Steele Lecture 2

7/30/2019 Steele Lecture 2

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Markets versus Controls

Capitalist and Command Economies


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Capitalist (Market) Economy

Market mechanisms allocate goods, services

and factors

Markets are flexible, and adapt quickly tochanging conditions

Subject to Market Failures:

Market power monopoly and oligopolies

Externality and Public Good problems

Spillover effects (i.e. infant industry arguments)

Underdeveloped institutions


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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


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Mixed Economy

Economy in between capitalist and control

Market sets prices

Government may intervene through policy


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March Towards Markets I

Most governments have been moving

towards capitalist systems

Initially Marxs belief in chaotic nature ofmarkets influenced designers of economic

systems

Move from agriculture to manufacturing

helped by central control


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March Towards Markets II

During 80s and 90s control systems started

to break down

Pressure to substitute market mechansimsfor central control

Deregulation and privatization were popular

Widespread corruption and rent seeking

created waste and slowed growth


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Implementing Market Reforms

Conditions necessary for transition from control

to market economy

1. Stable prices, macroeconomy in equilibrium2. Most goods and services bought and sold

through market mechanism

3. Competition

4. Prices should reflect scarcity5. Firm managers, farmers etc. must respond to

incentives (Market Signals)


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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.)


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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


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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


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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 interventionsEx. Credit restrictions, import tariffs, price controls


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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


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Lit ReviewGovernment Failures in Development

Anne O. Krueger


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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


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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



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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 andwasteful

Large public sector deficits led to inflation



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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



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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 growth-

promoting (savings did not lead to growth)



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Main Questions

1. What is the government?

2. What is the comparative advantage of

government?

3. What are the dynamics of government

intervention?

4. Can a positive theory of political behavior be

formulated that will help explain when and

how alternative policies will evolve?



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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



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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?



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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 andorganizational requirements

Focus on non-essential provision has diverted

resources from comparative advantage



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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 forprograms within their domain



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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 thatminimize rent-seeking

Policies with more transparency should be

chosen



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Conclusion

Political actors have objective functions and

constraints that need not maximize social

welfare

Policies should be chosen keeping these

competing objectives in mind



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East Asia and Latin

America as ContrastingModels

Ching-Yuan Lin


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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


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Economic Performance

AnnualGrowth

Change inPrice Levels

Taiwan 10.4% 3.7%

South Korea 8.9% 12.7%

Chile 3.4% 42.9%

Argentina 3.1% 27.5%


Lin East Asia vs Latin America


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Motivation

After 1960s, economic progress of East Asia

and Latin America diverged

What caused this divergence?

Do government policies explain the

divergence in growth?



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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



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Korea and Taiwan 1950s-60s

Exchange rate was corrected

Incentives for exports were increased

Competitive search for profitable export itemsor outlets resulted

Korea instituted massive export promotion

regime



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Chile and Argentina 1960s

Moderate export promotion was undertaken

for nontraditional exports

Specific products were targeted



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Effective rates of production (late 60s)

effect of tariff structure on value added per unit



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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



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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




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Lit Review - Institutions

Rodrik vs. Sachs


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Institutions Rule:The Primacy of institutions over

geography and integration ineconomic development

Dani Rodrik, Arvind Subramanian andFrancesco Trebbi


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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



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R d ik t l I tit ti R l


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Overview

Empirical estimate of effects of geography,

integration and institutions on growth

Conclusion: Quality of institutions trump

everything else




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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

Institutions is modeled after AJR

Mortality rates of colonial settlers had an effect on

type of institutions that were developed in colonies




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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



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Institutions Dont Rule:Direct Effects of Geography on Per

Capita Income

Jeffrey D. Sachs

Sachs Institutions Dont Rule


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Overview

Malaria transmission directly affects level of

per capita income

They were all wrong.

Geographical variable was not good

SachsInstitutions Dont Rule



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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

SachsInstitutions Don t Rule



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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




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Result

Geography matters!

Null hypothesis is rejected in all data sets

There is good theoretical and empiricalreason to believe that development reflects

institutions, policies and geography



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Getting Institutions Right

Dani Rodrik


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Getting Institutions RightDani 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 institutionsindependent

Enhancing judiciary

Rodrik Getting Institutions Right


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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




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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




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Geography-based IVs do not implygeography 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




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Centrality of institutions does notpreclude 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




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Measure of institutional quality isnebulous

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 mapinto unique institutional design

Futile to link specific rules to economic outcomes




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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.


Steele Lecture 2

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