The Poverty Trap

Wednesday, October 30, 2002

The past two decades have witnessed two large-scale experiments to transform centrally planned economies (such as that of the former Soviet Union), or market economies in developing countries with high levels of central planning (such as those found in Latin America in the 1950s–1980s), into economies with efficient markets. Much to everyone’s surprise, the end results of these experiments have not been sustained economic growth. The economy of the former Soviet Union sputtered and stalled and then collapsed after 1998. The economies of Latin America, with the sole exception of Chile, performed only somewhat better. Most countries have undergone periods of strong growth that are then followed by equally strong collapses, of which the recent Argentine meltdown is only one example. The GDP figures for virtually all Latin American countries tell the same story: Real per capita incomes in 2002 are at the same level that they were in 1980.

An Uneasy Marriage: Government and Markets

A major reason for these failures is that the set of market-based policies—the so-called Washington consensus—that underpinned the Russian and Latin American experiments has a fatal flaw: It assumes that it is possible to carry out economic reforms to create efficient markets without a concomitant reform in the political institutions that limit government and guarantee property rights and individual liberty.

The reason this assumption is flawed is that there is no such thing as a “free market” independent of politics. The efficient functioning of a market requires that some individual or organization enforce contract and property rights. Without such an enforcer, transacting is a free-for-all: Everybody knows that everybody else can behave in an opportunistic fashion; therefore everybody behaves opportunistically. The inevitable result, as Thomas Hobbes warned in Leviathan, is very low levels of transacting. Moreover, in order to be credible, the individual or organization that enforces contract and property rights must be able to force people to adhere to its decisions. This necessarily implies that the enforcer is the government. In point of fact, world history offers us no case of a well-developed market system that was not embedded into a well-developed political system.

The necessary connection between government and the market creates a thorny problem. Government is crucial because it enforces contract and property rights. Yet any government that is strong enough to enforce property rights is also strong enough to abrogate them for its own benefit, either by outright expropriation or by taxing away all of the income produced by private property. Governments, in fact, have powerful incentives to do this. First, the government needs revenue for its own political survival. It must make expenditures to gain political support, and it must defend itself against internal and external enemies. Second, politically crucial constituents typically demand that the government use its power to provide them with economic benefits. Often, these benefits come at the expense of the property rights of other economic agents. They may demand, for example, that the government tax away all of the profits of their competitors and provide them with monopoly rights, protection from competition, or other special privileges.

Thus, human beings have two natural tendencies. Following Adam Smith, humans have a natural tendency to barter, truck, and trade. Second, following Thomas Hobbes, they have another equally natural tendency—to use politics to force others to transfer their wealth and sources of value.

The fundamental problem of economic development is therefore devising the appropriate means for channeling government action to support rather than predate on markets.

One approach to solving this fundamental problem of economic development is to search for political leaders who have the right kind of values and vision. The problem with this approach is that it assumes that the ability of political actors to make good decisions is a function of their personal attributes, rather than the political incentives they face. Doubtless, there have been extraordinary individuals in many countries who have made hard decisions and stood by them regardless of the personal consequences. Yet the relative economic success of the countries of the developed West over other countries cannot be attributed, over the course of several centuries, to the fact that they have larger stocks of extraordinary individuals.

Another approach to solving this fundamental problem of economic development is to remove political leaders from economic decision making. This approach underlies much of the Washington consensus. The problem with this approach is that there are strong incentives for both political decision makers and citizens to politicize the policymaking process. In point of fact, there has never been a case in world history in which political leaders did not play a key role in economic decision making. This view is therefore utopian and unrealistic.

These observations mean that the diagnosis of the problem of economic development in the literature and in the Washington consensus—namely, that development requires taking politics out of economic policy making—is wrong. Any attempt to remove politics from policy making will inevitably end in economic failure.

Vibrant markets require government, but not just any government will do. There must be institutions that limit the government from predating on the market. Solving the development problem therefore requires crafting political institutions that limit the discretion and authority of government and of individual actors within the government. That necessarily requires institutions that protect individual liberty. As Friedrich Hayek, one of the foremost students of liberty, observed, “There is only one such principle that can preserve a free society: namely, the strict prevention of all coercion except in the enforcement of general abstract rules equally applicable to all.”

The problem in the developing world is thus as much a problem of governance as it is of economic policies that support markets. Indeed, the fundamental problem in the developing world is not that there is no protection of property rights; it is that the government may protect the property rights of some people while simultaneously abrogating or reducing the property rights of others. Too often governments in developing countries arbitrarily reallocate the property rights of some individuals to other individuals who happen to be in the governments’ good graces. Governments may also craft economic policies in such a way as to increase the property rights of that select group (for example, by giving them tax exemptions or awarding them special concessions to exploit public resources).

There are times when the government can seize upon these kinds of political opportunities and turn them to its own fiscal advantage. Consider, for example, Mexico’s experience with bank privatization in the early 1990s. When the Mexican government privatized the banks, it created a banking system that was highly concentrated. From the point of view of the purchasers of the banks, this was attractive: They did not have to compete against one another. This arrangement was also attractive to the government: It could obtain more revenue than otherwise because investors will pay more for an oligopoly than they will for a firm that has to face effective competition. There was only one problem: Maximizing government revenue meant that most of the capital of the banking system went to purchase the banks; little was left to provide reserves against economic volatility. The result was a tragedy: Four years after privatization the banking system collapsed under the weight of peso devaluation. The resulting bailout cost Mexican taxpayers $100 billion, roughly 20 percent of annual Mexican GDP.

Sanctions and Incentives

Limited government is therefore necessary for economic development. But the question of how to do it is a thorny one. It preoccupied the two great seventeenth-century English philosophers, Thomas Hobbes and John Locke. It loomed throughout the debates surrounding the writing of the U.S. Constitution. Indeed, it is a major theme of the Federalist Papers. In more recent times, it preoccupied the influential economists Friedrich Hayek and James Buchanan.

No simple recipe for limiting government exists. Yet two principles are clear. First, a country must create mechanisms and incentives for different branches and levels of government to impose sanctions on one another if they exceed the authority granted to them by the law. Second, these sanctions cannot be imposed in an arbitrary or ad hoc fashion: The sanction mechanisms themselves must be limited by the law. This is not to say that the sanctions cannot be harsh (indeed, if they are not harsh they are not credible sanctions).

There are essentially two ways to create these sanction mechanisms and incentives. One is a system of checks and balances that limits a strong central government. In a system like this, political competition among actors in the different branches of government provides incentives for actors to police one another’s actions. France is a good example of this kind of system.

A second way to limit government is federalism, in which different levels of government limit one another. Here the incentives to police the actions of other government actors come from the self-interest of each level of government. Imagine, for example, that local, state, and federal governments all individually tax a particular business enterprise. Each knows that increasing taxes discourages this enterprise from additional productive investment (as well as creating other economic distortions), which will ultimately limit the amount of tax that a particular level of government can extract from the firm. This means that each level of government has a strong incentive to limit the taxation of the firm by other levels of government. Concomitantly, actions by a level of government that reduce the property rights of the firm also reduce the taxes that any of the other levels of government can collect. The result is an outcome in which each level of government essentially balances the others—without the need for checks and balances within the central government. Canada is a good example of this kind of system.

The United States is an unusual combination of both kinds of systems: It contains checks and balances in the national government as well as a strong federal system. This means that the president faces multiple bodies that can check arbitrary actions, including a bicameral legislature, an independent judiciary, state and local governments, and a professional civil service that staffs executive federal agencies. The combination of both methods of limiting the authority of government provides an unusually high degree of property rights protection.

The problem in the developing world is that those countries have neither system. Federalism and checks and balances often exist on paper—as in Mexico and Argentina—but in reality they fail. Power is too concentrated in two senses: The central government has too much power over the federal system and, within the federal government, the president has too much power. These characteristics allow arbitrary behavior and hinder development.

This is not to say that the only necessities for economic development are constitutions that establish limited government—either through checks and balances or federalism. In point of fact, there are countries that have essentially mimicked the U.S. Constitution—Liberia being a case in point—but which have neither limited government nor economic growth. To make laws and constitutions work in practice requires an appropriate mix of other institutions such as an educated population with a sense of civic duty.

But no attempt at economic reform can hope to succeed if it ignores the concomitant need for political reform. Without attention to their political foundations, markets cannot flourish. Donor agencies must therefore attend to the political security of markets as well as to the economic policies creating them.