The Role of the State in Third World Economies

Economic growth is one of the necessary conditions for the development of every country. The government’s role in stimulating economic growth has been a controversial subject of public debates for centuries. This essay will try to explain some of the major economic concepts throughout history, and some of the economic models implemented in the developing world. One of the first schools of economic thought was mercantilism. It emerged in the 16th century and influenced most of Western Europe. Mercantilists favored foreign trade and manufacture and viewed money (gold) as a source of prosperity of one nation.

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The state was considered both the regulator and enforcer of economic policies and the beneficiary of the achieved wealth. In 1776, a brilliant Scottish philosopher and economist Adam Smith published his book “The Wealth of Nations”, in which he proposed the concepts of free trade, market economy and less state involvement. A direct challenge to mercantilism, his theory marked a new era of economic thought and introduced political economy, a concept that later developed into a separate systematic discipline.

The 19th century was marked with the ideas of Karl Marx, who advocated state ownership over the means of production and centrally planned economy. In the 20th century, Sir John Maynard Keynes emphasized the necessity of government investments in times of slow economy, even at the cost of budget deficit, to provide employment and keep economy vital. His ideas were embraced by President Roosevelt and helped to boost US economy after the Great Depression and World War II.

Finally, laissez faire economy, a part of libertarian ideology of the 20th century involves minimal government involvement and relies primarily on market forces to determine economic policies. In developing countries, weak economy, high poverty, dependence on global markets and limited investment power encouraged many governments to assume an active economic role. 2 Some of the major economic models implemented and their impact on countries’ development are described further in this essay. Command Economy

Command economy stemmed from Marxist ideology. Promising “great equality and social justice” and “freedom from dependency”, that system was appealing to many leaders of developing countries, especially where the difference between the rich and the poor was significant. The main feature of command economy is state ownership and management of the means of production – factories, banks, infrastructure and farms. Private sector is very limited. Production decisions are not governed by market forces, but are rather set forth by centralized state planning.

At their start, command economies displayed surprising results in economic performance. GNP in Soviet Union grew 5% annually during the first few decades of industrialization. China showed even better results of 8. 2% annual economic growth, far exceeding the norms even of industrialized democracies. Command economy also reduced income inequalities, distributed land through agrarian reform and implemented free health care and education. However, it showed its weaknesses soon. As the economy becomes more complex, it’s harder to manage centrally.

Production and demand are not synchronized, primarily because the bureaucratic apparatus in charge of planning does not have the necessary skills or technology to conduct marketing surveys. Quantity, rather than quality of the product is a basis for reward. Command economies are also more capable of building factories, mills and similar early industrialization assets, than to produce consumer goods, which limits their trading capabilities. Furthermore, highly privileged, powerful members of the bureaucratic apparatus tend to become corrupted with time.

Command economy, once a praised and appealing system, failed in almost every country. The Soviet Union and many other former communist countries failed to achieve economic growth and better standards for their population. The only exception is China, whose transition to market economy while keeping state control, improved the standard significantly. Latin American Statism In the early 20th century and later under the influence of the Great Depression, most Latin American countries had difficulties securing markets for the export of raw materials and food, and were lacking foreign currency to import industrial goods.

These conditions led to state supported industrialization that first started in Argentina, Brazil, Chile and Mexico. The economic sector was mostly left in private hands. The state owned strategic enterprises such as transport, power and the petroleum industries and also invested in sectors that were less attractive to private capital. Ownership of strategic resources allowed the state to subsidize the cost of essential needs like power and transport to private companies.

To further stimulate industrial growth, the state promoted Import-substituting industrialization programs (ISI) that protected domestic products from foreign competition through import tariffs, quotas, subsidized loans and advantageous exchange rates. State supported economy was very successful in many Latin American countries, showing high investments and growth in manufacturing industry. Even the demographic structure of the countries changed when many people migrated to the cities and a strong urban middle class formed.

However, over time government protection and heavy subsidies made domestic industries less efficient and less competitive. Capital intensive ISI programs created only relatively small amount of jobs for skilled workers. Under political pressure and to offset high unemployment, the state was creating more and more unnecessary jobs in parastatals (state operated enterprises), which consequently became overstaffed and were eventually driven to bankruptcy. Latin American statism lasted too long and governments lost the ability to support protective economic policies when expenditures constantly exceeded revenues.

Excessive government spending and insufficient taxation of middle and upper classes resulted in deficits, inflation and depression. Since 1980, most Latin American countries have attempted to reduce state influence and privatize state owned enterprises; however, this has resulted in huge lay-offs and a decline of living standard. Once prosperous and even affluent, countries like Argentina, Mexico and Brazil are now striving to keep inflation under control, and are going through periods of moderate economic growth and sharp economic decline.

Developmental State Developmental state, a term formulated by Berkeley professor Chalmers Johnson, is a model specific to East Asian countries – Japan, Singapore, Taiwan, South Korea and others. Productive capacities are mostly owned by private enterprises, and the state sector is relatively small. The State’s role is to guide and promote the economy through active intervention. Powerful government agencies are in charge of planning and coordinating industrial policies, whether in whole sectors, or in specific industries or corporations.

The state has some influence over the private sector, particularly in areas of taxation, raw material pricing and credit policies, and is a major driving force in stimulating economic growth in the areas of government interest. Protection of new industries from foreign competition is for a limited time only. Starting in the 1960’s, during the rapid expansion of world trade, East Asian industrialization has been export oriented (EOI model), based on manufacture and free market.

With limited resources of raw materials to export and cheap labor, implementation of the EOI model that emphasizes manufacturing for export achieved tremendous economic growth – in the period from 1960 to late 1990 the annual rates were from 4-10%. Furthermore, East Asian countries using this industrialization strategy were able to distribute income with relative equality and promote education to create more skilled workers. The developmental state model proved successful in East Asia, but there are some doubts about its transferability to other developing regions.

This model requires high level of cooperation between industrial sectors, businesses and labor, and the bureaucratic apparatus of skilled economists. It also requires a somewhat authoritarian regime, capable to direct the management and to repress labor unions. In 1990 some of the weaknesses of this model started to show – government regulations repressed competition among the private sector, corruption and favoritism started, and in some countries (Indonesia) state involvement created “crony capitalism” where favored investors were provided with insider opportunities.

Since state planners rather than market dynamics influenced investment, loans were not always granted to industries that would benefit from them the most. Local currencies tied to USD caused trade deficits when the dollar strengthened. Coupled with some bad business decisions made in the private sector, all these factors amounted to East Asian economic crisis in 1997. Since that time, some concepts of the developmental model have been modified (i. e. fixed currency rate) and the state influence is being reevaluated. Neoclassical Ideal

The neoclassical ideal or neoliberalism is one of the stronger ideologies today. The state role in neoliberal economy is limited to defense, the legal system, education, limited investments in infrastructure (only where private capital would not be successful) and redistribution of the income to the poorest. Production decisions and prices should be driven by free market forces only. Protective measures such as tariffs, quotas, subsidies and artificial exchange rates affect price dynamics adversely and should be removed from the economy.

The neoclassical ideology is promoted mainly by the world major lender organizations – World Bank and International Monetary Fund, and under their influence, some African and Latin American countries loosened state involvement in their economies. Although many economists tend to consider East Asian rapid economic growth as an example of liberal model, the only economy in that area that comes close is Hong Kong. However, Hong Kong with no rural population and an extremely beneficial geographic position is such a specific case that it can hardly serve as a universal example for neoclassical economy success.

The major critics of this model are environmentalists – they require governmental responsibility for pollution, and at the dangerous level where world population and pollution are today, “society can no longer afford to let free-market mechanisms allocate penalties for pollution”. 4 Developing countries are so diverse in their size, geographic position, natural resources and investment power that it is impossible to prescribe a universal plan for economic development. To find the right development method and appropriate level of state involvement in stimulating economic growth is one of the major challenges for the Third world governments.