Is a strong state a prerequisite or an obstacle to economic growth - Russell Kwok

Note :In the interests of simplicity, we shall use the Solow-Swan Model for long-run economic growth to assess policy implications and we will define a strong state as one having a government which is able to create and enforce laws easily and stringently, which greatly influence the lives of citizens.

The implementation of unprecedented fiscal and monetary policies in conjunction with the recession caused by the Covid19 lock-down has once again brought up the discussion of economic growth. In response to the virus, many nations have curtailed freedoms and vastly increased government control over society (Jain, 2020). This essay will demonstrate that a strong state is, in most circumstances, an obstacle to economic growth. The issues of how an authoritative government may affect productivity, investment, corruption, political stability, recession management and state-owned businesses (SOEs) will be investigated.

A government’s influence on productivity is arguably the most significant determinant of economic growth, as Roubini and Backus assert: “Productivity is the cornerstone of economic growth.” (Roubini Backus, 1998). Since a favourable economic environment can significantly bolster innovation and diligence, the state must be vigilant about its policies. One characteristic of a strong state is efficient legislation, leading to more laws. Increased regulation often increases bureaucracy which may impair productivity; an example is the United States, which passes 2-3 million words into legislation every term (GovTrack, 2020). It is possible that certain laws may increase productivity; however, since regulations are by definition a restriction, it is more probable that such legislation will stifle economic growth by reducing the freedom needed for creativity. Evidence of such can be found in the United States, where the Code of Federal Regulations has increased 600% from 19,335 pages to 134,261 pages from 1949 to 2011. Dawson and Seater modelled the effect of such lawmaking and concluded: “if regulation had remained at the same level as in 1949, current GDP would have been $53.9 trillion instead of $15.1 trillion in 2011” (Dawson Seater, 2013). This is a difference of $38.8 trillion, which is approximately 13.5 times the GDP of Britain.

An apparent exception would be China, with an average growth rate of 9.1% from 1992 to 2019 according to the CEIC, with comparatively fewer regulations than most developed countries. Such impressive economic development would seem to be improbable given the powerful state present, but one should look at the details. According to a report from the U.S. Congress: “the Chinese government decided to break with its Soviet-style economic policies by gradually reforming the economy according to free market principles. . . [to] significantly increase economic growth and raise living standards.” (Congressional Research Service, 2019) As Deng Xiaoping put it: “Black cat, white cat, what does it matter what colour the cat is as long as it catches mice?” Therefore, it was the weakening of the strong state, in the form of regulatory and bureaucratic reduction, that has provided the basis for such impressive economic growth.

Another keystone to economic growth is private investment which is, in essence, a vote of confidence in a particular country. Given that only 18% of the world population are employed by the public sector, the role of the private sector is considerable (OECD, 2019). Therefore, the implementation of unfavourable policies will have substantially

negative implications, especially towards SMEs since they account for 70% of the jobs around the world (Ready, 2018), and will inevitably precipitate an economic slowdown. However, some see government investment as a solution to this problem. Such increased economic control can be identified as another way a strong state is manifested. Unfortunately, state spending is vastly inferior to its private iteration as it incentivises waste and disincentives efficiency (Folsom Folsom, 2014). This is because state spending, mostly revenue taken from the private sector via taxation and/or SOEs, displaces private investment. In addition, government spending is not sub ject to the market forces that ensure efficient resource allocation in the private sector, thus increasing wastefulness that suppresses growth. (Riedl, 2010) Evidence from this can be seen in a study from the Journal of Macroeconomics that indicated that a 1% increase in government size decreases the rate of economic growth by 0.143% (Guseh, 1997). Although certain countries may have other revenue streams, such as natural resources, which reduces the displacement of private investment, the inefficiency of government spending still stands true.

Because of efficient taxation in strong states that provide large revenues, the potential benefits of managing that capital may engender political conflicts (Acemoglu, 2010). Embezzlement and cronyism are often present in strong states; executors control an estimated $800 billion globally used for unofficial purposes (Eckert, 2007). This damages the economy grievously through the reduction of essential investment and increases in inefficient spending. Furthermore, transparency in such administrations is reduced through bureaucracy, resulting in a system which increases the ease of cover ups for unprincipled behaviour by officials. An opposing view may argue that such conduct would be reduced if remuneration was sufficient. However, as Lord Acton pointed out that "Power tends to corrupt", even principled public servants would be likely to succumb to the temptations of controlling a strong state. Economic consequences of bribery are articulated by Shleifer and Vishny: “corruption is costly to economic development”. (Vishny Shleifer, 1993). This demonstrates that the influential sway of strong states causes corruption, which obstructs economic growth.

People believe that the main advantage of a strong state is the effective implementation of policy, which can potentially enforce a strong rule of law that defends private property rights (Licht, et al., 2007) and fosters favourable commercial environments. This is because a strong rule of law provides certainty for businesses, encouraging investment. In reality, evidence shows that a weak rule of law is more prevalent in strong states (Henderson, 1991), principally caused by excessive legislation (Somin, 2017). The implementation of new laws may precipitate an unpredictable business landscape causing a reduction in investment and dampen economic growth (Bakari, 2017). Moreover, the tight influence a strong state has over society often leads to oppression, sparking civil unrest (Mountford, 2017) which may reduce economic growth through revenue reduction leading to capital outflows. The same occurs when burdensome taxes that a strong state can impose are put into law (Haque, 2006). Since investments are the building blocks on which an economy is built (Stiglitz Shell, 1967), capital outflows from a particular jurisdiction will have a detrimental effect on the growth of the local economy. In addition, the departing owners of these monies typically have greater business expertise, also causing the flight of valuable human capital.

Another aspect in which a strong state would be an hindrance to economic growth is their response to recessions. Usually, a quick and sustainable recovery is most

desirable so as to maximise the average GDP growth rate. The Great Depression is a good example. In 1929, the Smoot-Hawley Tariff Act was passed soon after the stock market crash on Black Tuesday, leading to a collapse in commodities, grievously affecting the large agricultural industry (Sennholz, 1969). Moreover, there was an increase in federal, state, and local taxes from 16 percent of net private product to 29 percent in the Revenue Act of 1932, which would alone have caused a recession (Rothbard, 1963). There is a view that government intervention would have shortened the crisis. This may have seemed to be true after the institution of the New Deal, when there was a recovery, albeit an extremely weak one; the GDP in 1939 was still 27% below the GDP before Black Tuesday (Johnston, 2020). However, the recovery was unsustainable and most likely ended when the fiscal stimulus was removed. Another view is that the Second World War stimulated an increase in government spending which lifted the US out of the Great Depression. In actuality, Roosevelt had proposed a Second Bill of Rights, which if promulgated, would have advanced a stronger state, as he believed the economic contraction would continue after the war due to massive military spending (Folsom, 2010). However, the economy recovered sustainably due to corporate tax cuts, income tax cuts and the repeal of the excess profits tax in 1945-46 and 1948. The above examples show that poor decisions of a strong state can cause a serious impediment of economic growth, thereby suggesting that it is not a prerequisite.

The intervention and resultant distortion of the free marketplace is also a trait present in strong governments, often through SOEs. Advocates of such market intervention postulate that market control ensures the beneficiaries include stakeholders and not solely shareholders. Unfortunately, a principal-agent problem arises when the ob jective of management, the success of the business, and the government’s wishes, affordability and other reasons, are in conflict. This is inevitable as the desire for profit is in direct opposition to unsustainably low prices. Sánchez notes that: “When an enterprise’s objectives are ambiguous or contradictory, executives and managers tend to lead the company towards their own interests.” (Sánchez, 2016) Proponents of SOEs will state that consumers will benefit from suppressed prices. However, their increased costs from inefficiencies (Greene, 2014), are borne by the taxpayer, meaning there is no net benefit. Furthermore, their dual roles as businesses and state-controlled entities introduce the element of moral hazard, where management expects sustained financial support from the government due to weak fiscal discipline or “soft budget constraints” (Sundram, 2018). Government backing means SOEs can gain market share by taking imprudent risks or through regulatory laxity (which regulators can ignore), putting competitors at a severe disadvantage. Buccola and McCandlish observe: “Managers of the state firm and their supervisors within the civil service form a coherent lobbying group whose interest is to defend the enterprise from competition.” (Buccola McCandlish, 1999) In addition, SOEs take a quasi-monopoly position through limiting consumer choices and suppressing prices through quality reduction, which are often due to wastefulness that arises from the mixed incentives present. Additionally, the bureaucracy and opacity in these entities encourages corruption and embezzlement. Accordingly, an OECD survey found: “fortytwo percent of 347 SOE respondents report that corrupt acts or other irregular practices transpired in their company during the last three years” (OECD, 2018) As discussed previously, such behaviour is detrimental to GDP growth; consequently, the disruption of markets by the government creates an obstruction to development of the economy.

The government’s role in society is

undeniably indispensable as it upholds laws that protect the free market and guarantee the validity of contracts, which are both essential for economic growth by providing stable business conditions. Although one cannot invariably assume that a strong state is always a barrier to GDP growth, proved by the example of Singapore, the intrusive actions characteristic of strong states may incur agency dilemmas and cause the warping of free-markets that impede the development of the economy. Examples of laissez-faire successes such as Hong Kong prove that a strong state is absolutely not a requirement for economic growth.