Markets and Governments: Finding the Balance in Developing Countries

Mehdi Shafaeddin

The recent global economic crisis has renewed interest in the debate over the role of the government in economic activities, in developed countries as well as developing countries. Rich countries had to stimulate their economies by injecting enormous amount of cash to deal with the financial crisis caused by the unregulated market and the activities of financial institutions. In the case of the United States, such injections amounted to over one trillion dollars. Yet, the International Financial Institutions continue to advocate a different policy for poor countries. The recommendation of the IMF to the Government of Malawi to impose pro-cyclical monetary and fiscal policies on the economy is only one example.

For developing countries, particularly least developed countries (LDCs), the question is not merely the role of the government in dealing with the business cycles. More importantly, it concerns the relative role of government and market in long-run development and industrialization. In fact, the global economic crisis is a wake-up call for developing countries, particularly those which are at early stages of development, to reconsider the “market-oriented” approach to industrial and development strategies. Such strategies have been advocated by the IFIs, WTO and bilateral donors, following the so-called “Washington Consensus.” Some of the African, Caribbean and Pacific (ACP) countries, which include many LDCs, are also under pressure from the EU to liberalize their foreign trade regime and internal markets through Economic Partnership Agreements (EPAs). Yet, the recent global financial crisis has revealed that market forces have deficiencies even in the case of industrialized countries, let alone developing countries, and particularly LDCs.

The market is only one element in the coordination of economic activities. The “coordination system” consists of the market, firms and government, complemented and supported by “non-price factors” (institutions, infrastructure, information and back-up services). Without the development of non-price factors the market cannot operate efficiently. The price mechanism is slow to create markets and develop non-price factors. The market mechanism can deal with gradual and marginal changes. But it is inadequate to accelerate growth of supply capacity and promote dynamic comparative advantage; to make inefficient industries efficient and competitive, particularly through shock therapy; to promote technological learning and achieve technological upgrading automatically. Hence, some government intervention is required to complement market forces at all levels of development. But the government actions and policies should complement the market, not replace it.

Meanwhile, in contrast to the neo-liberals’ presumption, firms are not passive: the firm, in my view, is the central driving force in the coordinating system since productive capacity is built- up at the firm level.

The relative roles of each element of the coordination system – the market, enterprises and government – and their interactions vary from one country to another and in each specific country over time in the process of development. Developing countries at early stages of development face a dilemma; they face great risks of market failure, entrepreneurship failure as well as government failure. There is a vicious circle: the coordination mechanism fails because of the low level of development; there is a low level of development because of the weak coordination system. In breaking this vicious circle, however, the government must play a key role to create or improve the market, to increase the organizational capacity of the entrepreneurs, to develop complementary and supporting “non-price factors”, including institutional factors, and last, but not least, to enhance the capacity of the state machinery itself.

In fact, the key to industrialization at early stages of development is to improve the learning capacity and efficiency of the government machinery in formulating, implementing, monitoring and correcting policies. At early stages of industrialization, the government may have to invest directly in areas where the private sector, including TNCs, is not prepared to take risks. As markets and enterprises develop, the role of the government in industrialization should decrease. The increasing domination of TNCs in global economic activities and their enhanced power in international markets during the last couple of decades have increased the need for government intervention at early stages of development, in contrast to the market-oriented approach which advocates reducing government’s role.

In short, the question is not market or government. It is to what extent and in what form the government should intervene to minimize government failure and market failure and inadequacies. But it is also important to avoid unnecessary, rigid and prolonged intervention as markets and enterprises are developed. Both functional and selective government intervention are required for capacity building as well as upgrading of the industrial structure as I have explained elsewhere.  (see Shafaeddin, Trade Policy at the Cross-roads, Recent Experience of Developing Countries, Palgrave, 2005).