Markets versus Controls

Capitalist and Command Economies

Capitalist (Market) Economy

Market mechanisms allocate goods, services and factors Markets are flexible, and adapt quickly to changing conditions Subject to Market Failures:

Market power monopoly and oligopolies Externality and Public Good problems Spillover effects (i.e. infant industry arguments) Underdeveloped institutions

Central (socialist) Economies

Central planners control allocation of goods, services and factors of production Used long run plans to manage economy Gave central planners high degree of control to achieve goals, restructure industries

Mixed Economy

Economy in between capitalist and control Market sets prices Government may intervene through policy

March Towards Markets I

Most governments have been moving towards capitalist systems Initially Marxs belief in chaotic nature of markets influenced designers of economic systems Move from agriculture to manufacturing helped by central control

March Towards Markets II

During 80s and 90s control systems started to break down Pressure to substitute market mechansims for central control Deregulation and privatization were popular Widespread corruption and rent seeking created waste and slowed growth

Implementing Market Reforms

Conditions necessary for transition from control to market economy
1. 2.

3.
4. 5.

Stable prices, macroeconomy in equilibrium Most goods and services bought and sold through market mechanism Competition Prices should reflect scarcity Firm managers, farmers etc. must respond to incentives (Market Signals)

1. Stability

With large price swings, governments face pressure to enact controls Creates either excess demand or excess supply, and disequilibrium Black market may result Increase in money supply causes inflation Rampant inflation fuels investment in more stable assets (gold, land, etc.)

Stabilization Programs
IMF supports reducing inflation by

Reduction of budget deficit (deficit requires borrowing increases money supply) Restrictive targets for central bank credit Exchange rate devaluation (raises price of foreign exchange) Removal of price controls Targets for restraining wage increases

Tied loans to reforms, speed of adjustment was controversial

2. Market Mechanisms

Dismantling controls necessary Structural Adjustment Make goods available for purchase on market

Both consumer goods and inputs

liberalization or deregulation

3. Competition

Competition needed to force firms to operate efficiently Governments often resist foreign competition, and perceived waste of domestic competition Deregulation of import controls and reduction of tariffs often necessary to create competition

4. Scarcity Prices
Relative prices tell firms how to manage resources If prices reflect scarcity, firms and consumers will act to maximize welfare Scarce resources should have relatively high prices Structural Adjustment tries to remove distortions by removing government interventions Ex. Credit restrictions, import tariffs, price controls

5. Market Signals

Induce producers to respond to incentives In control economies managers are appointed by government, profits go to govt In market economies owners/managers incentives often tied to profit Property rights need to be well defined and exclusive, transferable and enforceable

Lit Review
Government Failures in Development
Anne O. Krueger

Krueger - Government Failures in Development

Market vs. Government Failures

Market failures were thought to differentiate developed from developing countries Governments role was to correct for market failures Governments effort was often more damaging than original failure

Krueger - Government Failures in Development

Market Failures

When conditions for Pareto-optimality are not satisfied in ways which a government could correct for Thought to result from structural rigidities in developing countries (institutions)

Lack of responsiveness to price signals

Krueger - Government Failures in Development

Government Failures

Failures of commission

High-cost public sector enterprises

State marketing boards State ownership of retail shops (for essential goods) State operation of mines and manufacturing Monopoly rights

Investment programs were often inefficient and wasteful Large public sector deficits led to inflation

Krueger - Government Failures in Development

Government Failures

Failures of omission

Deteriorating transport and communications facilities Maintenance of fixed nominal exchange rates Mandating low nominal interest rates Failure to maintain existing infrastructure facilities

Krueger - Government Failures in Development

Effects of failure

Government failures led to large-scale and visible corruption Programs and policies for poor had disproportionately benefitted the more affluent Government policies were not growthpromoting (savings did not lead to growth)

Krueger - Government Failures in Development

Main Questions
1. 2.

3.

4.

What is the government? What is the comparative advantage of government? What are the dynamics of government intervention? Can a positive theory of political behavior be formulated that will help explain when and how alternative policies will evolve?

Krueger - Government Failures in Development

1. What is The Government

Theory says government should behave as a benevolent social guardian Coordination and administration of public sector activity assumed to be costless Practically it doesnt work this way Political pressure distorts economic programs Infant industry argument => protectionism

Krueger - Government Failures in Development

1. The Government (cont)

The Government consists of a multitude of actors, with differing objectives Individual actors within public sector are as concerned with self-interest as private sector What sets of institutions and incentives are likely to be most conducive to achieving a least-cost outcome?

Krueger - Government Failures in Development

2. Comparative Advantage of Government?

Theory Government should undertake a list of items that have aspects of public goods

Infrastructure

Undertaking any activity in the public sector is costly drains administrative and organizational resources Economically efficient division between public and private sectors based on administrative and organizational requirements Focus on non-essential provision has diverted resources from comparative advantage

Krueger - Government Failures in Development

3. Dynamics of Govt Intervention

Allocating goods/rights at below market value leads to rent-seeking behavior Policies with clear beneficiaries/victims will face organized support / protest Within the government interests will vary with department

Spending ministries will be advocates for programs within their domain

Krueger - Government Failures in Development

4. Guidance for Policy Makers

Action by government is not costless

Not all market failures warrant intervention

When intervention is optimal, bias should be towards policies and programs that minimize administrative and bureaucratic input If alternative mechanisms and policies are available, preference should be for those that minimize rent-seeking Policies with more transparency should be chosen

Krueger - Government Failures in Development

Conclusion

Political actors have objective functions and constraints that need not maximize social welfare Policies should be chosen keeping these competing objectives in mind

East Asia and Latin America as Contrasting Models

Ching-Yuan Lin

Lin East Asia vs. Latin America

Motivation

After 1960s, economic progress of East Asia and Latin America diverged What caused this divergence? Do government policies explain the divergence in growth?

Lin East Asia vs. Latin America

Economic Performance
Annual Growth Taiwan 10.4% Change in Price Levels 3.7%

South Korea
Chile Argentina

8.9%
3.4% 3.1%

12.7%
42.9% 27.5%

Lin East Asia vs. Latin America

Lin East Asia vs. Latin America

Motivation

After 1960s, economic progress of East Asia and Latin America diverged What caused this divergence? Do government policies explain the divergence in growth?

Lin East Asia vs. Latin America

Post-War period

All four countries practiced inward-oriented industrialization Import substitute production encouraged Production of traditional exports was discouraged Resources were reallocated from export sectors to new urban industrial sector Foreign exchange, credit and inputs were rationed

Lin East Asia vs. Latin America

Korea and Taiwan 1950s-60s

Exchange rate was corrected Incentives for exports were increased Competitive search for profitable export items or outlets resulted Korea instituted massive export promotion regime

Lin East Asia vs. Latin America

Chile and Argentina 1960s

Moderate export promotion was undertaken for nontraditional exports Specific products were targeted

Lin East Asia vs. Latin America

Effective rates of production (late 60s)

effect of tariff structure on value added per unit

Lin East Asia vs. Latin America

East Asia vs. Latin America

Taiwan and South Korea faced growing populations and minimal natural resources

Needed to promote manufactured exports

Argentina and Chile faced a lack of social consensus, large natural resource endowments and little population pressures

Lin East Asia vs. Latin America

Monetary Policy

Monetary policy diverged from the 1960s onwards Taiwan and Korea managed inflation well, keeping prices stable Chile and Argentina avoided managing inflation due to fears of recessions and unemployment Business attitudes adjusted to the reality of inflation in both regions

Lin East Asia vs. Latin America

Lit Review - Institutions

Rodrik vs. Sachs

Institutions Rule:
The Primacy of institutions over geography and integration in economic development

Dani Rodrik, Arvind Subramanian and Francesco Trebbi

Rodrik et al Institutions Rule

Theory

Three strands of thought on causes behind income variance

Geography climate, resources, disease Integration International Trade drives convergence Institutions property rights and rule of law

Difficulty lies in sorting out web of causality Problems of endogeneity and reverse causality

Rodrik et al Institutions Rule

Rodrik et al Institutions Rule

Overview

Empirical estimate of effects of geography, integration and institutions on growth Conclusion: Quality of institutions trump everything else

Rodrik et al Institutions Rule

Instruments and Variables

Geography is exogenous
Integration is modeled after Frankel and Romers approach

Instrument for actual trade/gdp ratios by using gravity equation and constructing predicted aggregate trade share Mortality rates of colonial settlers had an effect on type of institutions that were developed in colonies

Institutions is modeled after AJR

Rodrik et al Institutions Rule

Empirics

Estimate a series of regressions with geography variables, integration and institution instruments Gave information about cross-national variation in income levels (causal links among determinants) Result

Quality of institutions trump everything else in explaining income Institutional quality has a positive and significant effect on integration Geography has a significant effect on institutions

Remainder of paper focuses on robustness

Institutions Dont Rule:

Direct Effects of Geography on Per Capita Income Jeffrey D. Sachs

Sachs Institutions Dont Rule

Overview

Malaria transmission directly affects level of per capita income They were all wrong.

Geographical variable was not good

Sachs Institutions Dont Rule

Response to

Acemoglu, Johnson and Robinson, 2001 (mortality rates) Easterly and Levine 2002, Endowments Rodrik, Subramanian and Trebbis, institutions rule They used poor variables for geography Logic of the geographic-institutions linkage is also the logic of the geography-productivity linkage!

Equation used was too simplistic

Should use growth of income rather than income level

Sachs Institutions Dont Rule

Model

Simple regression with geography, and quality of institutions Geography is instrumented with malaria risk,

a new variable that abstracts from underreporting problems Involves temperature, mosquito abundance and vector specificity

Wanted to reject null hypothesis that geography doesnt matter

Sachs Institutions Dont Rule

Result

Geography matters! Null hypothesis is rejected in all data sets There is good theoretical and empirical reason to believe that development reflects institutions, policies and geography

Getting Institutions Right

Dani Rodrik

Getting Institutions Right

Dani Rodrik

Empirical research shows institutions exert very strong effect on aggregate incomes Focus on institutions has led to ambitious agenda of governance reforms

Reducing corruption Improving regulation Rendering monetary and fiscal institutions independent Enhancing judiciary

Rodrik Getting Institutions Right

An Instrument does not a theory make

Institutional quality is endogenous to income levels Correlation is NOT equal to causation! Economists ability to disentangle prosperity from institutions is limited

Rodrik Getting Institutions Right

Variable: colonizers mortality rates

Variation in average income levels among countries without colonization as large as those which had been colonized Correct interpretation: instrumental variable for something else, not actual explaining patterns

Rodrik Getting Institutions Right

Geography-based IVs do not imply geography based explanations

Most instruments for institutions likely to have large geographical component Can we separate geography and institutions effect on income? Geography may simply be an instrumental variable for institutions (i.e. Europe prior to 1989) Scholarly opinion remains divided on significance of geography

Rodrik Getting Institutions Right

Centrality of institutions does not preclude indirect role for geography

When one endogenizes institutional formation

Geography is an important part of the story

Even if geography and endowments do not directly affect income

may have an indirect effect through institutions

Rodrik Getting Institutions Right

Measure of institutional quality is nebulous

Measures based on perceptions are highly tied to income levels Disconnect between perceptions and actual rules and regulations Results do not show us rules, legislation or design that ties institutions to income Effective institutional outcomes do not map into unique institutional design

Futile to link specific rules to economic outcomes

Rodrik Getting Institutions Right

Conclusion

Large scale institutional transformation is hardly ever a prerequisite for jumpstarting growth Major task for growth economists is to develop a framework of growth diagnostics to identify jumpstarts.