The Importance of Government Policies in Promoting the Economic Growth - Literature review Example

Historical experience on policies for economic development What does historical experience show on the policies that best promote economic development? In this paper, the question is addressed in two ways. In the first way, history is taken as a snap shot as it would appear in a graphical relation, pie graphs, and tables of studies. The writer is confident that the snap shots would be suggestive of the policies that can promote economic growth. Analysis is enriched by the second way in this work, by taking the economic development of Asia as a case. In the writer’s opinion, the history of the United States and United Kingdom may not be a good case study for drawing insights on policies that can best promote economic growth and development because the two countries used to have colonies. . Economists have posited the crucial role played by investment in economic growth. This is in a conventional economic model known as national income accounting identity shown in equation 1 below (Dornbusch et al., 2005, p. 25). Equation 1 Y = C + I + G + (X – M) In equation 1, Y is national income or output. C is consumption, I is investment, G is government spending, X are exports, and M are imports. The quantity (X – M) represents net exports. It immediately follows from equation 1 that economic development is a function of consumption, investment, government spending, and net exports. At the same time, things are not really as simple as this a section of conventional economists identifying themselves as rational expectations economists or new classical economists would dispute the role of government spending in increasing output. Nevertheless, it remains valid to talk of the relationship between output and investment, especially if a production function is invoked instead as represented by equation 2. Equation 2 Y = f (L, K) In this production function, output or Y is a function of labour (L) and capital (K). Figure 2 next indicate the role of investment climate on investment growth. Investment climate is represented by “investment profile” (WDR, 2005, p. 27). As defined by the World Bank, investment profile refers to contract enforceability, expropriation, profit repatriation, and payment delays (WDR, 2005, p. 27). The said features were converted into an indicator and those associated with pro-market policies were associated with a positive profile and those not associated with pro-market policies were associated with a negative profile. Figure 1. Investment climate and investment Source: Figure 1.10, World Development Report, 2005, p. 27 The conclusion that will follow from figure 1, of course, is that policies that promote a freer market in terms contract enforceability, security from expropriation, and provide freedom to repatriate profit promote growth and economic development. Economic growth refers to output and income while economic development is something much more because it involves a restructuring of how society organizes and builds a system for producing output and income (Todaro, 2007, 14-22 & 811). Economic development covers not only income and output but also economies as social system (Todaro, 2007, 14-15). Figure 2 below captures the result of the survey of the World Bank covering 26,000 firms in 53 countries for WDR 2005. The figure indicates that foremost among the concerns of firms that affects their investments are policy risks covering policy uncertainty and policies that affect macroeconomic stability (WDR, 2005, p. 5). This also indicates the issues to be addressed by policy in promoting economic growth. Figure 2. View of firms on the constraints to investment climate Source: Box 2, World Development Report, 2005, p. 5 As indicated by Figure 2, based on the survey of the World Bank, the top five severe obstacles to investment are corruption, cost and access to finance, taxation, macro instability, and policy uncertainty. It follows therefore from Figure 2 that in order to promote economic growth and development, the obstacles to a better investment climate must be addressed and removed through policies. Figure 3 confirms the top investment concerns of firms surveyed by the World Bank for its 2005 report. However, in Figure 3, the respondent were made to identify their topmost concerns. In contrast, Figure 2 reflects how each concerned as rank as a severe, major, and minor obstacle by firms. Based on the World Bank surveys for the 2005 report, the top five concerns of the firms that were reflected by firms as their number 1 concern are macroeconomic instability, policy uncertainty, taxation, regulation, and corruption. Again, Figure 3 is different from Figure 2 but Figure 3 confirms the findings reflected in Figure 2. The figures indicate that it is important for policy makers the problem of policy uncertainty, macroeconomic stability, taxation, regulation and corruption in order to promote economic growth. Figure 3. Top investment concerns of firms surveyed by the World Bank Source: World Development Report, 2005, p. 47 Figure 4 next page reveals that as Latin America, Africa, South Asia, and the East Asia and Pacific have the largest percentage of firms that identify severe inadequacy of finance and infrastructure for business operations. These continents are also the poorest continents of the globe. In contrast, Europe and Central Asia have the smallest percentage of firms that identify finance and infrastructure as severely inadequate. This coincided with the richest countries of the globe. Thus, policies that promote infrastructure build-up and development of financial institutions are those that can make the country prosperous. Figure 4. Severity of inadequacy of finance and infrastructure Source: World Development Report, 2005, p. 11 Figure 5. Percentage of firms in select developing countries lacking confidence that the courts will uphold their property rights Source: Figure 10 of World Development Report, 2005, p. 9 Figure 5 above shows the results of a World Bank survey of firms in select developing countries on their perception of the courts with regard to their capacity to uphold their property rights. The Figure indicates that those with lower degree of economic development tend to have a low confidence on their courts to uphold their property rights. Thus, this constitutes a policy area Table 1 below shows the incidence of bribery based on firm reports and bribery fees exacted as a percentage of sales. The continents identified in Table 1 appears to be poor because the incidence of bribery as indicated by the firms indicated to have observed bribery is high and the percentage on sales exacted by the bribery is as high as around 10%. Table 1 . Bribery and sales across countries Source: World Development Report, 2005, p. 40 Table 5 indicates that when policies are formulated or discovered that will adequately address corruption or bribery, real or tangible benefits can be derived. Meanwhile, Figure 6 next page indicates or suggests that time it takes to start a business or get the approval of the authorities to start a business correlates with corruption. This implies that policies that can reduce the business start up or hasten the approval of businesses by authorities may be able to reduce corruption. The reverse is also supported: ending or significantly reducing corruption will significantly speed up business start-up and thereby promote economic growth. Figure 6. Business start-up and corruption Source: World Development Report, 2005, p. 42 Figure 7. Tax collection and GDP growth Source: World Development Report, 2005, p. 35 Figure 7 above suggests that improving tax collections can promote economic growth. On the other hand, the reverse is also supported, growth can translate into more taxes and can translate into economic growth. Figure 8 pertains to total factor productivity and the growth of gross domestic product. This suggests that policies that improve total factor productivity or productivity, through the promotion of research and development, for example, can promote per capita economic growth or GDP per worker. Figure 8. TFP and GDP growth per worker Source: World Development Report, 2005, p. 28 Meanwhile, according to a 2005 World Bank Report, total factor productivity accounts for 41% of growth. The component of economic growth that the World Bank attributes to education is 14%. The component of growth that can be attributable to capital formation is a high 45% (WDR, 2005, p. 3). The figures are shown next page on Figure 9. These imply that the policies that promote total factor productivity, education, and capital formation promote economic growth. Figure 9. Decomposition of sources of growth Source: Figure 2, World Development Report, 2005, p. 3 Figure 10. Governance and economic growth Source: World Development Report, 2005, p. 21 Figure 10 suggests that improving economic governance will promote economic growth. The governance variable on the horizontal axis of Figure 10 is actually a construct developed from several variables combined or consolidated into a single governance indicator. Figure 11. Changes national regulations and favourability to FDI Source: World Development Report, 2005, p. 112 Figure 11 indicates that the overall trend at the global level, policy makers are developing a greater number of policies favourable to foreign direct investment compared to a lower number of policies that they that are unfavourable to foreign investments. Worldwide. This indicates that more nations are considering foreign investments as a factor that can contribute to their country’s growth and economic development. Figure 12 next page indicates that, in general, a higher percentage of migrants in the population is compatible with a higher gross domestic product per capita. It even suggests that a higher percentage of migrants can even promote a higher gross domestic product per capita. The figure implies that policies that welcome migrants will not harm economic growth and may even promote growth. Figure 12. Migration as % of population and economic growth Source: World Development Report, 2009, p. 162 The World Development Report (2009, p. 135) interpret Table 2 of the next page as indicative that economies of scale is positively associated with higher human density and is negatively associated with distance from high population centres. Table 2 outlines the key results from several studies on the role of population density and various economic variables. One key finding of one study indicates that doubling human population density (economic density rather than population was used instead) increase productivity by 6%. The second study suggest that doubling employment density (again, a term for population density) increases productivity by 4.5 to 6.0 percent. The third study suggests, however, that an increase in local employment can increase the overall industry employment level. Unfortunately, this point does not appear to be in good fit with the other studies reflected on Table 2 except with the fourth study. The fourth study suggests that a 10 percent increase in local employment results in 0.6 to 0.8 increase in productivity. The fifth study suggests that being farther or having a considerable distance from population centres is associated with less productivity. The sixth study suggests that doubling the distance from a regional market lowers profit by 6 percent. Table 2. Population density and productivity Source: WDR, 2009, p. 135 Table 4.3 The seventh study suggests that plants can have lagged and contemporaneous effects on other local plants but may have no effects on plants outside the country. The same message is relayed by the eighth study. In summary, the studies depicted in Table 2 suggest that policies that concentrate population promote productivity because they promote economies of scale. Table 3. 30-years of theories affirm the role of scale economies in development Source: World Development Report, 2009, p. 136 based on Gill and Kharas, 2007 Table 2 pertains to empirical studies while Table 3 above pertains to theories. All the eight theories depicted on Table 3 supposedly favour a concentration of population because they highlight the role of economies of scale. However, an alternative interpretation of Table 3 is that the studies highlight the importance of economies of scale, period, and not necessarily of population concentration. In summary, we can conclude from the historical snapshots that policies that improve the investment climate, address investment obstacles, strengthen the legal system in defending property rights, eradicate corruption, promote tax collection, promote productivity, advances education, stimulate capital formation, governance, and the climate for foreign investment promote economic growth and thereby economic development (the two are related but different). Looking at the history of the economic development of East Asia, however, we may introduce some qualifications from the insights that we have developed on the policies that can promote economic growth. In 1993, the World Bank attributed the rapid growth experience of Japan, South Korea, Malaysia, Taiwan, and the rest of East Asian countries to market-friendly activism1 consisting in adequate investment in people, providing a competitive climate for private enterprise, keeping the economy open to international trade, and maintaining a stable economy (World Bank, 1993, p. 10). Gill & Kharas (2007), a World Bank publication, confirms that inspite of the Asian Crisis of the mid-1990s, East Asia is acquiring a big share of the World Economy. The World Bank emphasis has been that the activist policy of the most progressive economies of Asia has been market-friendly. However, Kim (1994) and Brown (1993) argued otherwise and claimed that the East Asian government have defied markets to a certain extent and even promoted state-owned enterprises. Brown (1993, p. 1) emphasised the East Asian countries maintained “governed markets”. Kim (1994, p. 14) reported that the South Korean exporters were supported through multiple exchange rates, direct cash payments, tax and tariff incentives, and permission to retain foreign exchange earnings to import restricted commodities. The World Bank in 2008, through its Commission on Growth and Development, appear to have less doctrinaire approach to the role of government. The Commission on Growth and Development (20008, p. 30) is that the role of government “evolves over time”. A stronger role for government can lead to corruption and Transparency International (2009, p. 296) warns that corruption can lead to lower economic growth. In conclusion, we must qualify the insights that we have obtained from the snapshot analysis within the more fundamental question on the appropriate role of government in the economy and economic development. The more conventional development professional tends to downgrade the role of the government and rely on the market. Although the more conventional development professional recognize market failure, he or she may cite that government also fails. As Stiglitz (2000, p. 10) pointed out, “markets often fail, but governments often do not succeed in correcting the failures of the market”. In other words, both markets and governments fail although they both have a potential in moving society towards greater economic growth and prosperity. The point of view adopted by this paper is to use both institutions. Use government policies to promote economic growth and analysis of the snapshots that we have undertaken to identify the policies that promote economic growth may be on the right track. However, the other equally important task is that we must use government policies to make markets work and succeed. This can be in the form of removing regulations where regulations are not needed and putting regulations where regulations are needed. One may ask, how do we know when regulations are not needed and when regulations are not? The right answer will only be found by strengthening the consultative processes with both citizens and business. Bibliography Brown, J., (1993). The role of the state in economic development: Theory, the East Asian Experience, and the Malaysian case (Staff Paper 52). Asian Development Bank: Economics and Development Resource Centre. Commission on Growth and Development (CGD), 2008. The growth report: Strategies for sustained growth and inclusive development. Washington: The World Bank. Dornbusch, R., Fischer, S., & Startz, R., (2005). Macroeconomis. 9th ed. Boston: McGraw Hill Gill, I. & Kharas, H., (2007). An east asian renaissance: Ideas for economic growth. Washington: The World Bank. Kim, Y., (1994). The role of government in export expansion in the Republic of Korea: A revisit (EDRC Report Series 61). Asian Development Bank: Economics and Development Resource Centre. Stiglitz, J., (2000). Economics of the public sector. New York/London: W.W. Norton & Company. Todaro, M. and Smith, S., (2007). An introduction to economic development. 9th ed. Harlow: Pearson/Addison Wesley. Transparency International, 2009. Global Corruption Report 2009. Cambridge: Cambridge University Press. World Bank (WB), (1993). The East Asian Miracle: Economic Growth and Public Policy. Washington: The World Bank. World Development Report (WDR), (2005). World development report 2005: Better investment climate. Washington: The World Bank. World Development Report (WDR), (2009). World development report 2009: Reshaping economic geography. Washington: The World Bank. Read More