On state and markets

Hayami and Yoshihisa Godo.
The beauty of the book is that it provides a comprehensive, systematic treatise on development economics, combining classical political economy, modern institutional theory, and current development issues. It is, as if, telling the tales of travels of how nations graduated from poverty to opulence, from backwardness to development. The book is also, seemingly, sympathetic to non-economists -- pointing to policy makers -- by not involving much of econometric works.

Market and state
Yujiro Hayami and Yoshihisa Godo opine that, in terms of the nature of transactions, market and state are at opposite poles: market is an organization that coordinates the production and consumption of goods and services through voluntary transactions while the state is an organization to coordinate people's activities by monopolizing legitimate coercive power. Thus, they stand diametrically opposite as far as resource allocation is concerned. But, barring small subsistence economies, market and state can also be construed as inseparably interdependent.

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For example, market cannot function fruitfully unless property rights are resolved by the state through enacting laws and enforcing contracts by courts and police. The state, in turn, is dependent on market for cost-effective resource generation. In the words of the authors: "Thus, no economy of any contemporary significance operates without the state and the market. Differences in economic systems reflects a difference in the way in which the state and the market are combined, i.e. which aspects of economic activities the state is in charge of, which aspects are left to the market, and how strongly and widely market activities are controlled by the state's administrative organization -- government. It is a matter of degree. The question here is what combination of these two organizations would optimize the growth of developing economies."

Market matters
The orthodoxy of economics, from Adam Smith and the English Classical School to the neoclassical school, considered competition in a free market as the basis of socially optimum allocation of resources. Under these conditions, there should be no need of government interventions. Pareto optimum prevails and efficiency in resource allocation augers well under the aegis of "invisible hand," division of labour, or persuasion of personal interests. By and large, efficiency in resource allocation under market economy dominates deliberations of development economists -- including that of the authors I referred to earlier.

However, in the book Development as Freedom, the Nobel Laureate economist Amartya Sen lamented that the focus in assessing market mechanism has tended to be on the results it ultimately generates, such as the incomes or the utilities yielded by the markets: "That is not a negligible issue. But the more immediate case for the freedom of market transactions lies in the basic importance of that freedom itself. To deny that freedom in general would be in itself a major failing of a society."

So much market matters as a field of freedom that Amartya Sen adduced the fall of socialism in economic inefficiency of the communist system as well as to the denial of freedom in a system where markets were ruled out.

Market failures
Despite allocative efficiency and the freedom fetched from market, market mechanism had been severely subject to criticisms on many grounds. Yujiro and Youhihisa present a few of them. First market failure emerges in the supply of public good where property rights are not specified to result in "free riders." Second, some private goods such as automobile could be "public bads" because of air pollution, and market mechanism overlooks the social costs. Third, asymmetric information results in monopolistic competition, and finally, the market is the mechanism to promote economic efficiency but not to improve income distribution. Further, J.E Stiglitz pointed to new market failures embracing costly information, transaction costs, and the absence of futures markets that extend the range of market failures beyond the earlier attention to public goods and externality.

Graceful government
After World War II, as we all know, the governments of Asia and Africa turned to economists in the US or UK for a recipe to realize economic independence. At that time, grand models of development strategies that involved structural transformation and an extensive role of government, with an eye on raising the per capita income, lay at the heart of the approach. The suggested models and hypotheses, from the western advisors, highlighted the role of a strong state sector on the heels of pervasive market failures that underdeveloped countries are faced with. To correct or avoid market failure, they advocated central coordination of the allocation of resources. The newly expanding subject of welfare economics also provided considerable rationale for government action for facing market failures. Thus, state emerged as the major agent of economic change to the first generation of development advisers in the wake of an unreliable price system, limited entrepreneurship, and the need for large structural adjustments to put developing countries on an even keel. They had the faith in the government in the spheres of promoting capital accumulation, utilizing surplus labour, undertaking policies for industrialization, relaxing foreign exchange constraint via import substitution, and coordinating the allocation of resources through programming and planning.

Government failure
The growing governmental interventions, on the heels of market failures, gave rise to grievous governance and state patronage so much so that during the 1990s, government failures allegedly got more prominence than market failures. Some of the failures are for example and according to the authors: (a) Over and under supply of public goods entailing higher budgetary costs and constraining growth, respectively; (b) Political leaders tend to maximize their likelihood of staying in office and at the cost of resource uses under sound economic considerations. Thus, not surprisingly perhaps, allocation for scientific researches and extensions remained on the backburner while "political projects" attracted allocations to create an over supply; (c) Since government is a monopolist of legitimate coercive power and has no danger of bankruptcy, strong incentive prevails for socially unproductive pursuit of enhancing power and position of bureaucrats; and (d) Rent seeking activities run galore in a regime of licensing and regulations.

Which way to go?
Yujiro and Yoshihisa argue that both the market and the state are indispensable for allocating resources. One needs to clearly identify the failures of the systems and eke out a thread of combination that works well in terms of efficiency and welfare. For developing countries it is especially important to recognize that the types and magnitudes of both market and government failures are different for different cultural heritages as well as for different stages of development. Thus Japan, Korea, and Taiwan jumped up in a system in which the area under government control is wider than in the populist model in Latin America. There is no doubt that developing countries are subject to severe market failures. But the reasons underlying such failures could invite more government failures than market failures. According to Yujiro and Yoshihisa: "With the recognition of this possibility, the choice of an optimum combination between the market and the state under given historical condition is most fundamental in the design of development."

Abdul Bayes is Professor of Economics at Jahangirnagar University.