Laissez Faire as a Development Policy
MAY 01, 1987 by JOHN SEMMENS
Filed Under : Development Economics
The majority of the people in the world live in poverty. Fatalistic philosophy and pessimistic disposition induce many to accept this situation as inevitable. Others, observing the prosperity of the minority, are inspired to anger and envy. Fortunately, the prosperity of the minority also serves as evidence that something other than poverty is possible for humankind.
Knowing that poverty is not inevitable still leaves us with the question of how the condition is to be overcome or ameliorated. In the eagerness to speedily conquer the ills of poverty, much of the development economics literature has emphasized approaches calling for government planning, direction, and control of the economies of developing nations. The impetus behind this approach is the idea that the market left to itself cannot produce growth as fast or as well as a planned or directed economy. Unplanned markets rely upon atomistic decision-making by independent actors in the economic environment. There is no assurance that any particular type or quantity of industrialization will take place.
In contrast, it is argued, a planned economy can aim at specific objectives of development. Target industries can be developed and nurtured. Educated and trained experts can guide the economy onto planned paths that might, or might not, have been taken by an uncontrolled economy. The experts, informed by experience and observation of what has worked elsewhere should be able to avoid many of the costs of an unguided, trial-and-error, profit-and-loss market system. Thus, the planners conclude, economic growth should be forced into a higher pace.
While planned development may sound good in theory, the reality is quite a bit different. The government experts in control of Third World nations’ economic policies are neither willing nor able to chart a better course than the unplanned market. Government attempts to direct economic development are little more than plausible sounding theory. An especially pessimistic view of the role of government intervention in economic development was expressed by Mancur Olson in The Rise and Decline of Nations. On the one hand, he perceived that it would require “. . . an enormous amount of stupid policies . . . to prevent economic development . . .” On the other hand, he observed that” . . . growth-retarding regimes, policies, and institutions are the rule rather than the exception . . .”
The problem with government control of the economy is one of devotion to socialist dogma. The key elements of this dogma include (1) suppressing or supplanting the market with government price and allocation schemes, (2) a reliance on government manipulation of the economy that routinely ignores individual incentives, (3) interference with free commerce via tariffs, quotas, or subsidies, and (4) an emphasis on redistribution of income. Many developing countries were formerly subjected to colonial status by various European nations. The socialist regimes that have arisen in the wake of decolonization are often reflective of government controls employed by colonial powers. That less developed countries have not thrown off the yoke of interventionist policies is probably due to a combination of the traditional tribal tendency to authoritarian political structure and the advice of development economists who believe that the laws of economics don’t apply in the Third World.
The contrast between approaches to economic development could not be more stark. The advocates of a strong government role in directing economic development frequently write and speak as if there is no alternative to government intervention. It seems to be assumed that the market hasn’t worked or cannot work or that the mere demonstration of imperfection in the market is sufficient to justify intervention by government. Little consideration seems to be given to the prospect that government imperfections may be worse than those of the market.
The First Development Economist
It is interesting that in all of the many articles on development economics listed in the Journal of Economic Literature only one in the last decade explicitly mentions Adam Smith. Even at that, the article questions the relevance of Smith’s work to development economics. Granted, the analogy between a developing Western world of the eighteenth century and the less developed countries of today is not a perfect match. However, Adam Smith was concerned precisely with the fundamental issue facing less developed countries: how to achieve prosperity. After all, Smith’s main treatise was An Inquiry into the Nature and Causes of the Wealth of Nations. Smith’s objective was to elaborate on how wealth could be obtained.
How a nation is to obtain wealth is the crucial issue in development economics. Wealth must be produced by the efforts and investments of human action. However, not all effort and investment are guaranteed to produce wealth. The waste of time and money is a possible outcome of any effort or investment. Some undertakings yield losses. These diminish the wealth of the nation. Undertakings that yield profits increase the wealth of the nation. Reducing the occasions of loss and multiplying the occasions of profit are the essence of development economics.
The prevailing economic policy in the eighteenth century was mercantilism. This policy was oriented toward promoting national wealth by extensive government intervention. There were regulations, exclusive monopoly franchises, trade barriers and manipulations of all sorts designed to guide commerce and industry into paths deemed favorable by the government. The government controls may have resulted in high profits for favored firms, but did they really increase the wealth of the nation?
Like the socialistic development economists of today, mercantilists perceived that the nation could be guided to superior economic performance via the wisdom and expertise of knowledgeable experts and statesmen. Smith, in contrast, perceived that the statesman was also a politician subject to influence by special interests to the detriment of the economy as a whole. As Smith saw it, establishing barriers to free human action enabled the few to profit at the expense of the many. This could not be the true path to a wealthier nation. Prosperity could not be built upon the deprivation and exploitation of the many, no matter how much gold was earned by state franchised monopolies.
Ironically, many who today profess an abiding concern for the well-being of the masses end up asking that the government use its powers of coercion for the benefit of the powerless masses. The improbability of this outcome should be readily apparent. The powerful are apt to control or influence the government already. Granting the government more power in the economic sphere and urging that this power be used to control the economy is unlikely to dismantle the privileges of existing elites or their political successors. Adam Smith was acutely aware of this difficulty. His solution, unlike the misguided notions of modern radicals, was not to merely transfer coercive governmental power to a new “right-thinking” elite, but to urge the diminution of government economic intervention. This would allow individuals the freedom to pursue their own welfare. Freedom would allow the economy to assume its natural course—which is to grow and prosper.
The Key to the Wealth of Nations
Economic growth was the key to the wealth of nations and the prosperity of the masses of people. Individuals didn’t need to struggle over the distribution of a fixed amount of wealth. More could be created. Rather than the desperate squabbling over redistribution that breeds envy and expropriation, the human condition can be one of cooperation for mutual benefit. If government can be restrained, the market can channel the human proclivity for acquisitiveness into a process of serving the needs of others. In the market economy, free of government interference, the only path to individual riches is through service to consumers. Thus, individual greed is made to fulfill human need by the “invisible hand.”
So, Adam Smith did provide a model for promoting economic growth and development. The role of the government was to be confined to that of protecting the individual’s right to freely pursue his own interest. Pursuit of this self-interest would lead the individual to specialize and cooperate with other economic actors. This specialization and cooperation would permit greater productivity. The greater productivity would broaden markets and lead to even more specialization and cooperation. The result would be an ever-expanding wealth for the nation.
Smith’s laissez-faire model for economic development provided an effective rationale for the liberal political economies of the nineteenth century. This model appears to have been a better predictor and explainer of economic growth in the ensuing period than the theories of some of Smith’s famous successors (i.e.: Malthus, Ricardo, and Marx). However, is Smith’s model still relevant for less developed countries today? Even if we question the fit of Smith’s model to contemporary development problems, the issue is whether the ideas advanced by the first development economist, imperfect though they may be, are better than alternative approaches. There is much to suggest that Smith’s ideas are better.
Government vs. Market: The Evidence
Adam Smith’s model for economic growth was a key guiding influence for nineteenth-cen- tury economic policy. Policy in Britain upheld the security of property fights over class privilege. This meant that contract rather than status determined an individual’s position and fate in the economy. This is the crucial distinction between a liberal capitalist society and a more traditional social structure. Inevitably, the replacement of status by contract “disrupts” the static equilibrium of the society. Unconstrained individuals desert their traditionally assigned roles and create new places for themselves. In the process, old ways of doing things may be made infeasible, even for those who would wish to maintain them.
It wasn’t so much that the 1776 publication of The Wealth of Nations immediately let loose a flood of reform legislation. Undoing some of the regulatory restrictions left over from the mercantilist period took decades. However, a key feature of the capitalist economy is its dynamic nature. Without being prevented from doing so, individuals will tend to adopt easier ways of accomplishing objectives. This leads to increasing efficiency, productivity, and wealth creation. As long as the political regime does not raise new barriers in anticipation of new industries and new methods, the dynamism of the market will surge past obsolete government regulations by innovating around them. This is precisely what transpired in the industrial revolution of the nineteenth century. New industries and methods fell outside the scope of many existing regulatory constraints.
The political support of capitalism in the industrial revolution was basically passive in nature. This is not to say that there were no public works programs or no assistance through subsidies or tariffs. These types of government action were relatively insignificant, as well as contrary to the guiding principles of laissez-faire capitalism. Low taxes and the shrinking relevance of obsolete trade barriers and regulations were government’s major contributions to economic growth.
Comprehensive government planning, direction, or control did not play a major role in the development of any of today’s most highly advanced Western nations. In fact, the more closely a nation’s policies approximated the laissez-faire model promulgated by Smith, the more rapidly its economy grew. The overall success of the market approach to economic development has been overwhelming. No other approaches have even come close to matching, much less exceeding, the results. (See Rosenberg and Birdzell: How the West Grew Rich.) Today, less developed countries have not only Smith’s basic model, but the demonstration of specific examples of economic development experienced in the West. Consequently, some of the false starts and unsuccessful investments undertaken in the past can be avoided by nations just beginning to industrialize today. So, entering the development process later should be a significant advantage.
Unfortunately, only a few developing nations have made the most of this late-start advantage. For the most part, the economic policies adopted by the majority of less developed countries can be characterized as disastrous. Rather than benefiting from the demonstrated utility of Smith’s laissez-faire model, all too many less developed countries insist on imposing mercantile-like heavy government intervention on the economy. Seeing that modern economies are industrialized, developing nation leaders pursue ritualistic imitation. A prime victim of the attempt to modernize via ritualistic imitation is the agricultural sector. Inspired perhaps by Marx’s denigration of “rural idiocy,” many less developed countries suppress farm prices in order to provide cheap food for urban workers. The idea is that low food prices will permit lower wages and make industrialization more financially feasible. The predictable result, of course, is the simultaneous suppression of agricultural output. In terms of resource availability, it has been estimated that the world’s farmers could feed 40 billion people. (See Rydenfelt: A Pattern For Failure: Socialist Economies in Crisis.) That millions starve is a reflection of bad economic policies, not inadequate means.
A favorite, and sad to say frequently recommended, policy of less developed countries is the establishment of inefficient, capital-intensive, highly subsidized, and protected industries. Like the mercantilists of the eighteenth century, many modern development economists seem to imagine that sheltered monopoly franchises will make nations develop an industrial base. This approach is just as senseless today as it was in Smith’s time.
Establishing protected industries causes the nation to consume capital rather than build an industrial base. By producing a resource that it could have bought more cheaply, a firm or nation diverts scarce capital from more productive uses. Of course, many endorse protective policies as a temporary expedient, a sort of investment in the future. In the market, businesses have been known to sustain short-term losses on investments intended to produce long-term gains. The fact that private firms decline to establish the types of firms that require protection, unless protection is assured, is convincing evidence that the supposed long-term gains are sufficiently remote or uncertain to discourage these uses of resources. It should not be surprising, then, to discover that “temporary” protection becomes permanent, and that few “infant” industries ever grow to self- supporting maturity.
The long-term effect of government intervention on the fortunes of less developed countries is clearly negative. There is no sound theoretical support for government enhancing growth through planning, directing, and controlling the economy. Statistics also bear out the theoretical case against government control. Unprotected economies consistently perform better than protected ones. Government intervention consistently and significantly reduces a country’s rate of economic growth. The price distortions caused by heavy government intervention can more than halve the potential growth rate of a developing nation. A study for the World Bank in 1983 found that countries with heavy governmental controls grew at an annual rate of about 3 per cent (on average). This is less than half the annual 7 per cent average growth rate for economies with a low incidence of government interference in the market.
As Adam Smith predicted, market-oriented economies grow faster. The so-called “gang of four” (Singapore, Hong Kong, Taiwan, and South Korea) have engineered what many label “economic miracles” in spurring their nations into high growth paths. The performances of these economies are not due to any miraculous event, unless, of course, one views sensible refrain from interference on the part of their governments as miraculous.
The 1960 to 1980 annual combined growth rates for these countries exceeded 7 per cent. This compares favorably with the low income country average of 2.9 per cent, the middle income country average of 3.7 per cent and the oil-producing country average of 6.2 per cent. in terms of current levels of well-being we find that Taiwan with a per capita Gross Domestic Product of $2160 is substantially better off than the People’s Republic of China with a GDP of $300/capita (figures are for 1981). South Korea with a GDP/capita of S1700 is more well off than the Democratic People’s Republic of Korea with a GDP/capita of $1000.
While these data do not conclusively prove that a freer market is the cause of improved economic results, they lend important support to the premise that a freer market can make a substantial difference. Critics of the market approach to economic development cite U.S. foreign aid to Taiwan and South Korea as a possible alternative explanation for the growth in these countries. However, rapid growth in these countries appeared only after U.S. aid declined. (See Melvyn Krauss: Development Without Aid.)
Why the Market Works Better
Supplied with both the theory and the practical demonstration of the superiority of a laissez- faire model for economic development, the tragedy is that the adoption of market approaches has not been more widespread. The seductive allure of using government power to force a faster pace of growth now dominates most economic development policies. Waiting for the market to produce growth seems so passive. However, the attempt to jolt an economy into more rapid growth by government intervention has more often electrocuted than electrified less developed countries.
It is not the announced intentions of development policies that are defective, but the institution through which they are to be implemented. Government is an institution designed to apply force. This makes it suited to performing functions like national defense and law enforcement. Government is not well suited to the task of making a profit. Yet, making a profit—generating a surplus of value over cost—is essential if real economic growth is to occur. Adam Smith recognized this truth and advised against an active governmental role in the economy.
The key problem with looking to an active government to promote development is that it serves to politicize economic decision-making. The same force that can be used to deter ag gressors or punish criminals can also be used to seize and redistribute resources. Profit-maxi- mizing actors in the society may perceive that it is harder to produce resources than to use the government to seize them. Considerable effort and investment will be diverted toward in fluencing government to grant monopoly franchises, provide subsidies, outlaw competitors, and so on. So, not only do we observe the dis-toning inefficiencies of the interventions, but the additional diversion of resources toward political lobbying. This attempt to obtain resources through government coercion and its policy outputs act as a drag on the productive capacity of the economy. The result is retarded development.
Rather than promoting an active government and the struggle over who will seize whose wealth, development policy could achieve better results by seeking governmental passivity in order to permit an active private economy to create wealth. After all, wealth creation is a subjective, individualized process. The goal is to maximize value. However, value is a subjective concept. Only individuals are in position to know what is valuable to them. Left free to pursue value, people are more likely to achieve it than if they are channeled toward what some government expert believes will benefit the society. Smith recognized this in urging that individuals be left to make their own economic decisions.
People will tend to be more energetic and more enthusiastic when carrying out plans of their own choosing than when responding to the plans others seek to impose upon them. A laissez- faire development policy will allow a maximum of individual plans and actions. This market- based approach can unleash what may be the most scarce resource of all: entrepreneurship. Developing an economy entails risk. Not all plans can succeed. Government planners can afford to devote huge sums of a nation’s scarce resources to money-losing ventures. Private entrepreneurs cannot. Bad decision-makers in the private sector will lose their capital. Bad decision-makers in government lose someone else’s capital. A policy framework that allows private sector entrepreneurs to experience the rewards and penalties of their decision-making will generate a better set of decisions than a policy framework that suppresses or supplants this market process.
The market economy involves a dispersion of power that facilitates optimal growth. When political power plays an excessively large role in the economy, entrenched elites and vested interests will be positioned to oppose the transformation of society that will inevitably occur with economic growth. Whether the entrenched position is one favoring traditional culture, well- connected elites, or an ideology, the victims are still the masses of people denied the opportunity to better themselves. Constructing a laissez-faire model for political economy that would grant the masses of people the opportunity to better their economic condition was Adam Smith’s ingenious contribution to world economic development.