints money

to pay debt

Specifics of IMF stabilization policies

● Budget consolidation: Cut spending and increase taxes

● Inflation: Control growth of money supply by restricting central-bank credit to government and commercial banks.

● Exchange rate: Devaluation or free float. ● → Makes country's exporters more competitive

and reduces balance-of-trade benefits.

Specifics of IMF policies (2)

● Removal of price controls: interest rates, food prices, fuel and utility rates etc.

● Restraining wage growth: if wages are above workers' productivity, tend to have – Less-competitive firms – Unemployment – Inflation

Conditionality

● IMF provides loans to finance balance-of-payments gap.

● → Austerity measures less drastic than if the government financed them by budget adjustments.

● Disbursement of loans is conditional on implementation of recommended policies.

Conditionality: discussion

Criticism (anti-globalization movement etc.) ● Austerity measures often painful ● Rich countries force neoclassical policy

prescriptions on poor countries. ● Rebuttal: ● Countries would have to make painful choices

anyway – don't blame doctor for disease. ● Countries had choice not to accept IMF help.

Structural adjustment

● First step: Make as many goods as possible available through markets

● → less central planning (as in former communist countries), less quantitative controls (e.g. India before 1990s).

● “Getting prices right”: Market mechanism allocates goods to highest-priority use.

● → no price controls (e.g. fuel, minimum wage)

Price controls

● Often politically motivated ● Hard to abolish if...

– ... a few individuals benefit a lot. – … the majority loses little.

● Breed corruption: – Connections determine who obtains goods – Re-sale on shadow markets

Ensuring competition

Abolish/reduce: ● Monopolies → over-pricing ● Import restrictions (tariffs, regulation) ● → allow inefficient domestic firms to survive Argument for import restrictions: ● Temporary infant-industry protection ● → But: often abused, hard to terminate

Privatization

Government-run businesses lack incentives to ● innovate, ● cut costs, ● improve quality. ● Reform example: agriculture in China and Vietnam

– Break collective farms/communes – Hand over land to individual households

● → Led to increase in agricultural output

Market-supporting institutions ● Enforceability of contracts ● → strong legal system ● Regulation of banking system ● Weed out corruption in government bureaucracy ● Property rights should be:

– Well-defined – Exclusive – Secure – Enforceable

Case: privatization in Russia in 90s

● Vouchers on state-owned firms given to – Local governments – Managers – Workers – General public

● Could be re-sold in auctions → Designed to stop stealing of public property.

Privatization in Russia: results

● Performance of privatized firms improved, but not as much as hoped for

● Cronyism in later privatization deals undermined trust in property rights (oligarchs)

The timing of reforms

● Controversial: when and how fast should reforms be carried out?

● Economic theory agrees on what policies are good...

● …but is silent about when they should be carried out.

“Shock therapy” → Implement all reforms immediately ● Idea: new political regime has short window of

opportunity when seizing power. ● Done by Poland and Russia. Results:

– State companies made big losses – Were helped by central-bank loans – Printing money → inflation – Real income of many consumers eroded

Shock therapy: Long-term outcomes Central/Eastern European countries, former Soviet

Union: ● Initial slump in GDP, only recovered to pre-reform

levels by 2000. ● But: Countries that had transformed their

economies most (e.g. Poland) recovered fastest.

Gradual approach to reform China and Vietnam: ● First: abolished price controls and returned to

household farms in agriculture ● Later: Freed up industrial sector → Creation of

small- and medium-scale industry ● These put competitive pressure on large public

companies ● High growth throughout reform process ● But: Industrial state enterprise sector was smaller

to start with (unlike in Russia)

Credibility of reforms ● Economic agents have to be convinced that reforms

are permanent ● No trust in reforms → low investment etc. ● A commitment device for government: join

international organization – Mexico: NAFTA – Central, Eastern, Southern Europe: EU – China: World Trade Organization

Reform outcomes: success stories

Especially in Asia: ● South Korea: Dismantled market controls after

1970s → high growth ● Indonesia: Highly regulated in 1970s, growth after

market-based reforms. ● Taiwan: Strong growth, based on small private

enterprises.

Reform outcomes: failures

Failed stabilization programs: ● Argentina and Brazil in 1980s ● Argentina around 2000 But: successful market-based reforms in Chile ● Poor results in African countries: Ghana,

Mozambique, Tanzania, Uganda.

Debate about results of Washington-Consensus reforms

● Not successful everywhere ● Some successful countries violated some of its

prescriptions, e.g.: – Korea: Government ownership of banks – China: Fixed exchange rate, slow pace of reform

● But: ● Prescriptions were often not fully implemented ● Time is needed for reforms to take effect

Extra: Washington Consensus in detail (1)

Article by economist John Williams in 1990: ● Fiscal discipline: budget deficit < 2% of GDP ● Public expenditure priorities: education, health,

infrastructure, essential administration. ● Tax reform: modest marginal tax rates, limit

evasion. ● Liberalization of interest rates ● Floating (i.e. free) exchange rates

Extra: Washington Consensus in detail (2)

● Trade liberalization ● Liberalization of foreign direct investment: foreign

companies bring capital and know-how ● Privatization ● Deregulation: Abolish barriers of firms into

markets, but keep sensible regulation (safety, environment, banking, judicial system)

● Secure property rights