Lessons from Developing Countries about Economic Policy

Article excerpt

For many years, economists based their policy prescriptions on several, apparently innocuous, assumptions. First, it was presumed, usually implicitly, that the entity undertaking the policy--presumably the government--had the best interests of the citizenry as its objective function. Second, it was assumed that those seeking to optimize social welfare would automatically have full information on which to base their decisions. Third, policies were analyzed as if they were costless to impose, administer, and enforce.

On the basis of these assumptions, it was easy to conclude that the government should intervene whenever there might be market failure (indeed, on these assumptions there was really no evident reason why the government should refrain from any activity: it could perform at least as well as private parties). This approach to policy formulation was widespread when policy makers in developing countries began addressing their objectives of more rapid economic growth and rising living standards, the levels of poverty that were prevalent were themselves sufficient to convince most observers that market failures must have occurred. Moreover, given the assumptions about the costlessness of government intervention, little need was seen to investigate the nature, magnitude, or correctability of failure: it was taken as self-evident that government intervention could achieve the desired goal.

In the years after the Second World War, most developing countries' governments adopted a series of economic policies intended to achieve economic development that were based, in large part, on these premises. Policy stances were very similar across a large number of developing or, as they were then called, underdeveloped economies.

Policies were usually set forth in a "plan". It was thought that developing countries were poor because they had little capital per man with which to work, so the plan focussed first on estimating a target rate of economic growth and a needed rate of investment in order to attain that target (based on an estimated or assumed incremental capital-output ratio).

The plan then set forth measures to increase public savings and investment and to encourage private investment. For this latter purpose, interest rates were artificially suppressed and credit rationing was generally adopted so that credit could be directed to firms undertaking projects in favored industries. For the same motive, efforts were made to keep imports of capital goods cheap. Perhaps most important, however, was the adoption of "import substitution" as a policy to induce private investment in activities to replace imports. It was (probably correctly) generally believed that industrialization was an essential concomitant of rapid growth, and (probably incorrectly) that new entrants in developing countries, as infant industries, could not possibly compete with established firms in industrial countries and would require a "hothouse" or protected environment. Hence, policies were prescribed in plan documents to provide automatic protection against imports (usually by prohibiting them) once domestic productive capacity had been established. Both SOEs and private firms were encouraged to enter new industries. Often, the development plans identified the new industries to be established, and set forth a delineation of those to be undertaken by private entrepreneurs and those to be undertaken by SOEs.

For a variety of reasons, policies also included a number of controls and regulations over much private economic activity. These included price controls for a number of commodities, regulations governing private firms' rights to expand output or capacity (based on the presumption that if expansion were not controlled, resources might be directed into lines other than that called for by the plans), and, as already noted, credit rationing. In many countries, there was also an investment license required before private firms could invest to insure that scarce investible resources were allocated to the activities deemed by the policy makers to be most desirable. …