Tuesday, October 25, 2011

The Market and Government

Many people, including economists, believe in government intervention. Rodrik (2001), says, “Markets are the essence of a market economy in the same sense that lemons are the essence of lemonade.  Of course, if you put too much water in the mix, you ruin the lemonade, just as too much government meddling can make markets dysfunctional.”  He then adds, “the trick is not discard the water and the sugar, but to get the proportions right.” [1]

Nobel Laureate Professor Gary Becker (2011) says that government intervention is a function of the size and persistent of the market failure.[2] The larger the market failure, and the longer it lingers, the more government intervention is needed. 

Many economists in developing countries seem to believe that economic and social developments require more government interventions, at least at the early stages of development. Some examples include China, Singapore, Malaysia, and Turkey. Britain and the United States, for example, had more government interventions in their early stages of development.

Milton Friedman (1962) believes that the government poses a threat to individual freedom, which is essential for prosperity.[3]  Amartya Sen (1990) believes in development as freedom.[4]  While Friedman sees little benefit from governments, Sen reserves a role for the state along with other agents in society to achieve development and freedom.

Rodrik (2011) believes that the Chinese development result is a miracle because it is centered on government intervention in the markets. Despite its economic success,  China is neither a democracy nor are its people free.

The data seem to be  inconsistent with the intervention story.  I examine the Chinese data (Maddison).  Real GDP is the measured part of output of a nation.  Figure 1 plots real measured GDP and its potential level (HP filter). Before 1980, the Chinese economy did not grow.  Growth began in the mid to late1980s, increased in the 1990s, and really sped up from 2000 onwards.  The Chinese government between 1950-1970 had more control on the economy and the society than the governments of the mid 1980s onwards. The Fraser House Economic Freedom Index, which is a proxy for freedom, indicates so.[5]

Thus economic growth, which China experienced in the 1990s onwards, has been associated with less, not more, government intervention.  Figure 2 shows a positive correlation between GDP growth and the freedom index.

Figure 1.

Figure 2. GDP Growth and The Fraser Chain-Linked Index (1950-2008) 

[3] Friedman, M., Capitalism and Democracy, 1962.
[4] Sen, A., Development as Freedom, 1999.
[5] http://www.freetheworld.com/,The Fraser Index is for a 5-year period from 1975 to 2000, and yearly thereafter.  There are five areas of measurements. Area A1, Size of Government: Expenditures, Taxes, and Enterprises; Area A2, Legal Structure and Security of Property Rights; area A3, Access to Sound Money; area A4, Freedom to Trade Internationally; and area A5, Regulation of Credit, Labor, and Business.  The overall index of all five areas of the economy is between 0 and 10, with 10 being the freest market. The chain index underlying data for area A1 showed no significant change over time.  There were some improvements in the index for area A2 and a significant improvement in the index in areas A3, A4 and A5.  The improvement in the score happened in two steps. It jumped from 4.96 to 5.30 in 1995 and again in 2005, where the index jumped from 5.66 to 6.08.  This indicates that the Chinese government moved closer to a less interventionist government with time.