This is part two of a presentation by Mr. LaFaive, director of the Mackinac Center’s Morey Fiscal Policy Initiative, for The Nassau Institute on Thursday, March 12, 2009.
Economic Diversification: Should Mandates or Markets Rule?
By Michael LaFaive
Download a PDF of the presentation here…
Why don’t these programs work? Many studies don’t address that, but I can suggest some broad theoretical explanations.
First, government can’t give anyone anything that it hasn’t first taken from someone else. To paraphrase Milton Friedman, there are no free lunches in economics. Why do you think it’s called “the dismal science?” Economists are forever reminding people that everything in this world has a cost, even if it’s just an opportunity cost. In this case, for the government to encourage economic growth in one area, it must necessarily suppress it in another, or a little bit in many others, which may actually set-back progress toward a more diversified economy.
Unfortunately, the day-to-day activities of these programs frequently garner lots of positive media coverage because they benefit particular plants or firms or large new construction projects that reporters can point to and take pictures of. The broader effects on the economy as a whole are only visible in the form of dry statistics — unseen and thus unreported are all the homes or hotels that are not built as a result of transferring wealth from the many to the few.
To illustrate, imagine I robbed a bank in Parliament Square and spent all the money at the Nassau straw market. Would the media only interview the sellers about how great business has been, or would they recognize that some people had to lose in order for others to gain? With government eco-devo programs, the “bank robbery” is much less dramatic and its impact more widely dispersed, but this is in fact this is exactly how those stories are reported.
Moreover, these programs represent a very inefficient way of transferring wealth. In the middle of every deal you almost always find an expensive bureaucracy, reviewing proposals and approving or refusing them. None of those people work for free.
Related, there are only four ways to spend money: Spend your own on yourself, spend your own on someone else, spend a stranger’s on yourself, and spend a stranger’s money on yet another stranger. The likelihood of inefficiency and waste is highest with the last, because there’s zero connection between the two strangers, and the intermediary who does the spending has a strong incentive to arrange the transactions in a way that make himself a beneficiary.
(Second) Next-up on the theoretical explanations for eco-devo’s ineffectiveness, the would-be central planners who devise Industrial Policy programs must face the inevitable “knowledge problem” detailed so eloquently by Nobel laureate F.A. Hayek.
Hayek explained how knowledge about an economy is widely dispersed among millions of people, making it utterly impossible for government central planners to ever acquire and process sufficient information to construct rational plans for a wise and efficient allocation of scarce resources to meet various demands.
He used the term “the Fatal Conceit” to describe the illusion that central planners can somehow grasp all the nuance and detail of the economic lives of millions and arrange them more optimally than if all those people had been left to their own devices. At best, the planners can hope to get lucky now and then. Even a broken watch is right twice daily.
To see just how lucky they would need to be, consider an illustration devised by the respected Stanford University economist Paul Romer:
There are only six ways to arrange three playing cards. Increasing the number of the cards increases the number of potential arrangements at a dramatic rate. With just 20 cards, the number of arrangements rockets to more than 2 quintillion — a figure greater than the number of seconds in 75 billion years. With a full deck of 52 playing cards, it’s conceivable that some arrangements have never occurred in all of human card-playing history.
And that’s just 52 factors. Economic development officials hoping to manage an entire national or state economy would have to deal with potentially millions of items, including the particular preferences and plans of every individual business and consumer. Then they have to filter all that through the narrow imperatives of the political class, which may be unrelated to the broad long term interests of the economy at large.
Of course, the complexity and dispersed nature of economic knowledge means big problems for entrepreneurs and business managers too — one reason that so many start and fail. But they have some distinct advantages over the central planner, including sharper incentives to quickly make mid-course corrections and to manage scarce resources with greater care.
Third, and Continuing with my tour of the theoretical waterfront, “rent seeking” is the awful term coined by economists to describe potential beneficiaries of government programs seeking special favors from politicians and bureaucrats to help them collect higher than normal “rents” or returns than they would receive in open market competition. In and of itself this activity can retard economic growth and development.
Harold Brumm, an economist with the U.S. General Accountability Office, examined the phenomenon in the 48 contiguous states and found a inverse relationship between the level of rent seeking and the rate of economic growth. He concluded, “The implication . . . is that a state government which promulgates policies that foster sustained artificial rent-seeking does so at considerable expense to its economic growth,” and, “To the extent that economic growth is a desideratum, a goal of public policy should be the restraint of government interventions that create and sustain artificial rents.”
Yet this is the very thing that state development programs do: encourage the seeking of “artificial rents.”
Last, targeted tax breaks and subsidies are unfair. Not infrequently they’re given to one business operating in direct competition with another existing business. I’ve seen complaints in Bahamian newspapers from locals about receiving unfair treatment under laws that reportedly favor Foreign Direct Investment. Indeed, an amendment to the Hotels Encouragement Act to help create a more level playing field would not have been necessary if there had not been a Hotels Encouragement Act in the first place.
A solution more conducive to growth and possibly diversification would be a “Fair Field and No Favors Act” lowering the burden of starting or investing in any business, regardless of the origin of the capital or entrepreneur, and limiting government’s ability to hand out goodies to the latest fad industries or favored corporations.
After all, the implicit message of every concession made to some particular industry, corporation or business is that the general cost of doing business in a certain location is so high as to make enterprises there unable to compete with ones in other jurisdictions.
When I was first approached about doing a speech on economic development in the Bahamas I did a quick literature review specific to the islands. This revealed a relative dearth of empirical studies relevant to the Bahamas, or even the Caribbean.
Unfortunately, time didn’t permit, but one existing product whose hypothesis has been tested in peer-reviewed journals does provide some insights relevant to the Bahamas. It’s the “Economic Freedom of the World” index published by the Fraser Institute of Canada and the Cato Institute in Washington D.C.
This annual publication ranks nations based on 42 different measures of economic liberty — from citizens’ freedom to exchange in a marketplace to the ease of entering particular markets, and to the protections of property rights. Other major components include “Size of Government;” “legal structure and security of property rights;” “Access to Sound Money;” “Freedom to Trade internationally,” and Regulation of Credits, Labor and Business.”
The good news — no, the great news — is that the Bahamas does very well overall and in most categories. Actually, not having a personal or corporate income tax makes it hard not to do well. Indeed, the 2008 index ranks the Bahamas 42nd out of 141 countries, using data through 2006. The bad news is that in 1980 the same index pegged the Bahamas at number 21, so there’s been a precipitous decline in net economic freedom here.
While it may be easy for critics to say “So what? We’re still the second-wealthiest people in the Northern Hemisphere,” according to a ranking by the Heritage Foundation, a research institute based in Washington, D.C., imagine how much better Bahamians would be had the islands maintained rank instead of tumbling 21 places.
Like other nations at this moment in economic history, the Bahamas should be concerned about sustaining economic growth of any type right now, never mind micromanaging growth in narrowly targeted industries-du-jour favored by government central planners.
That brings me back to the economic freedom index. One of its findings is that economic freedom “is highly correlated with both the level and the rate of growth of real per-capita Gross Domestic Product.”
In 2003, economist Julio Cole from the University of Francisco Marroquin in Guatemala conducted his own exhaustive analysis of the index. He wrote: “The EFW index provides . . . a report card with considerable predictive power. Policy analysts would be well advised to keep an eye on this index in the future.”
So how might the Bahamas improve its grade? I can’t offer a comprehensive plan in a single speech, but we all could benefit by looking to another island nation that has routinely occupied the top spot as the most economically free nation on earth — Honk Kong.
Hong Kong out ranks the Bahamas in all five of the major index categories, and it beats the U.S. in all but one, access to sound money. (The U.S. ranks number 10 overall, by the way.) The index authors gave the Bahamas surprisingly low marks for “freedom to trade internationally” (126) and “access to sound money” (95). Reform in these areas is likely to bring about much greater improvements the Bahamas’ economic growth and development than highly problematic economic development programs.
Another index area that deserves attention is “size of government.” Bahamas scores relatively well at number 15, but there’s still room for improvement. The Bahamian government consumes some 20 percent of the nation’s GDP, compared to less than 14 percent in Hong Kong. I suspect my friends at the Nassau Institute have some good ideas about where to start trimming government services
Before I conclude, a warning: Beware of the efforts of well intentioned people in business, government and academia to use the worldwide economic slowdown as a rationalization for more government intervention in the marketplace.
An article from a few years back in a peer-reviewed journal especially raised my eyebrows. It was called “The Development of the Bahamian Economy at the Crossroads,” and read in part:
"Devising the necessary measures to stimulate regional growth and industrial regeneration, while giving priority to investments necessary to allow the fullest and most efficient utilization of existing resources in the country, seems to be a better option for the growth of the Bahamian economy than a frantic search for accelerated “Western style” modernization and laissez-faire antidote."
The article continues…
". . . a central core (or strategic planning agency) is absolutely necessary, which should consist of a small entrepreneurial team. This executive ‘new look’ elite would possess accurate intelligence, inventiveness and active, strategic and sophisticated responsiveness to a changing economic reality."
Friends, I’ve been around this track more than once and can testify: Every new government economic intervention either originates in academia, or else academia ends up providing the talking points, rationalizations and frequently spurious correlations used by politicians to justify their new incursions into economic decision making.
So, I offer this sage advice: be sensitive to the promises of any politicians, or their lieutenants, or members of the academic community wishing to practice King Canute economics. It’s very difficult to command economic waves to splash or not splash, but economic storms are frequently the shield behind which central planners advance their latest intervention.
There is a mountain of evidence that purposeful — government directed — economic planning programs fail to live up to expectations. Rather than embrace more of the same, perhaps it would be better if Americans, Puerto Ricans, Bahamians and others removed obstacles to freedom of association and trade and let a diversified people with diversified interests invest and consume as they say fit. The sum total of their work and their lives will very well likely make the fabric of any economy stronger — even more diversified — than it might otherwise be when directed by the iron fist of government.