(Reprinted from HKCER Letters, Vol. 9, July 1991)
Policy Versus Chance in Economic Development
Arnold C. Harberger
Lessons of Development
In 1983 I attended a conference in Mexico that dealt with the problems of and the role of policy in economic development. I came up with a summary of lessons of economic policies that participants of the conference agreed on. I will go through them very quickly: Keep budgets under adequate control; keep inflationary pressures under control; take proper advantage of international trade; make the tax system simple, neutral, and easy to administer; avoid excessive income tax rates; avoid the excessive use of tax incentives to achieve particular objectives; use price and wage controls sparingly if at all, and the same goes for quota, licenses, and similar quantitative restrictions. I closed with some statements about public sector enterprises. It is well recognized that they had a miserable record, but the miserable record comes in large part from the fact that governments do not permit such enterprises to function as enterprises. They do not let them close down bad lines of production, they force them to sell the products at falsely low prices, they turn them into semi-welfare agencies, and so on. We do not mind Singapore Airlines, we think they are fine. Why? Because they are allowed to function as an enterprise.
Chance May Help
Some people have said that if good policies always pay off, why is it that some countries with good policy do not have high growth rates, while some others attain high growth rates without having good policies? I have made a list of countries arrayed according to their accumulated growth rates from 1965 to 1988. The leader is Botswana, with 8.6 percent accumulated growth. Then comes Singapore, 7.2, Korea 6.8, Oman 6.4, Hong Kong 6.3, Lesotho 5.2, Hungary 5.1 and so on. In that list there are some pretty miserable performers as far as my grading of economic policy is concerned. If one extends the list down, one will find some other countries that are not on the list but to which I would give good grades for economic policy.
It is correct that countries that do good policy achieve the benefits of its consequences, and when they do bad policy they suffer bad consequences. But the base from which those things are happening is influenced in important ways by chance. The most obvious one is lucky products. Diamonds -- that is the story of Botswana. But on the above list there are five countries that have practically nothing. There are another five or so that are oil countries, and oil was a big part of the explanation of their high growth rate.
The Policy Environment
So that is part of the story of chance. There is, however, another source of explanation of economic progress that I think, in some way, is more interesting than the sheer luck of finding diamonds or having enough oil to be an oil exporter. Economists have called it growth of total factor productivity, sometimes the growth of output per unit of total input, or simply, technical advance. I prefer to call it real cost reduction. The term "real cost reduction" is just an umbrella. It has to be realized that real cost has to be coming down either if total factor productivity is increasing, or if output per unit of total input is increasing, or if technical advance is taking place. I think real cost reduction is a terminology that spells out what the essence of the growth process is. There are thousands of ways in which real costs not only can be reduced but are being reduced and are generating economic growth all over the world.
This leads to my story of mushrooms. Real economic growth is like mushrooms, where all of a sudden one pops here, then another one over there, just like that. You never know where they are coming next. People who grow mushrooms say the whole thing is getting the environment right. You are got to get the temperature and the humidity right, and you have to provide the right combination of light and darkness, but even then you do not know where one will pop up. I think that is exactly the way economic policy can work in promoting the suitable environment for the growth process. Everybody has an incentive to reduce real cost -- at least, if he is allowed to keep a decent share of what he makes, he has an incentive to reduce real costs. What policy can do is to make sure that this natural process works as much as possible.
Real Cost Reduction
There is no doubt in my mind that the biggest potential for real cost reduction is with those who are somewhat behind in the development race. We talk about the technological gap. Most developing countries are very far behind, and the farther behind you are the less you have to really invent the new thing. Your task is really to take things that are known -- knowledge and techniques that exist -- and adapt them to the special circumstances of a particular country. All such adaptations should be seen in the context of reducing real costs, and everybody who is doing that kind of thing is reducing real cost entirely. At the same time, he is contributing greatly to the growth of the economy. It would be harder for countries to reduce their real costs if entrepreneurs have to, for example, grope around in the fog of inflation. Countries will make a lot more mistakes if the costs people are trying to reduce are false costs. It is distortions that often are put into the economic system by bad economic policy that turn true costs into false ones. Getting rid of, or dramatically reducing the extent of real distortions, is one of the clear tasks that economic policy in most countries still has ahead of it.
So what do we have? Going back to the topic of "Policy versus Chance," first of all, we see that observed growth is not always one-for-one with good policy. Luck definitely comes in. Good and bad luck come into play especially in terms of being in the right product at the right time and having good luck with movements of world prices of whatever products the country does produce. In what I have been calling real cost reduction, we cannot easily predict where the next big boost to technological advance will come from. So I think there is luck there. But there is also an element of policy, in that countries can create the environment in which whenever the die turns up favorable, the countries can take maximum advantage. They can also have bad policy in which the likelihood is that the countries will not take full advantage.
Another thing I should mention is that a clear way in which mistakes are made is to have arbitrary and frequent changes of policy. With many countries in the world that make those types of policy changes, people just stop investing for the long run. They turn into speculators on the next turn of the policy wheel, rather than investors trying to do serious productive investment projects.
That is really what I have to say about "Policy versus Chance. Both of these forces are at work, and the place where chance is most clear is in terms of movements in world prices, and the place where both policy and chance enter is in this important area of creating the policy environment in which real cost reduction can take place. Policy environment is obviously policy, but whether in a given decade or a given twenty-year span, the country will have a lot of real cost reduction or not is not something that the policy maker himself can determine. It is in considerable part determined by events of development, technological and otherwise.
Dr. Arnold C. Harberger is a Professor of Economics at the University of Chicago and the University of California at Los Angeles. He is well known for his writings on economic development, project evaluation, and public finance. His talk was delivered at the Centre and was co-sponsored with the International Center for Economic Growth.