Free Market Vs Regulation - Essay Example

Free Market Vs Regulation Introduction: The purpose of this paper is to better understand the concept that is encapsulated in the of-used statement in economics: How far can markets be free. In this paper, we will try to identify the key concepts that are related to the topic at hand i.e. concepts that relate to the proper functioning of the markets. We will try to identify the conditions where this topic comes to the fore i.e. in places where a change into the system has to be made; be it additional or mere substitution and then look at the pros and cons of the thesis statement in light of the work of many renowned economists all of which will help us in trying to ascertain a judgment towards the statement at hand. Government Role in Infrastructure: Infrastructure is a very vital cog of any country, and hence takes a supremely significant position in the government’s perception. Now, Rostow, who was a specialist in this field has made note and brought to light the fact that the inability of the governments to create infrastructure was one of the major road blocks that were faced during the process of modernization in Europe during the 19th century. In his argument, he says that the “creation of preconditions for take-off was largely a matter of building social overhead capital”. This comes in line with the generally accepted argument that the cost of infrastructure or the social overhead capital compliments the industrial production process as this facilitates the transfer of goods, which leads to the creation of mobilization of markets on a national and international level. Haber, another esteemed expert in this field, has further developed the importance of infrastructural support in his arguments based on the case study of Mexico. (Bracking, 2009) Here, he offers the opinion that Mexico was unable to solve the problem of surplus capacity which it was facing in the 1980s by exporting goods to different countries around the world. All of this, he attributes to the lack of infrastructural support that was present in the country at that point in time. He cites Avisador Comercial de Havana which attributes this problem related to the exorbitant costs of transportation: “How, then, can goods be shipped to the coastline at a beneficial value? How can they [Mexican manufacturers] compete in foreign markets…if within their own borders they have incredibly high freight rates?” (Geoffrey, 2002) In recent times, economic analysts have argued that the major difference between the growth differentials of different countries is infrastructure as highlighted by the case on India and China. Due to the importance infrastructure plays in the workings of a country and its non-excludable and unrivalled nature has further substantiated the claim for the need of governmental intervention to facilitate and hasten industrial growth in the country. On face value, one can see that this notion is somewhat not contestable in nature in that not many can refute the claim that has been put forward; however, some economists have also offered the notion of a private sector backed infrastructural growth. This notion certainly has immense promise in theory as this would basically remove the role of the government from this entire workup and would subsequently move the entire mechanisms onto a free market which would be highly appreciated in light of the concept at hand. However, that certainly does not appear to be a distinct possibility at the current point in time which is why infrastructural support has been ascribed to governments to this day and age. (Kiely, 2007) The rationale behind this is suggestions like the one offered are more likely to fail in the developing countries as private sector led infrastructural growth needs immensely advanced institutional or technological support in order to create and sustain excludable and rivaling properties. Due to this, infrastructure would remain severely under protected as well as remain under produced which would be due to the large number of externalities that cannot be catered to by the entrepreneurs who are undertaking the workings of such an enterprise. Rostow further backs his basic argument by providing supporting arguments which favour the propagation of government-led infrastructure investments which arises from his observation that observing that “the long period of gestation and pay-off, the lumpiness, and the indirect routes of payoff decree that government must generally play an extremely important role in the process of building social overhead capital.” (Rostow, 1964) Simultaneous Industrialization and the Governments role: Gerschenkron, who was another esteemed economist of his time, formulated and subsequently promulgated his own opinion regarding this topic: “industrialization processes begin only if the industrialization movement can proceed…along a broad front…This is partly the result of the existence of complementarities and indivisibilities in economic progress” (Gerschenkron, 1964). A number of economists have acknowledged a ‘Big Push’ as the probable model which can be utilized for the renovation of a society. However, in accordance with the works of Rosenstein-Rodan, a simultaneous industrialization process would do much better in facilitating income growth and creating cross-sector demand; all of which could be so well demanded that it could even render this entire process of industrialization profitable for its creating party; which is most usually the government. This truly assists in solving the problem that Haber was able to spot in the case study of Mexico: “Mexico did not have a “market that [could] absorb the vast quantities that a modern manufacturing plant is capable of producing.” Now, any market would be unable to achieve massive industrialization on its own, at least it would have to be highly unlikely for one to achieve this feat; this is largely due to the extreme costs of coordination between the different segments of the market. (Haber, 1989) Here, Paul David argues that costs of coordination like the ones mentioned earlier have the tendency of being “very high if individual agents are expected to act spontaneously under conditions of incomplete information.” What further compounds this problem is the presence of incomplete markets in developing countries. An incomplete market is one where the information that has been made public by the firms in not indicative of the entire history of practice of the said firm. In addition to this, these are also limited credit markets which basically imply that aside from a few key individuals or large scale organizations that are present outside the bounds of the operating government, no one has the ability to borrow enough funds from the market in order to finance a coordinated effort towards cross-sector industrialization. Based on this hypothesis, Johnson Chalmers notes about the Japanese government who either allowed for the directed engagement with entrepreneurial efforts from the state or pooled resources with privately owned industries in order to achieve this mass industrialization. However, as with any entity that exists in the world, both of these strategies have their own costs and benefits. (David, 2000) The ‘Big Push’ scenario provides an added incentive in this framework: it is able to explain the over-capacity problem that Mexico has faced and also offers opinions on how it can be overcome. Many economists have offered their analysis on this matter and Murphy, Shleifer and Vishny argue that a competition based on the paradigms of an oligopoly that “characterizes industries with vital scale economy often leading to surplus capability except if there is a harmonization of investment activities amongst competing firms (Murray, 2006). Excess capacity leads to price war, which damages the profits of the firms concerned and may force them to scrap some of their assets”. Hence, it is an implicit conclusion that an approach that is harmonized could go a long way in decreasing the capacity problems in Mexico and hence reduce the costs of scrapping the unused or unusable assets which will have to be borne by the society. Therefore, we can see that job that could not be done by the markets had to be done by government intervention which further substantiates the rationale that is provided in the topic statement. (Murphy et al, 1989) The need for governments in executing industrial policy: Johnson Chalmers (1983) and W.W. Rostow (1964) are both in complete agreement over the view that a strong centralized government in intrinsically essential towards the ascertainment of the process of industrialization. This provides vindication to our thesis topic i.e. governmental intervention is necessary wherever the creation of a market is not possible. Rostow offered his idea on the matter by saying that “building of an effective centralized national state - on the basis of coalitions touched with a new nationalism… [Is] a necessary condition for take-off” (Rostow, 1964) Both of these economists agree on the idea of the centralized power of the government as being the key to effectively and optimally introduce infrastructural investments on the national level in the country. Johnson Chalmers highlights the way the MITI was able to influence the modernization process in Japan through transfers of wealth and centralization of executive powers which was completely insulated from public pressure and was able to work on it own. A strong government is also a necessary cog for the process of modernization as it has the ability to apply powers of coercion to change the institutions and norms that are prevalent in the country at that point in time. Rostow (1964) and Gerschenkron (1962) both agree on the concept that institutions and norms that have prevailed in the society have to change in order in order for the complete transition in modern society can take place. As an example, we have the argument of Gerschenkron, who says that the “emancipation of peasants…was an absolute prerequisite for industrialization.” However, there is a flipside to this entire argumentation which is that any social norms carry with them a weight of tradition which acts as the major inertia towards the process of change. Modernization is a very welcoming concept which many people embrace with open arms, but when it comes at he expense of forgoing tradition then most people are not too welcoming. Legacy systems are called that because of a reason: they are defined by the knowledge that they have been in place for a large period of time and processes have been conducted on these systems in the same manner over this large stretch of time. Traditions are a difficult commodity to change as high levels of sunk costs have been invested in the institutions that have defined the industry for the large period of time, all of whom are geared towards the execution of these traditions. It is a commonly known and often observed concept that people have a rather irrational outlook towards sunk costs i.e. they consider it a cost that has to be repaid in order to completely abandon it and move away from it. Therefore, it is essential for the government to use its powers of coercion to drive the modernization process and hasten the process of disbanding of traditional legacy systems. Alternative Conceptions of Modernization: The pivotal importance of the role that the government has to play in the process of modernization is somewhat forecasted by the narrow impression that has been garnered with regards to the term modernization; which is basically considered to be merely an increase in the overall levels of production and the production efficiency involving the overall industrialization of the market. This does not in any way try to imply that alternative definitions of the term modernization do not exist and even if they do exist, they would lead to the same conclusion. To better explain this hypothesis, we will use an example; if we were to acknowledge Amartya Sen’s (2000) argument on the ‘development as freedom’, the omnipotent development state with its immense powers of coercion and consistent breach of individual autonomy might not be the best move when it comes to choosing a model for societal ‘modernization’. The Underdeveloped world: need of a well developed financial system: The development of the financial system is an important factor in enhancing the growth and economic performance. A well functioning financial system facilitates economic transactions, stimulates savings and channels savings to productive investment activities thus helping to mobilize resources and improve their allocation. Recent research has found that an important reason why many developing countries experience very low rates of growth is that their financial systems are under developed; a situation referred to as financial repression. A repressed financial system fragments domestic capital markets, with adverse effects on the quality and quantity of real capital accumulation. Under such circumstances, the adoption of financial liberalization is advised in order to enhance economic growth, a suggestion that many developing countries have implemented in varying degrees. (Calderon et al, 2006) Traditionally, banks have taken the centre stage in investments financing, with specialists and policy makers, ignoring capital markets, with more corporate finance being raised from banks than from equity issues. However, when a financial system relies heavily on its banks it is usually seen that systemic vulnerability of the economic system increases. The Asian financial crisis provided ample evidence of this. A sound domestic capital market provides market signals on current situations and future expectations as it provides access to capital for borrowers both foreign and local. Along with an increase in the range of financial products offered, investors are able to borrow as long as they meet the requirements of the markets. (Macarov, 2003) The financial systems in developing countries such as Uganda face several difficulties that keep them from operating efficiently. The two important tools used by developed countries to help solve adverse selection and moral hazard problems in credit markets namely collateral and restrictive covenants are almost missing. The system of property rights i.e. the rule of law, constraints on government exploration, absence of corruption, is unable to optimally functions which makes the effective use of this tools rather difficult. (Hoogvelt, 1997) Where the market is unable to use collateral effectively, the adverse selection problem will be worse because the lender will need more information on the quality of the borrower so as to screen out a bad loan from a good one. The result is that it will be harder for lenders to channel funds to borrowers with the most productive investment opportunities. There will be less productive investment and hence a slower growing economy. Similarly a poorly developed or corrupt legal system may make it extremely difficult for lenders to enforce restrictive covenants. Thus they may have a more limited ability to reduce moral hazard on the part of the borrower and so will be less willing to lend. Again the outcome will be less productive investment and lower growth rate for the economy. (Payne, 2005) Governments in developing countries often use their financial system to direct credit to themselves or to favored sectors of the economy by setting interest rates at artificially low levels for certain types of loans, by creating development finance institutions to make specific types of loans or by directing existing institutions to lend to certain entities. Unlike governments, private institutions have an incentive to solve adverse selection and moral hazard problems and lend to borrowers with the most productive investment opportunities. Governments have less incentive to do so because they are not driven by the profit motive and thus their directed credit programs may not channel funds to the sectors that produce high growth for the economy. The outcome is again likely to result in less efficient investment and slower growth (Mishkin, 2007). In addition, banks in many developing countries and until recently in Uganda are usually owned by their governments. Again the because of absence of the profit motive these state owned banks have little to incentive to allocate their capital to the most productive uses. Not surprisingly, the primary loan customer of such banks is the government which does not always use the funds wisely. It is arguable that government regulation can increase the amount of information in financial markets to make them work more efficiently. Many countries like Uganda have an under developed regulatory apparatus that retards the provision of adequate information to the market place. For example these countries often have weak accounting standards making it hard to ascertain the quality of the borrower’s balance sheet. As an outcome, asymmetric information problems are harsh, and the financial system is relentlessly hampered in channeling funds to the most productive uses. (Murray, 2006) From the above reasons, we can conclude that a well developed financial system is the key to economic growth and the lack it may explain why many countries stay poor while others grow richer. Conclusion: Based on the analysis that has been conducted, it is clear to see that the statement at hand certainly holds a lot of weight. Going by basic theory, we can simply see why leaving a free market is the best way to move forward, as the supply and demand curves sort themselves out without any interference and the best price and output produced is reached. The same rule can, thus, be superimposed on any economic framework and hence should be applicable for the economies of different countries. However, as we have seen in the analysis above, the case is not as simple and straightforward as the theory of perfect competition suggests. The inflow of capital and resources into the underdeveloped and the less developed world is not completely unbiased and free of any hindrance, but rather is usually routed towards the developed world due to the lure of higher returns and lesser risks on these investments. That is where governments have to intervene in order to ensure the continuity of the country’s economy but creating a planned economy built around sustenance as opposed to natural selection. Therefore, we have to summarize that despite the fact that the best theoretical mechanism of operation for any market is the perfectly competitive model of business; it cannot be applied to markets holistically and markets have to be regulated or at the bare minimum directed in a certain way, in order to ensure the sustenance and growth of the said market. Bibliography 1. Geoffrey, SEE Kok Heng (2002) “Industrial Policy as a Necessary Substitute for Market Arrangements in the Modernization Process” Wharton, University of Pennsylvania. Avaaiable at http://www.oikono.com/essays/Hist107SP.pdf {Retrieved on May 1, 2009] 2. Chalmers, Johnson. 1983. MITI and the Japanese Miracle. Stanford, California: Stanford University Press. 3. David, Paul A. 2000. Path Dependence, Its Critics and the Quest for ‘Historical Economics’ Working paper 00011. Stanford University Department of Economics: Stanford, California. 4. Gerschenkron, Alexander. 1962. Economic Backwardedness in Historical Perspective. Cambridge, Massachusetts: The Belknap Press. 5. Haber, Stephen H. 1989. Industry and Underdevelopment: The Industrialization of Mexico, 1890–1940. Stanford, California: Stanford University Press. 6. Murphy, Kevin M., Shleifer, Andrei, and Vishny, Robert W. October 1989. “Industrialization and the Big Push.” The Journal of Political Economy (Vol. 97 No. 5). 7. Rostow, W. W. 1964. The Stages of Economic Growth. Cambridge: Cambridge University Press. 8. Sen, Amartya. 2000. Development as Freedom. New York: Anchor Books. 9. Bracking, S. (2009). Great Predators in the Political Economy of Development, Pluto Books, London. 10. Kiely R. (2007). The New Political Economy of Development, Palgrave. 11. Murray, W. E. (2006). Geographies of Globalisation, Routledge. 12. Payne, A. (2005). The Global Politics of Unequal Development, Palgrave. 13. Hoogvelt, A. (1997). Globalisation and the Post-colonial World: The new Political Economy of Development, Macmillan. 14. Macarov, D. (2003). What the Market does to People, Zed Books, London. 15. Calderon, Cesar, and Luis Serven, (2004), “The effects of infrastructure development on growth and income distribution,” World Bank Policy Research Working Paper No. 3400 (Washington: World Bank). 16. Mishkin Frederic, (2007): The Economics of Money, Banking and the Financial Markets., 8th Edition , Pearsons Boston Read More