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Chapter 5

Chapter 5

States andMarkets

Norton Media Library

Dwight H. PerkinsSteven Radelet

David L. Lindauer

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The Story of Ghana

• in 1957 Ghana gain independence, with great hope for future: the world’s largest cocoa producer, the highest per capita income, large foreign exchange reserves... with plans to be industrialized economy, state intervene in the economy, controlled P, restrictions on trade and I, state-owned enterprises, heavy borrowing, import substitutions

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• in mid 1960s, cocoa prices collapsed

• the state heavy hand led to corruption, poor investment decisions, distorted prices, and growing instability

• coups and countercoups for 17 years

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• economic fluctuations due to unstable cocoa prices

• economic growth fluctuates as a result:

• -6%, 7%, -5%, -14%,

• in 1983 the economy collapsed

• cocoa production was half as large as before

• inflation 120%+, growth rate -6% for 3 years

• per capita income 30% than 26 years before

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• in 1983, an economic recovery program was introduced by IMF and WB

• modest outcome: less inflation 20%, lower trade deficit, more stable and positive economic growth

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• Ghana’s experience is typical to many developing countries

• in 1980s: a shift away from government intervention to more market-based reforms through stabilization and structural adjustment programs

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• The 1980s were called the “lost decade” of Africa. These was also applied to Latin America due to state driven excessive control on the economies

• Ghana led the way in economic reforms followed by others. Later the collapse of the Berlin Wall in 1989 enable many African countries make reforms along market system.

• The end of the cold war and demise of the former Soviet Union led to fall of African dictators

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African Economic ReformsThe 1980s were called the “lost decade” of Africa. These was also applied to Latin America due to state driven excessive control on the economies

Ghana led the way in economic reforms followed by others. Later the collapse of the Berlin Wall in 1989 enable many African countries make reforms along market system.

The end of the cold war and demise of the former Soviet Union led to fall of African dictators such as in Ethiopia, and Somalia, etc

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I. Markets and Market Failures

Market economics well developed in Introductory Principles of Economics (Microeconomics & Macroeconomics)

Markets under certain conditions provide the “invisible hand” to the economy

The Power of Markets in organizing national economies have been proved in successful market Economies

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Arguments for Markets

1.Allocate resources efficiently. Under competitive economy economic welfare is maximized under free working markets

2.Market system is more flexible and able to adjust to business cycles than government control

3.Market promote competition which motivate consumers and producers guided by enlightened self interest.

4.Reliance in Markets disperses economic and political power and therefore consistent with democracy.

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I. Areas of Market Failure

Markets can fail due to numerous reasons

1.Monopoly or oligopoly control..

2..Presence of Externalities ( Positive Spill Over effects)- such as public education, etc

3. Negative Externalities (negative spill over effects- such as pollution

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4. Markets may not facilitate change in economic structure- Infant Industry argument at early stages

5. Missing or underdeveloped Institutions rules/laws

6. Macroeconomic Imbalances

7.Misguided National Goals promoted by autocratic governments especially in Dictatorship. examples

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II. Market Pessimists & Market Optimists

Some Roots of Market Pessimism:

“Great Depression of the 1930 & 1940’s when war led blocked trade barriers

Arguments for intervention and control

(balanced growth, big push arguments)

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Forced structural transformation of economies by States justified by Lewis theory of labor surplus- the Soviet Union was the model 1950 &60’s,

Marxist, Leninist, Mao ideologies of central control and direction of the economies..

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Market Optimism

Intellectual basis for Market Optimism

Economic Theory provides the basis for market supremacy.

Powerful theories by the Chicago School of Economists such as Friedman, Schultz, etc

The historic collapse of the Soviet Union in 1991 and the end of the Cold War

East Asian Miracle of Asian Tigers such Singapore, South Korea, Taiwan, Malaysia, etc.

(See BOX 5.1 Decline of state control over time)

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Implementing Market Reforms

Due to regulations and control that led to rent seeking that diverted investors and entrepreneurs to unproductive activity and corruption, it became necessary to promote markets and the private sector

The World Bank and IMF helped to countries economic reforms: structural adjustment and stabilization reforms.

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Stabilization of the Macro-economy

Stabilization refers to correcting imbalances in budgets, & money supply aimed at controlling inflation.

It also means the need to devalue the currency or exchange rate to avoid currency controls.

With inflation and uncertainty investors divert resources from productive activities such as transfers to overseas, etc

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IMF Stabilization Programs

There are five such remedies

1.Reducing government budget deficit via higher taxes, reduce spending, financing by borrowing which crowds out private investment.

2.Restrictions on central credit-control of money supply

3.Adjust exchange rate via devaluation to stimulate exports.

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4.Remove price controls on consumer goods including food prices

5.Restrain wage increases since wages greater than productivity increase costs and contributes to inflation

Case of Bolivia stabilization program Box 5.2. 1985-86

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Structural Adjustment Program (SAP) by the World Bank

Trade reform- opening the economy to trade

Adjusting Prices” Getting Prices Right”

Promoting market competition

Fostering Privatization

Creating Market Support Institutions (Legal system, financial system, well define property rights rules that promote long term investment and productivity.

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Timing of Market Reforms

Faster reform- shock therapy often recommended by the IMF. This may work under new regimes- Russian & Eastern Europe case.

Graduate reform-based on sequencing of reforms- China and Vietnam

China began with household responsibility system in the rural sector (Box 5-3 A case of China reform 1999-2001)

Attempted reforms in Africa with varying results;

(Uganda, Kenya, Ghana, Mozambique, and Tanzania)

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Credibility of Reforms

How do we evaluate and monitor credibility of reforms.

Public perception matters:

IMF & World Bank are supposed to evaluate reforms

IMF & World Bank reliability of evaluation is questionable especially in dictatorships.

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The Washington Consensus

• Economist Williamson labeling of growing agreement among Washington Institutions ( US Government, World Bank, IMF)

There are 10 components of these consensus

(See Box 5.4 –Washington Consensus case of Brazil)- abolished by most recent government of Lula)

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The ten Components of the Washington Consensus

1.Fiscal discipline-Balance budget, deficit l to2%

2.Reordering public expenditure and priorities- reduce subsidies including Military expenditure

3.Tax Reform: Reduce taxes, improve incentives

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4.Liberalize interest rates: Nominal rate should be higher than the rate of inflation, real interest rate should be positive

5. Promote competitive exchange rate. Avoid currency controls, aimed at expanding exports

6. Trade Liberalization: Reduce or eliminate tariffs (export and import taxes)

7. Liberalization of Foreign Direct Investment (FDI): Attract inflow of capital, skills and knowledge

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8.Privatization: State enterprises should be privatized since they are more efficient under private ownership than state.

9.Deregulation: reduce government regulations including entry and exit of firms. Also ensure safety of the environment.

10. Secure Property Rights in the private sector. Provide long term property rights that is secure and transferable.

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The future Economic Reforms

While implementing the Washington Consensus helps the challenge remains along these lines:

1. The need for strong democratic institutions and good governance necessary to implement development policies

2. The need to for transparency in national and international institutions including global institutions that re-solve peacefully and promote sustainable peace and justice.