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The Role of Government in Economic Development

1. Introduction to Economic Development and Government Intervention

1. Introduction

Throughout the history of economic thought and development, the interest in how government can promote economic growth has been a major issue. Development economics emerged as a distinct sub-discipline during the post-World War II period, amidst the wave of economic nationalist, pro-statist reconstruction and development programs that characterized the period. This sub-discipline has posed the key question of how it is that the apparently simple expedient of having government take a more active role in development could trigger explosive rates of economic growth. Efforts to answer this question have moved back and forth between two distinct approaches. One sees the role of the government as providing individual basic growth-enhancing services. The provision of these services particularly allows the private sector to execute its role effectively, and this presumption has been one of the bases for the efficacy of government intervention. The other approach proceeds from the observation that, in practice, successfully-developing countries have employed a vast array of additional tools and institutions to promote their growth.

2. Theoretical Frameworks: Market Failures and Government Interventions

Market failures are the reason for having government intervention in a market economy. These are situations where the free market does not produce efficient outcomes, failing to allocate goods and services in the best interest of society as a whole. There are many forms of market failure, and it is convenient to organize them under general categories such as monopoly power, externalities, lack of information, and public goods.

The problem with monopolies is that their enormous power can lead to a lack of competition, resulting in increasing costs and prices, reducing output, restricting innovation, and lowering the quality of products. In the case of external costs or benefits, third parties who are not buyers or sellers of the product are affected by its use or consumption. These third parties do not pay for the negative external costs or benefits and cannot obtain the benefit of the positive external effects of the use or consumption of that good. It can be difficult to correct the market failures that persist due to the presence of external negative costs and benefits, lack of knowledge, and public goods.

3. Empirical Evidence: Case Studies and Impact Assessments

Government interventions are today widespread in many developing countries. However, it is only in a few cases that we have been able to obtain a comprehensive assessment of the direct and indirect impacts of these interventions. Such assessments are difficult. It is not easy to design an evaluation strategy that demonstrates such impacts convincingly. First, this is because of the difficulty of identifying appropriate counterfactuals, i.e. to find groups that are similar to the ones affected and that are not affected by the intervention. Second, it is because it is often difficult to disentangle the various effects and mechanisms involved.

There are only a limited number of studies that come as close as possible to identifying these impacts, either through case study evidence or through some form of quantification. These studies have demonstrated varying degrees of success, but they all suggest that government interventions frequently suffer from large deadweight losses, often fail to achieve intended results, paradoxically generate excessive producer incentives, and most controversially, distort governance. Criminal activities have also been shown to increase in response to public expenditures.

4. Policy Recommendations and Future Directions

Reassessing the role of the government in economic development is both timely and necessary. Based on the discussions above, we believe that the following principles provide guidance to policy recommendations.

1) Creation of an economic environment conducive to long-term investment should be the first and foremost task of developing societies.

2) When such conditions do not exist, government intervention can be justified, but it should be exercised sparingly and, if possible, withdrawn over time.

3) Government intervention should complement, rather than substitute, market mechanisms. In practice, this means assistance to the poor and other disadvantaged regions and groups and those provoking correcting externalities.

There should be a general acceptance that investment-induced growth is the best way to contribute to poverty reduction. The countries that have made the advances in living standards already clearly show that such growth is about people, not about “capital,” but that long-term investment is needed to move people out of poverty. The correlations between poverty reduction, which includes the improvement in health, nutrition, health care systems, water sanitation and the broad enhancement of opportunities, etc., and the building of a healthy, skilled, entrepreneurial labor force, with higher household incomes and living standards, are significant provided these things occurred before they were needed.