On State as a Visible Hand

Economist_HandOfState_NeilWebb

By Shagun Nayar

According to the renowned development economist Scitovsky (1954), the market mechanism could be relied on to take care of the production problems of an economy, but investment allocation required state intervention. Thus, the state emerges as a ‘visible hand’ in the role of an investment planner, particularly, in the context of developing countries.

The concept of the state acting as a visible hand in an economy can be traced back to Adam Smith’s “science of the legislator” which advocated for state intervention to fulfill individual as well as societal objectives. This form of state intervention was tasked with the responsibility of restructuring attitudes and beliefs about economic policy in a way that promoted the general good of society rather than that of an individual or a group of powerful individuals. The aim was to ensure that the self-seeking behavior of an individual not only leads to his/her material needs being met but also that of the society. The market was considered beneficial when subject to free and fair competition with regulatory checks in place to ward off any monopolistic tendencies i.e. “the wretched spirit of monopoly”, in the words of Adam Smith. A competitive market mechanism is capable of facilitating the production problem of an economy i.e. producing goods and services in the right quantity where the demand of buyers meets the supply by producers. Therefore, the production problem of an economy can be better dealt with by market forces than by the state due to price fluctuations based on the calculations made by would be-buyers and would be-seekers. These calculations automatically adjust the quantity demanded and quantity supplied towards the equilibrium price. Government intervention in this regard does more harm than good because intervention leads to a loss in the potential of buyers and sellers in negotiating freely in the play for prices. This hindrance, in turn, creates artificial surpluses or shortages. However, the functionality of market forces does not entail that the economy is better off sans state intervention. Instead, as theorized by the first fundamental theorem of welfare economics, “given certain conditions, all individuals pursuing their respective self-interest leads society to an optimal state”.

In interpreting the second part of the statement, it is pertinent to briefly explain developmental economics as a sub-field of economics. Developmental economics is primarily concerned with identifying the fundamental causes of economic backwardness and formulating strategies to pull such economies out of backwardness and towards progress through state intervention. The “visible hand” of state intervention replaces the “invisible hand” of the market forces (in part). This arrangement is unique in its ability to analyze the economy from a socio-economic lens with the primary objective of ensuring economic development and growth. This subfield of economics gave rise to the concept of Investment allocation and with it, the idea of a “good government” which was to drive economic growth and development through centripetal1 and centrifugal forces2. It was entrusted with the responsibility of minimizing information asymmetries within the classes i.e. the traditional classes of landlords, workers, and merchants, promoting technological innovation and increasing competitiveness in order to achieve economic development, growth and security. Therefore, the central position enjoyed by the state in its role as an investment planner is grounded in the concept of “economics of growth” wherein income, factor endowments and productivity function within formal socio-political arrangements. These institutions, in turn, facilitate policies regarding trade and foreign investment within the geographical boundaries of the state. Accordingly, economic growth and development of a state are evaluated through degrees of political freedom, economic facilities, social opportunities, transparency and protective security.
The growth and development of an economy, therefore, should be analyzed through tools of complementarity and inter-relationships.

Akin to his predecessors and contemporary developmental economists, Scitovsky too advocated for the state’s role as an investment planner as a tool for achieving capital accumulation. This gave rise to the concept of “planning agencies” that formulated investment plans based on country-specific economic conditions and temperaments. Scitovsky’s assertion was grounded in the implicit assumption that upon achieving productive capacities, subsequent problems of employment, output, income etc. would be resolved automatically. Scitovsky’s theory was insufficient as it neglected the significance of behavioral and institutional issues while conducting economic decisions. In magnifying the importance of mere capital formation as the source of economic growth, he overlooked other critical aspects of growth. For Instance: levels of technical progress, a capacity of economic agents, policy environment, evolving structure of trade and strategies of a market organization. The role of the state as an investment planner gained ground in developing economies, especially erstwhile-colonized countries. The rationale behind an increased role of the state in an economy was due to the calamitous state of its domestic economy, a skewed structure of production, information asymmetries, archaic capacities, obsolete technology and multiplicity of objectives as a direct consequence of prolonged foreign rule, experiences of annexation, war, and partition.

To argue that state intervention in the investment planning stage (of an economy) is either advantageous or disadvantageous would be to oversimplify the complex functioning of an economy. Therefore, I will be defending as well as criticizing the “visible hand” through empirical examples of economic practices as conducted in India and South Korea.

Case: Economic policies and strategies employed by the Indian state as an investment planner in the Agriculture sector. My study is divided into four phases, each phase including investment strategies by the government and its consequences.
(a) The first phase i.e. 1947 to the mid-1960s focused on Agrarian reforms, institutional changes and marked a shift from the colonial style of agricultural policies to ones under independent India as seen in the abolition of intermediaries and giving due credit to the actual land cultivators. The state invested in Community development programmes, Intensive area development programmes and set up an Agricultural price commission to advise the government on how to fix support prices of agricultural crops. In doing so, the state invested with the aim of providing the agrarian economy with a strong framework.
(b) The second phase i.e. mid-1960s to 1980 focused on research, input supply, credit availability, marketing and the spread of technology. Under the fourth FYP3, the agricultural strategy employed by the state underwent a significant change. This is related to the ‘choice problem’ that is explained at a later stage in the text, wherein the state decided to prioritize self-sufficiency in food grains instead of interregional equity. A trade-off was made in favor of self-sufficiency than in pursuing interregional equity as a result of which, the state invested in the Green Revolution strategy that introduced a High-yielding variety of seeds, multiple cropping patterns, a spread of irrigation facilities, increased use of fertilizers etc. This agricultural policy of the government led to the attainment of whilst registering disproportionate levels of economic growth and development.
(c) The third phase i.e. 1980-1991 marked a shift from a one-dimensional pattern of investment to a pattern of diversification of investment in the agriculture sector i.e. in non-food grain goods such as milk, fishery, vegetables, fruits etc. This was made possible through an increase in subsidies and resulted in a considerable growth of the agricultural GDP. It is interesting to note that even though there was a decline in investment in infrastructural development in real terms, farmers were seen investing independently of governmental subsidies. An interventionist would argue that this change in the propensity to invest was made possible due to the direct support provided by the state in the initial stages of agricultural growth and development as illustrated in the aforementioned phases.
(d) The fourth phase i.e. 1991 onwards led to the liberalization of the economy and the removal of protection that was erstwhile enjoyed by the domestic market. This phase displayed the reality of the Indian economy; the inferior structure of domestic industries, poor quality of goods and services, obsolete level of technological advancement, stunted rates of economic growth and the diminished capacity of its economic agents.

Case: The Statist approach employed by South Korea as an investment planner in the Manufacturing Sector. The rationale behind choosing the manufacturing sector instead of the agricultural sector is because a majority of the economic policies and strategies were directed towards the manufacturing sector owing to the ultimate objective of progressing as an export-led industrial economy. This is in contrast to the Indian state, which lacked the basic foresight required to develop its economy comprehensively. My study is divided into 3 stages.
(a) The import substitution stage (1954-1960) focused on the protection of domestic goods and services through massive investment in physical and human capital infrastructure. Even though there was no substantial increase in the rate of economic growth, it created a strong foundation in order to support its subsequent stage of advancing an export-led industrialization economic policy. The state did so by safeguarding the domestic industries through direct state intervention (statist approach), licensing and other regulatory mechanisms, investing in basic industries and by collaborating with the dominant socio-economic forces of the Chaebol.
(b) The outward orientation stage (1961-1979) focused on the growth of the manufacturing and industrial sector through incentives that encouraged expansion based on export demand. The 1970s saw state intervention in pushing for Heavy Chemical Industrialization or HCI, included in the third FYP (1972-1976). The state did so by appointing non-ferrous metals, petrochemicals, general-type machinery, shipbuilding, electronics etc. This investment strategy prioritized five strategic fields and mirrored the strategy adopted by Japan wherein the Ministry of International Trade and Industry or MITI collaborated with private Japanese industries. The primary aim of the collaboration was to identify favored sectors and regions for future action through research and development. Due to the huge cost and risk associated with the HCI strategy, private Korean businesses become more dependent on the state for preferential credit policies and protection. This, in turn, strengthened the relationship between the state and its private counterparts’.
(c) The balanced stabilization stage (post-1980) emerged because of domestic political impediments, the oil shock of 1980-1981 and a massive crop-failure in the country. As a result, there was an immediate need for the stabilization of the economy in order to achieve a balanced growth path.

Therefore, even though the state functioned as the central authority guaranteeing the protection of domestic industries through licensing, other regulatory mechanisms and through incentives, the trajectory of economic development and growth differed largely in both these countries. Instead of simply arguing for or against state intervention in the stage of investment planning, I find it more useful to highlight certain economic policies and practices that made centralized investment planning successful and those that posed as an impediment to economic growth and development. My rationale behind employing this form of argumentation is grounded in the fact that no single theory or set of strategies can be employed in its elemental form because every state has a unique set of demands and requirements owing to their historical experiences, limitations posed by exogenous factors such as, geography, compulsions posed by demographic considerations etc. For Instance, the implementation mechanism of investment planning in India varied greatly from that of South Korea. One implementing agency came to existence upon inheriting a fully functioning bureaucracy from British rule while the other was composed of a group of business elites owing to a complete absence of a functioning bureaucracy. Similarly, the state in South Korea was able to better integrate itself with private industries due to the existence of large family-owned conglomerates i.e. Chaebols. While, in contrast, India had no such institution and remained largely autonomous from private industries.

Successful investment practices by the state (South Korea):
(a) the state employed a credit policy wherein differential interest rates, ranging from 8% to 34% acted as incentives for domestic industries to remain competitive and encourage export-led production of goods and services. The credit policy served as an alternative form of credit policy. This strategy of Libertarian Paternalism awarded the state a greater control over the economy’s capital market whilst giving the illusion of the state not directly intervening in the processes of production, exchange, and consumption.
(b) Public Sector Undertakings or PSUs at the enterprise level enjoyed a relatively fair degree of autonomy in managing their internal affairs. This reduced the number of objectives to be fulfilled in consonance with those mandated by state authorities, thereby, reducing the burden that would have otherwise been imposed due to bureaucratic delays. Moreover, this strategy gave the semblance of a delegation of authority and power to other sections of the society, making them more confident of their place in the economy.
(C) The most significant policy of investment planning was the incentive structure that encouraged expansion based on export demand. It embodied the role of an interventionist state geared towards developing and supporting the market economy through incentivizing its domestic industries in order to become a competitive market economy globally.

Limitations posed by a centralized form of investment practices:
(a) The choice problem arises due to the multiplicity of objectives to be fulfilled by a state in deciding priority areas of where, when and how to invest. This perpetual state of trade-off poses a significant challenge to the state in deciding its investment policy direction. Unlike market forces that can justify decisions based on the sole principle of profit maximization, the state as the guarantor of the ‘collective will’ needs to keep in mind ethical considerations, group interests, international compulsions whilst preserving its political status.
(b) As part of state intervention in investment planning, there is an immense amount of protection offered to certain domestic sectors or industries through licenses and other regulatory mechanisms. Due to the overarching guarantee of protection, producers are discouraged from becoming competitive in the economy i.e. they are not incentivized to cut costs or to improve the quality of good. Captive markets, therefore, stunt domestic economies and lead to moderate levels of economic growth.
(c) Lastly, in the pursuit of gaining protection, subsidies, and benefits, domestic businesses and industries indulge in the phenomenon of ‘rent-seeking’ or ‘license-seeking’. Now, because the incentives are higher to procure such licenses than to become competitive economically, domestic players shift their priority away from economic development and growth & towards obtaining such licenses for immediate, short-term gains. This additionally leads to the diminishing of production-possibility due to a shift in resources that are now allocated to ‘rent-seeking’ instead of production.

Therefore, state intervention instead of generating savings and investment in order to promote economic growth and development becomes a drain on the economy i.e. from a supplier of savings to a consumer of savings. This ultimately leads to a detrimental policy environment, the dissatisfied citizenry, prolonged periods of economic stagnation, loss in foreign exchange reserves, high prices, reduced levels of economic growth etc., all ending in market failure.

 

References

  1. Chaudhuri, Mrinal-Dutta. 1990. “Market Failure and Government Failure .” The Journal of Economic Perspectives 25-39.
  2. Kim,  Kwan S.  1991. “THE  KOREAN MIRACLE  (1962-1980) REVISITED.”  KELLOGG INSTITUTE.
  3. Mohan, Rakesh. 2008. “The growth record of the Indian economy, 1950-2008 .” Institute of Economic Growth, New Delhi.
  4. Prasad, Amarnath Tripathi & A.R. 2009. “Agricultural Development in India.” Journal of Emerging Knowledge on Emerging Markets.
  5. Uk HEO, Houngcheul JEON, Hayam KIM and Okjin KIM. n.d. “THE POLITICAL ECONOMY OF SOUTH KOREA.” British Journal of Political Science.

 

Shagun Nayar is a student at Jindal School of International Affairs.

Featured Image Source: Neil Webb

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