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The Road to Prosperity:Market vs State
Rok Spruk  Economist, Slovenia  1/20/2011 4:43:33 AM

 The relationship between the economic policy and economic growth is one of the most studied ones in the economic literature and, indeed, one of the most important questions considering the prospects of economic growth and development. In the course of economic history, the clash between political philosophies has resulted in a wide range of economic experiments that were ultimately divided between success and failure. The failure of the Soviet political and economic experiment largely resulted in the institutional transition of former communist states to the principles nested in the market economy. Despite the Common Law legal origins, India has pursued predominantly socialist economic policies since the country gained the independence from the British rule in 1947. The pursuit of economic policies based on protectionist trade policy, autarkic self-sufficiency and state interventionism did little to prevent high rates of poverty and even less to promote economic development in a longer term. Despite significant economic growth dynamics in the past years, India’s GDP per capita (PPP-adjusted) is ranked 163rd in the world together with Mongolia and Vietnam. It is nonetheless important to outline the premises of public policy that rely on free market, limited government and the rule of law as the guiding principles to which the policy of economic development in developing countries shall adhere.
The reliance on socialist economic policies which India pursued since gaining the independence from the United Kingdom has largely resulted in economic mismanagement and deteriorating income mobility. The resulting outcome of the socialist political and economic idea contradicted the primary ideological goal of socialist political philosophy - the eradication of poverty and the pursuit of economic equality for all. According to World Bank, in 2005, 41.6 percent of Indians lived in poverty with less than $1.25 per day. In 2008, the mortality rate for children under the age of five stood at 69 per 1,000 which is a little less than in Haiti (72 per 1,000) and more than in China (21 per 1,000). Hardly any evidence could further dispute the self-destructive nature of socialist economic policies to deliver the promised goals.
The failure of socialism in development policy reflects its misunderstanding of the emergence of economic system as an order of spontaneous creation. Socialist political experiment rests mainly on the idea of guiding the development policy through economic dirigisme. In the course of political economic history, socialist political leaders pledged on the promise of delivering social goals such as free education and health care and a better standard of living for all members of society. The socialist philosophy of economic policy is mainly derived from the philosophical thought of Marx, Hegel, Rosseau and Lenin. The epistemological nature of economic philosophy is subject to the perception of human nature of greed in relation to the concept of “homo economicus” firstly developed by Adam Smith in “The Wealth of Nations”. In its origins, the conceptual framework in development policy depends on which economic philosophy shall prevail as a set of guiding principles in the policy course.
The rise of the British empire in the 19th century of the Victorian age to the world political and economic giant was largely based on the legacy of the economic thought from enlightenment which stressed the importance of free market, sound money and limited government which focused on the enforcement of the rule of law. The intercourse of development policy in each country lies firmly on the grounds of formal and informal institutions. The interaction between formal and informal institutions is one of the most powerful determinants of a perspective of economic development in a long term.
Formal institutions such as the constitution and legislative laws are nonetheless a central element on which the creation of the fundamentals for the pursuit of economic development is based. However, formal institutional phenomena could not be explained without a proper understanding of informal institutions such as ethics, culture and habits. These institutions endogenously determine the very nature of formal institutions since the latter are not established mechanistically but rather through human action and behaviour. Douglass C. North, a Nobel laureate in economics from 1993, captured the essence of the importance of well-functioning interaction of formal and informal institutions for economic development: “The inability of societies to develop effective low-cost enforcement of contracts is the most important source of both historical stagnation and contemporary underdevelopment of the third world.” (North 1990: 54). The alleged failure of socialist economic policy is entirely reflected in its ignorance and pretense of understanding the evolution of the market system as a spontaneous order. The pretense of full understanding of the society without the awareness of the limits of knowledge in curing society’s ills is the most important source of predatory behaviour that is so detrimental to economic development. One of the most notable sources of stagnation of less developed countries has been the failure to protect property rights through a well-functioning and stable judicial system. It would be impossible to expect a well-functioning law enforcement in failed states since the political dictatorships and widespread rent-seeking behaviour emerging from privileged interest groups are the main causes, not consequences, of predatory behaviour such as the insecurity of property rights and, hence, the lack of the rule of law. The inevitable consequence of predatory political behaviour emerged from a totalitarian development paradigm is a widespread prevalence of rent-seeking behaviour that ultimately results in a total inability of formally established institutions to enforce the rule of law as the guardian of the protection of private property rights. The experience of least-developed and developing countries in the course of development policy suggests that most of them have become failed states with the prevalence of widespread and cumbersome corruption even though these countries were forecast to encounter high economic growth and the resulting increase in the standard of living alongside the official developmental assistance from creditor countries and international institutions.
Nevertheless, the belief in the power of political elites to boost the economic development by the means of their supposed knowledge of the economic behaviour is a fatal conceit. The experience of less and least developed countries suggests that political elitism complements predatory political behaviour focused on the extraction of political rents rather than on the implementation of an effective set of policies aimed at boosting the economic development. Therefore, the only plausible question in this regard is what kind of development policies to pursue to prevent least developed and developing countries from the capture of political elitism, corruption and rent-seeking that has led to a constant underdevelopment and economic stagnation compared to the advanced countries?

Establishing the Rule of Law
The lack of a well-defined and well-functioning legal order has been the main cause of the corrupt political elitism that led to civil wars, stagnating per capita incomes and politico-economic instability. Countries that have moved up the economic ladder and maintained high levels of prosperity, such as Singapore and Hong Kong, have first established a framework of the legal order based on the rule of law - a framework that was able to protect private property rights against expropriation and political abuse. Without a coherent and robust system of law, it is impossible to establish an independent judicial system. The empirical evidence from the economic consequences of the legal origin suggests that English-based Common law is by far the most efficient legal framework regarding the confluence of legal system on economic growth and development.

Protecting Private Property Rights
Historically, less developed countries have suffered heavily from the lack of independent judicial system that imposed high cost on the protection of private property rights. The insecurity of private property rights is a significant drawback on economic development not only from the perspective of foreign and domestic investors but also from the individual point of view. Insecure and improperly defined private property rights incur significant cost on the defense of private property which is, from an economic point of view, counterproductive. The lack of effective protection of private property rights largely resulted in undeveloped or practically non-existent capital and financial markets. By most measures and empirical judgments, there is a close and remarkably high correlation between the level of financial market development and income per capita. The foremost task of less developed countries, including India, is to establish a set of political institutions that instill an effective system of checks and balances on the rule of law as a mechanism curtailing the coercive power of policymakers and interest groups.

Abolishing Price Controls
The system of price controls is a heavy impediment on economic growth and, therefore, a major drawback on the productive behaviour such as entrepreneurship, savings, investment and education. The majority of price control schemes is intended to bequest a particular group of the society. Traditionally, price controls have been imposed on goods such as food, drugs and commodities. But when the laws of supply and demand prevail, the effect of price controls immediately translates into the parallel informal economy where prices are determined according the shifts of supply and demand. Price ceilings cause shortages. The mechanism of free price system is one of the most important fundamentals of a free-market economy. There is, in fact, no better alternative approach to start alleviating poverty than setting a system of free prices and abolishing all price controls that sooner or later result in shortages of basic good if prices are not allowed to adjust freely.

Abandoning Special Privileges and Caste System
Perhaps the most fundamental question of development economics and policy is what accounts, over time, for a growing gap between the wealthy and poor countries and, hence, how poor countries can sustain high economic growth and the consequent growth of the standard of living. The main failure of development economics in the past century is the unrecognized and rather powerful role of social rigidities and special interest groups in imposing policies that nevertheless hurt the prospects of economic development. Interest groups tend to act like small distributive and elitist coalitions that seize the capture of the state. By exerting an enormous influence on policymakers and political leaders, these groups hinder the implementation of public policies that would nonetheless boost civil and economic liberties and, hence, economic development. In the widest possible sense, economic and civil liberties would empower millions of individuals to spur the potential of human knowledge that is the ultimate source of progress. Although the ancient caste system in India was abolished in 1960s, as an informal institution, its social entrenchment has not fully disappeared. The existence of caste system significantly reduces the scope of economic and social mobility. The influence of the institution of caste system is, by no further clarification, an ultimate source of widespread poverty and the lack of mobility. As Mancur Olson (1982) contemplated, the benefits of policies in favour of particular interest groups are selective incentives concentrated among the members of privileged groups while the costs are diffused among the entire population. As little public resistance to such groups is arisen, these groups tend to exert stronger influence and capture the state into the status quo which is, by no dispute whatsoever, the main obstacle to greater economic liberty and, hence, greater economic development. The inability of societies to enforce the rule of law and institutions of economic and civil liberties against the coercive power of rigid political and social elites is perhaps the only plausible explanation of economic stagnation marked by high poverty rates, and rachitic progress in terms of education and poverty reduction. It is nevertheless important to stress that it is a fatal illusion to believe in the power and ability of political elites to cure the ills of poverty by the implementation of socialist public policies aimed at the premise of the big role of government and bureaucracy in achieving the economic and social progress. The road to higher levels of economic development requires greater strengthening of human liberty. The disappearance of social rigidities such as caste system is a necessary condition and the ultimate opportunity to tackle the endogenous patterns of corruption and other predatory political behaviour. The task of economic development is not a self-sustaining quest. As Friedrich A. von Hayek (1978: 60) notes “Experience tells us much about the effectiveness of different social and economic systems as a whole. But an order of the complexity of modern society can be designed neither as a whole, nor by shaping each part separately without regard to the rest, but only by consistently adhering to certain principles throughout a process of evolution.” The only plausible alternative to boost the economic development is not by the greater strength of the state, caste system and interest groups of special privilege but by the greater spread of economic and civil liberties such as free price system, deregulated markets and individual liberties

Limited Government and Safeguarding the Individual Liberty
The belief in the power and ability of the state to enhance the policy framework of economic development by facilitating particular measures while the patterns of informal institutions remain unchanged is the main remnant of the failed epistemic assumptions of development economics. Development, defined in the widest possible sense of economic and social progress, does not depend on the effectiveness of particular policy design but rather on the tacit acknowledgement of the importance of economic and civil liberties as the basis of economic development. The experience suggests that greater coercive power of the state is the ultimate source of economic decline and stagnation. The capture of the state, broadly defined as the inability to enact long-term policies aimed at promoting economic development, cannot be properly understood without the awareness of the power of interest groups of special privilege. The enactment of the rule of law as a system of limiting the coercive power of the state and interest groups, is the main determinant of economic development. The enforcement of the rule of law requires a fundamental change in the nature of informal institutions. Unless the premises of civil and economic liberties and of highly limited power of the state are not adopted and recognized as the main precondition for economic development, the effort to establish the rule of law would fail. The failure of socialist economic policies largely resulted from the assumed believe in the power of the state to establish and design the economic order. Consequently, the failure to acknowledge the impossibility of the state to create and economic order resulted in decades of economic mismanagement that ultimately led to the economic stagnation and decline. Among the preconditions for a steady course of economic development is the security of private property rights. Having failed to recognize the importance of the judicial protection of private property rights, the less and least developed countries failed to capture the essential understanding of the economic development. Adhering to the certain principles of the rule of law and limited government is not merely an attempt to restore the foundations of development policy but an approach aimed at the very understanding of the evolution of economic development. Pretending to adhere to the scientific principles of economic development is nothing else but a mere failure to acknowledge the importance of the role of economic liberties on which the evolution of development is based. The adherence of principles of economic and civil liberties is built on the premise of limiting the coercive power of the state which may, if left unchecked, sooner or later result in the capture by interest groups and, hence, implementation of policies and laws that would nonetheless hinder the prospects of economic development in the name of social justice. As James Madison noted in 1788 in The Federalist Papers “It will be of little avail to the people that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood.” It is nevertheless essential for less developed countries to recognize the failure of economic dirigisme and foreign aid in promoting economic development. Instead, it should be well-known that the approach that boosts development and progress is not the implementation of certain policies that temporarily alleviate issues of particular concern. It is rather the awareness of the importance of the rule of law and protection of private property rights. The rule of law, ascertained on the principles of its legal origin, is not an end itself but a precondition for instituting the principles of economic and civil liberties and limits on the redistributive and coercive power of the state and interest groups, which is so essential to the course of economic development. Civil and economic liberties may encounter a heavy resistance from small and powerful interest groups that enjoy vast privileges from social rigidities. But it should not be forgotten that the existence of specially treated interest groups with yields substantial amounts of privilege for its members and cost for other members of the society. It is the strong influence and power of these groups that forestalled the status quo and detracted poor countries from the steady road to prosperity embodied in sound property rights, the rule of law, free markets and limited government. 

References and Additional Thinking
• Hayek, F. A. (1978). Law, Legislation and Liberty, Vol. 1: Rules and Order. Chicago, IL: University of Chicago Press
• Olson, M. (1982). The Rise and Decline of Nations: Economic Growth, Stagnation and Social Rigidities. New Haven, CT: Yale University Press
• Madison, J. (1788). Federalist No. 62, in Hamilton A., Madison J. & Jay J. (2003) The Federalist Papers, New York, NY: Penguin Classics
• North, D. (1990). Institutions, Institutional Change and Economic Performance. New York, NY: Cambridge University Press

(The views expressed in the write-up are personal and do not re?ect the official policy or position of the organization.)


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