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The State and Economic Development

Paul Jasper

Student ID: 548084

MSc Development Economics

Department of Economics

School of Oriental and African Studies, London

January 11, 2012

Course: 15PEC007: Growth and Development

Tutor: Mushtaq Khan

Assignment:

Does the framework of market failure and binding constraints provide an ade-quate guide for determining the functions of the state in sustaining growth?

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1 Introduction: The Puzzles of Economic Growth

One of the central questions development economics has been concerned with

in the past decades, is what accounts for the differences in economic growth

between countries and how policies can be devised to accelerate it.

Clearly, these differences in growth patterns exist. For example, in the

1990s, Sub-Saharan Africa experienced only slight growth as opposed to e.g.

East Asia. (See Figure 1) Similar results can be shown when looking at

longer time horizons or more segregated and detailed data. (World-Bank,

2005) Hence, divergence in relative productivity levels (. . . ) is the dominant

feature of modern economic history. (Pritchett, 1997, p.32)

Figure 1: Growth in the 1990s. Source: World-Bank (2005)

In addition, few countries have shown stable growth paths over time,

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but instead alternating phases of growth, stagnation and decline. (Pritchett,

2000) In fact, achieving rapid growth for a limited period of time has not been

uncommon for many countries. As Hausmann et al. (2005) show, this sug-

gests that achieving rapid growth over the medium term is not something

that is tremendously difficult and it is well within most countries reach.

(Hausmann et al. , 2005, p.316)

The main issue concerning economic growth in developing countries henceis how to sustain it at sufficiently high levels over a significant period of time.

In fact, the group of todays advanced capitalist economies consists of coun-

tries that have shown a narrow range of moderately low and stable growth

rates over long periods of time. (Pritchett, 1997)

As the above evidence suggests, however, few economies have achieved

this exercise of catching-up so far: Out of 117 countries with populations

of more than half a million people, only 18 have been able to sustain growth

rates exceeding industrialized countries growth . . . (World-Bank, 2005, p.5)

To reduce differences in income sustainably, developing countries therefore

need to solve two puzzles: First, how to kick-start growth and create eco-

nomic dynamism that exceeds developed countries levels. Second, how to

sustain this dynamism so that a transition can happen towards an advanced

capitalist economy with stable and continuos per capita growth and techno-

logical progress.

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2 The Washington Consensus

The most prominent answer to the above challenge for developing countries

was, propagated during the 1990s and early 2000s, a set of policies termed

the Washington Consensus. Originally formulated by Williamson (1990),

it can be summarized as promulgating the following to poor countries: get

your macro balances in order, take the state out of business, give markets

free rein. (Rodrik, 2006, p.973) Table 1 provides a more detailed overview

of these prescriptions.

Hence, during the 1990s, a variety of states adopted related policies. How-

ever, due to unsatisfactory results in many countries, the consensus after thisdecade of reform is that the Washington Consensus has failed in promoting

growth. (World-Bank, 2005) Yet, not everywhere stagnation reigned. As

shown in figure 1, East and South Asian economies experienced rapid growth

throughout the 1990s. However, these countries did not implement the Wash-

ington Consensus: . . . , their policies remained highly unconventional (. . . ),

these two economies hardly looked like exemplars of the Washington Con-

sensus. (Rodrik, 2006, p.975) In sum, the 90s showed bad outcomes for

Washington Consensus policies, and good outcomes for unconventional poli-

cies implemented by countries mainly in East and South-East Asia. This led

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Table 1: The Washington Consensus. Source: Williamson (2000)

Fiscal discipline

A redirection of public expenditure priorities toward fields of-fering both high economic returns and the potential to improveincome distribution, such as primary health care, primary edu-cation, and infrastructure

Tax reform (to lower marginal rates and broaden the tax base)

Interest rate liberalization

A competitive exchange rate

Trade liberalization

Liberalization of inflows of foreign direct investment

Privatization

Deregulation (to abolish barriers to entry and exit)

Secure property rights

economists to explore alternative explanations for sustainable growth and

effective economic policies.

3 The First Alternative: Institutions

One of the main responses to the failing of development policy in the 1990s

was the idea that the Washington Consensus was in principle right, but its

implementation faulty. Basically, according to this approach, governments in

developing countries meant well, tried little, failed much.(Krueger, 2004)

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This led to two conclusions: First, policy-makers in developing countries

were not committed enough to the reform package. (Rodrik, 2006) Second,

commitment alone was not enough for the reforms to be successful. Even if

the above mentioned policy package was implemented, it might still not work

because background institutions were performing poorly: Regulatory and

supervisory institutions in product and financial markets proved too weak.

Poor governance and corruption remained a problem. (. . . ) Sound policies

needed to be embedded in solid institutions. (Rodrik, 2006, p.976 ff.)

In the empirical literature, two findings tried to provide evidence for such

institutions. First, Kaufmann et al. (1999) and the Governance Matters

papers showed a strong positive relationship between income and their gov-

ernance indicators.1 (See Figure 2.) According to the authors, this implied

that there is a large payoff in terms of per capita income to improvements

in governance. (Kaufmann et al. , 1999, p.15)

Second, Acemoglu et al. (2000) found that, in the long-term, differences

in institutions, mainly defined as security over property rights and constraints

on the executive, account for a mayor part of cross-country differences in in-

come.2

The central conclusion following this argumentation therefore is that the1Note that Kaufmann et al. (1999) define Governance as the traditions and institu-

tions by which authority in a country is exercised.(Kaufmann et al. , 1999, p.1)2See also Acemoglu et al. (2002).

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Figure 2: Governance and Per Capita Incomes. Source: Kaufmann et al.

(1999)

Washington Consensus needs to be replaced by an enhanced version of itself.

Hence, developing countries should try to provide the right environment for

economic activity, basically the one existing in the developed nations of the

world, and continue to pursue liberal and market friendly reforms. The result

would be accelerated and stable growth.3

3Note that another alternative view on how to achieve growth and development is theBig Push approach, advanced by Jeffrey Sachs and the U.N. Millennium Project. SeeRodrik (2006, p.980 ff.) for an overview.

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4 The Second Alternative: Market Failures,

Most Binding Constraints and Growth Di-

agnostics

Besides problems with the empirics of the above approach, the main criticism

brought forward against it is its laundry-list view on policies states should

implement. In the extreme, the list of institutional preconditions is open

ended and could lead to policy prescriptions that are dysfunctional.(Rodrik,

2006) To avoid this pitfall and to provide an alternative, Hausmann et al.

(2007) develop a concept that tries to focus reforms on specific market failures

in developing countries, so as to get the biggest pay-off of feasible reforms.

4.1 Market Failures

Hausmann et al. (2007) base their analysis on the assumption that the main

reason for low growth and underdevelopment are market imperfections.The

identification of market failures as a severe problem for underdevelopment is

not new. Historically, and from an allocative perspective, Economists defined

market failures as situations where a market does not provide for the efficient

allocation of goods and services. (Bator, 1958) Besides this allocative failure

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of markets, other authors have pointed possibility of creative market failures

that constrain the creative dynamism of an economy. In the extreme, market

failures can lead to the nonexistence of markets.

What causes market failures? Generally, markets fail to produce efficient

outcomes when the costs of participating in this market, i.e. the transaction

costs, are too high. (Arrow, 1969) Transaction costs can take different forms,

such as costs of gathering information, enforcing contracts, excluding free-riders, etc. More specifically, different transaction costs can be too high for

individual agents, in differing circumstances and in very different markets.

Stiglitz (1989) provides some theoretical perspectives on this heterogeneity.

Market failures exist both in developing and developed economies. How-

ever, the general consensus in the literature is that markets work even less

well, and institutions that might help to solve these failures are less suc-

cessful, in developing countries. (Stiglitz, 1989; Arndt, 1988) Therefore, the

problem of market failures is more severe there.

4.2 Most Binding Constraints and Reforms

Hausmann et al. (2007) assume such a relationship between market failures

and growth in order to develop their approach to policy reform. In their

model, market failures drive a wedge between private and social valuations

of specific economic activities. (Hausmann et al. , 2007, p.5) This leads

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to underinvestment, economic underperfomance and a distorted economy.

These distortions constrain policy-makers in their effort to maximize social

welfare: in a general equilibrium environment, any distortion in one activity

also affects all other economic activities in the economy.

This therefore translates into a second-best complication for reforms. If

a social planner wants to remove one distortion, i.e. tackle a market im-

perfection, the result on the social welfare consists of two effects: First, thedirect unambiguous positive effect of the reformed distortion. Second, an

interaction effect of the reform with all other distorted economic activities:

Change in Social Welfare = Direct Effect + Interaction Term.

The problem for policy making is ambiguous interaction term. It might

be positive, but might also be negative. Clearly, if it is negative and larger

than the direct effect, the economy is worse off after removing the initial

market imperfection. (Hausmann et al. , 2007)

In such an environment, choosing the right reform strategy is difficult.

Hausmann et al. (2007) suggest to prioritize reforms on the biggest direct

effect that will result from the reform. This strategy has two obvious ad-

vantages: First, policy makers get the biggest direct positive pay-off from

the reform. Second, since the direct effect is likely to be big, the relative

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importance of the interaction term diminishes and reformers need to worry

less about it.

4.3 Growth Diagnostics

How can these most binding constraints be identified? Hausmann et al.

(2007) develop a diagnostic approach, to show that it is possible to identify

the most binding constraint in an economy.4 They start with a simplified

growth model which assumes that growth depends on two main factors: high

expected return to private capital and low cost of finance.

Hence, if an economy is underperforming, this must be either because

the expected private return of asset accumulation is low (. . . ) or because

the cost of funds (. . . ) is high.(Hausmann et al. , 2008, p.19) These broad

constraints, when identified, can then be further split into more precise con-

straints. If in the first case the problem were low expected returns to asset

accumulation, the question would be whether this was due to low appropri-

ability of returns or low social returns. Again, this could be split into more

precise causes, moving down a diagnostic tree as depicted in figure 3.

As a result, after cautious analysis of the current state of the economy,

policy makers could identify the most binding constraint and target reforms

4See also Rodrik (2006, 2007) and Hausmann et al. (2008) for this approach.

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Figure 3: The Growth Diagnostics Tree. Source: Hausmann et al. (2008)

accordingly. (Rodrik, 2006)

5 Critique: Is this the adequate response to

the Washington Consensus?

On the first sight, the Growth Diagnostics approach has some promising

features for the analysis of developing economies and for the formulation of

policy prescriptions. It avoids, first, the spray-gun procedure of both the

Washington Consensus and the Institutions approach.

Second, the approach builds on a solid theoretical backing from the mar-

ket failure literature and on the empirical finding that growth accelerations

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among developing countries are not extremely rare. It is plausible that mar-

ket failures inhibit economic dynamism and that removing them can have

potentially large short-term positive effects on growth.

Third, the approach induces both policy-makers and academics to think

harder and in a more contextual manner about economic development and

policies for growth. As opposed to the Washington Consensus or the Institu-

tions approach, the diagnostics procedure asks for a detailed and customized

analysis of the situation of each single economy.5

However, criticism has also ensued over several problems. In this regard,

Felipe & Usui (2008) provide a comprehensive list of critical points. First,

the approach focuses solely on economic growth and no other important

policy objectives, such as e.g. environmental protection. Second, it is un-

clear wether capital accumulation and private investment are the only factors

driving growth and development. Both ideas have been have been challenged

both theoretically and empirically. (Felipe & Usui, 2008, p. 7 ff.)

Third, although the approach is very clear and straight-forward on a the-

oretical level, finding the most binding constraint in practice is complicated.

Both price and non-price signals need to be analyzed and interpreted. In

fact, prices might not necessarily reflect constraints on growth. For exam-5See for example the twelve World Bank pilot studies of 2005. (Leipziger & Zagha,

2006)

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ple, as shown by Aghion & Durlauf (2007), low interest rates might exist in

situations with tight credit supply. In addition, prices reflect the current sit-

uation of the economy, but do not show what growth dynamics might ensue

when a constraint is removed, i.e. the size of the direct effect on welfare of

a reform. (Aghion & Durlauf, 2007) Non-price signals, in turn, are heavily

dependent on the socio-political context of the economy. In-depth knowledge

is necessary to interpret them.

From my point of view, this implies two problems: First, the replicabilityof results is inhibited. Researchers might reach different conclusions depen-

dent on their interpretation of the signals, a point also made by Felipe & Usui

(2008). Second, the identification of the most binding constraint turns out

to be a highly complex process that requires much ex ante knowledge and

that inherently holds a high degree of uncertainty.

Fourth, as Felipe & Usui (2008) rightly point out, the approach rests on

the assumption that the branches of the decision tree (Figure 3) are indepen-

dent. However, growth and development are complex processes where many

factors interact. The identification ofone most binding constraint might not

be the correct procedure. Therefore, while the Washington Consensus suf-

fered from its generality, the Growth Diagnostics approach might suffer from

too much singularity.

Besides these methodological problems, two more fundamental critiques

need to be made.

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Sustainability As mentioned above, one of the central problems develop-

ing countries need to solve in order to reach higher income levels is to sustain

economic dynamism and growth over longer period of times.

Rodrik (2006) acknowledges this, saying that the nature of binding con-

straints changes over time, and in particular after reforms have been imple-

mented. Hence, institutions are needed to respond to this and to sustain

growth. However, according to the author, economic science typically pro-

vides very little guidance on how to proceed. (Rodrik, 2006, p.986) The

problem is that the Growth Diagnostics approach does not provide any an-

swer either. It does not give details on how the transition from an initial re-

form to an institutionalization of economic governance which sustains growth

could be designed.

The Role of the State Roughly, from a growth diagnostics perspective,

the states role in developing countries is to to identify the most binding mar-

ket failure, to deliver a policy that tackles this failure, e.g. strengthen the rule

of law, and let the market do the rest to kick-start growth. Institutions should

then be put into place that keep the economy growing. Khan (2004) defines

this view on the role of the state as the service delivery model, where the

state delivers public goods such as law and order, social security, and market

regulation, and relies on competitive markets to deliver all other goods and

services. (Khan, 2004, p.165) Essentially, this view of the service delivery

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state is also shared by the Washington Consensus and its augmented version.

However, it is not clear whether such a role of the state is sufficient for

a sustainable growth path of developing countries. In fact, the successful

stories of rapid and sustained growth, such as e.g. China, Taiwan, Vietnam,

and Korea, suggest a far more active role of the state in shaping economic de-

velopment and the transition to high-income and dynamic economies. Khan

(2004) argues that in order to achieve sustained growth, the state must beable to reallocate property rights and to manage rents, through e.g. con-

ditionality schemes, in ways that promote growth. In addition, in order to

maintain political stability in the process of economic growth, states must be

able to transfer rents in ways so as to compensate losers and to incentivize

the creation of productive capitalism.

According to Khan (2004), in particular the political dimension of the

economic transition needs emphasis. The distribution of power between dif-

ferent societal groups that participate in the economy and the state is pivotal

for the capacity of the state to enforce policies and implement institutions

that enhance growth. Khan (2004) supports this argumentation by giving

empirical evidence from successful examples of recently growing economies,

such as e.g. Thailand, Korea, and China.

The view that tackling binding constraints is enough to sustain economic

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growth might therefore be misleading. It ignores the active role states have

played in the past in shaping development transitions of successful economies

and does not take into account the political dimension of this process. By

doing so, it commits the same mistake as the Washington Consensus (see

section 2) and the institutional approach (section 3).

6 Conclusion

The dominant feature of growth patterns of economies in the past 300 years

has been divergence and variability. However, to increase income and re-

duce poverty, developing economies need to grow sustainably over a signif-

icant period of time. Hence, accelerating the process of economic growth

in a sustained manner is just about the most important policy issue in eco-

nomics.(Hausmann et al. , 2005, p.303)

Yet, economic policies that have been promoted by international organi-

zations and mainstream economic theory have failed in doing so. Countries

that followed their advice, did not experience sustainable economic devel-

opment. Instead, states that followed unconventional economic policies, in

particular in East Asia, have impressively succeeded in promoting growth.

The framework promoted by Hausmann et al. (2007) suggests that the

main problem of past policy prescriptions was their spray-gun approach.

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Instead, they suggest that developing countries should focus their reform ef-

forts on the most binding constraint, i.e. market failure, that constrains

economic activity. By tackling it, markets will work more efficiently and

hence promote growth.

As I have shown, however, this approach suffers from serious shortcom-

ings. First, there are methodological and practical problems with the appli-

cation of this approach. Second, and more severely, it does not satisfactorilyanswer the question of sustainability. After tackling a binding constraint,

how should economic dynamism be kept alive? Third, and finally, the ap-

proach suffers from the same blindness towards a more active role of the state

in economic development as did previous policy prescriptions. Successful sto-

ries of growth suggest that the state must play an active role in designing the

transition of developing countries towards developed economies. In failing to

incorporate this issue, the framework of binding constraints and market fail-

ures does not provide an adequate guide for determining the functions of the

state in sustaining growth.

(2969 words)

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