The Neoclassical Counter-Revolution: Market Fundamentalism PDF

The Neoclassical Counter-Revolution: Market Fundamentalism (Challenging the Statist Model: Free Markets, Public Choice, and Market-Friendly Approaches) In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and West Germany came with a neo...

The Neoclassical Counter-Revolution: Market Fundamentalism (Challenging the Statist Model: Free Markets, Public Choice, and Market-Friendly Approaches) In the 1980s, the political ascendancy of conservative governments in the United States, Canada, Britain, and West Germany came with a neoclassical counter-revolution in economic theory and policy. In developed nations, this counter-revolution favoured supply-side macroeconomic policies, rational expectations theories, and the privatisation of public corporations. In developing countries, it called for freer markets and the dismantling of public ownership, statist planning, and government regulation of economic activities. Neoclassicists obtained controlling votes on the boards of the world’s two most powerful international financial agencies—the World Bank and the International Monetary Fund. In conjunction with the simultaneous erosion of influence of organisations such as the International Labour Organization (ILO), the United Nations Development Programme (UNDP), and the United Nations Conference on Trade and Development (UNCTAD), which more fully represent the views of delegates from developing countries, it was inevitable that the neoconservative, free- market challenge to the interventionist arguments of dependence theorists would gather momentum. The central argument of the neoclassical counterrevolution is that underdevelopment results from poor resource allocation due to incorrect pricing policies and too much state intervention by overly active developing-nation governments. Rather, the leading writers of the counterrevolution school, including Lord Peter Bauer, Deepak Lal, Ian Little, Harry Johnson, Bela Balassa, Jagdish Bhagwati, and Anne Krueger, argued that it is this very state intervention in economic activity that slows the pace of economic growth. The neoliberals argue that by permitting competitive free markets to flourish, privatising state- owned enterprises, promoting free trade and export expansion, welcoming investors from developed countries, and eliminating the plethora of government regulations and price distortions in factor, product, and financial markets, both eco-nomic efficiency and economic growth will be stimulated. Contrary to the claims of the dependence theorists, the neoclassical counterrevolutionaries argue that the developing world is underdeveloped, not because of the predatory activities of the developed world and the international agencies that it controls, but rather because of the heavy hand of the state and the corruption, inefficiency, and lack of economic incentives that permeate the economies of developing nations. What is needed, therefore, is not a reform of the international economic system, a restructuring of dualistic developing economies, an increase in foreign aid, attempts to control population growth, or a more effective development planning system. Rather, it is simply a matter of promoting free markets and laissez-faire economics within the context of permissive governments that allow the “magic of the marketplace” and the “invisible hand” of market prices to guide resource allocation and stimulate economic development. They point both to the success of economies such as South Korea, Taiwan, and Singapore as “free-market” examples (although, as we shall see later, these ‘Asian tigers’ are far from the laissez-faire neoconservative prototype) and to the failures of the public-interventionist economies of Africa and Latin America. The neoclassical counterrevolution can be divided into three component approaches: the free-market approach, the public-choice (or “new political economy”) approach, and the “market-friendly” approach. Free-market analysis argues that markets alone are efficient— product markets provide the best signals for investments in new activities; labour markets respond to these new industries in appropriate ways; producers know best what to produce and how to produce it efficiently; and product and factor prices reflect accurate scarcity values of goods and resources now and in the future. Competition is effective, if not perfect; technology is freely available and nearly costless to absorb; information is also perfect and nearly costless to obtain. Under these circumstances, any government intervention in the economy is by definition distortionary and counterproductive. Free-market development economists have tended to assume that developing-world markets are efficient and that whatever imperfections exist are of little consequence. Public-choice theory, also known as the new political economy approach, goes even further to argue that governments can do (virtually) nothing right. This is because public-choice theory assumes that politicians, bureaucrats, citizens, and states act solely from a self-interested perspective, using their power and the authority of government for their own selfish ends. Citizens use political influence to obtain special benefits (called “rents”) from government policies (e.g., import licences or rationed foreign exchange) that restrict access to important resources. Politicians use government resources to consolidate and maintain positions of power and authority. Bureaucrats and public officials use their positions to extract bribes from rent-seeking citizens and to operate protected businesses on the side. Finally, states use their power to confiscate private property from individuals. The net result is not only a misallocation of resources but also a general reduction in individual freedoms. The conclusion, therefore, is that minimal government is the best government. The market-friendly approach is a variant on the neoclassical counterrevolution associated principally with the 1990s writings of the World Bank and its economists, many of whom were more in the free-market and public-choice camps during the 1980s. This approach recognises that there are many imperfections in developing- country product and factor markets and that governments do have a key role to play in facilitating the operation of markets through “non-selective” (market-friendly) interventions— for example, by investing in physical and social infrastructure, health care facilities, and educational institutions, and by providing a suitable climate for private enterprise. The market- friendly approach also differs from the free-market and public-choice schools of thought by accepting the notion that market failures (see Chapters 4 and 11) are more widespread in developing countries in areas such as investment coordination and environmental outcomes. Moreover, phenomena such as missing and incomplete information, externalities in skill creation and learning, and economies of scale in production are also endemic to markets in developing countries. In fact, the recognition of these last three phenomena gives rise to newer schools of development theory, the endogenous growth approach, to which we turn in Appendix 3.3 at the end of this chapter, and the coordination failure approach, discussed in Chapter 4. Traditional Neoclassical Growth Theory Another cornerstone of the neoclassical free-market argument is the assertion that liberalisation (opening up) of national markets draws additional domestic and foreign investment and thus increases the rate of capital accumulation. In terms of GDP growth, this is equivalent to raising domestic savings rates, which enhances capital–labour ratios and per capita incomes in capital-poor developing countries. The Solow neoclassical growth model in particular represented the seminal contribution to the neoclassical theory of growth and later earned Robert Solow the Nobel Prize in economics.17 It differed from the Harrod-Domar formulation by adding a second factor, labour, and introducing a third independent variable, technology, to the growth equation. Unlike the fixed-coefficient, constant-returns-to-scale assumption of the Harrod-Domar model, Solow’s neo-classical growth model exhibited diminishing returns to labour and capital separately and constant returns to both factors jointly. Technological progress became the residual factor explaining long-term growth, and its level was assumed by Solow and other neoclassical growth theorists to be determined exogenously, that is, independently of all other factors in the model. More formally, the standard exposition of the Solow neoclassical growth model uses an aggregate production function in which (Y = K 1AL21- ) where Y is gross domestic product, K is the stock of capital (which may include human capital as well as physical capital), L is labour, and A represents the productivity of labour, which grows at an exogenous rate. For developed countries, this rate has been estimated at about 2% per year. It may be smaller or larger for developing countries, depending on whether they are stagnating or catching up with the developed countries. Because the rate of technological progress is given exogenously (at 2% per year, say), the Solow neoclassical model is sometimes called an “exogenous” growth model, to be contrasted with the endogenous growth approach (discussed in Appendix 3.3). In Equation 3.10, represents the elasticity of output with respect to capital (the percentage increase in GDP resulting from a 1% increase in human and physical capital). Since is assumed to be less than 1 and private capital is assumed to be paid its marginal product so that there are no external economies, this formulation of neoclassical growth theory yields diminishing returns both to capital and to labour. The Solow neoclassical growth model implies that economies will converge to the same level of income per worker “conditionally”—that is, other things equal, particularly savings rates, depreciation, labour force growth, and productivity. The Solow neoclassical growth model is examined in detail in Appen-dix 3.2, where it is also compared with the Harrod-Domar model. According to traditional neoclassical growth theory, output growth results from one or more of three factors: increases in labour quantity and quality (through population growth and education), increases in capital (through saving and investment), and improvements in technology (see Appendix 3.1). Closed economies (those with no external activities) with lower savings rates (other things being equal) grow more slowly in the short run than those with high savings rates and tend to converge to lower per capita income levels. Open economies (those with trade, foreign investment, etc.), however, experience income convergence at higher levels as capital flows from rich countries to poor countries where capital–labour ratios are lower and thus returns on investments are higher. Consequently, by impeding the inflow of foreign investment, the heavy-handedness of many developing countries’ governments, according to neoclassical growth theory, will retard growth in the economies of the developing world. In addition, openness is said to encourage greater access to foreign production ideas that can raise the rate of technological progress. Conclusions and Implications Whereas dependence theorists (many, but not all, of whom were economists from developing countries) saw underdevelopment as an externally induced phenomenon, neoclassical revisionists (most, but not all, of whom were Western economists) saw the problem as an internally induced phenomenon of developing countries, caused by too much government intervention and bad economic policies. Such finger-pointing on both sides is not uncommon in issues so contentious as those that divide rich and poor nations. But what of the neoclassical counterrevolution’s contention that free markets and less government provide the basic ingredients for development? On strictly efficiency (as opposed to equity) criteria, there can be little doubt that market price allocation usually does a better job than state intervention. The problem is that many developing economies are so different in structure and organisation from their Western counterparts that the behavioural assumptions and policy precepts of traditional neoclassical theory are sometimes questionable and often incorrect. Competitive free markets generally do not exist, nor, given the institutional, cultural, and historical context of many developing countries, would they necessarily be desirable from a long-term economic and social perspective (see Chapter 11). Consumers as a whole are rarely sovereign about what goods and services are to be produced, in what quantities, and for whom. Information is limited, markets are fragmented, and much of the economy in low-income countries is still nonmonetised.18 There are widespread externalities of both production and consumption as well as discontinuities in production and indivisibilities (i.e., economies of scale) in technology. Producers, private or public, have great power in determining market prices and quantities sold. The ideal of competition is typically just that—an ideal with little substance in reality. Although monopolies of resource purchase and product sale are pervasive in the developing world, the traditional neoclassical theory of monopoly also offers little insight into the day-to- day activities of public and private corporations. Decision rules can vary widely with the social setting so that profit maximisation may be a low-priority objective, especially in state-owned enterprises, in comparison with, say, the creation of jobs or the replacement of foreign managers with local personnel. Finally, the invisible hand often acts not to promote the general welfare but rather to lift up those who are already well-off while failing to offer opportunities for upward mobility for the vast majority. Much can be learned from neoclassical theory with regard to the importance of elementary supply-and-demand analysis in arriving at “correct” product, factor, and foreign-exchange prices for efficient production and resource allocation. However, enlightened governments can also make effective use of prices as signals and incentives for influencing socially optimal resource allocations. Indeed, we will often demonstrate the usefulness of various tools of neoclassical theory in our later analysis of problems such as population growth, agricultural stagnation, unemployment and underemployment, child labour, educational demands, the environment, export promotion versus import substitution, devaluation, project planning, monetary policy, microfinance, and economic privatisation. Nevertheless, the reality of the institutional and political structure of many developing-world economies—not to mention their differing value systems and ideologies—often makes the attainment of appropriate economic policies based either on markets or on enlightened public intervention an exceedingly difficult endeavour. In an environment of widespread institutional rigidity and severe socioeconomic inequality, both markets and governments will typically fail. It is not simply an either/or question based on ideological leaning; rather, it is a matter of assessing each individual country’s situation on a case-by-case basis. Developing nations need to adopt local solutions in response to local constraints. Development economists must therefore be able to distinguish between textbook neoclassical theory and the institutional and political reality of contemporary developing countries.20 They can then choose the traditional neoclassical concepts and models that best illuminate issues and dilemmas of development and discard those that do not. Approaches to making these dis-tinctions and choices in key policy applications will feature centrally in parts two and three.