CHAPTER 6

Policy Framework: State and Market

The focus of this chapter is to analyze the role of government in regulating the various sectors of the economy and its response to market failures. Institutions as central to the economy as government, business, and law have been reformed from generation to generation, and an awareness of past changes in these institutions is needed to appreciate the significance of present day events.

Whatever one may think of a market-driven economy, no one would want a completely market-driven society; hence, the universal agreement on the need for laws, rules, and institutions to govern the functioning of markets and of individual and corporate behavior. What these look like is, of course, the very stuff of politics, as well as of moral philosophy. According to Nobel Laureate W Arthur Lewis (1955)

No country has made economic progress without positive stimulus from intelligent government. On the other hand, there are so many examples of the mischief done to economic life by governments that it is easy to fill one’s pages with warnings against government participation in economic life.

Sensible people do not get involved in arguments about whether economic progress is due to government activity or to individual initiative; they know that it is due to both, and they concern themselves only with asking what is the proper contribution of each. (Hudson 2015)

Governments may fail because they either do too little or do too much. Cairncross (1966) has observed that

government intervention has developed piecemeal, each measure being adopted on its merits and only rarely in order to give effect to some theory of economic organization. No one can claim to have foreseen, much less planned, the present blend of private enterprise and public control, although a mixed economy of some sort has long been recognized as desirable and indeed inevitable. A theory of controls is correspondingly difficult to construct except as a critique of the controls that are in being at some point in time.

Even in capitalist countries there are certain aspects where government intervention is required for better performance of the economy. A certain consensus seems to be emerging these days on the role the government is supposed to play on the economic front.

Market failure: Even though markets may be the best way of organizing production and distributing goods and services, there are important instances when they fail to produce efficient outcomes. This is because market forces (Asher 1994)

1. I.do not bring in competition in its fullest sense;
2. II.often lead to the creation of monopolies and oligopolies;
3. III.divert investment to those directions in which profits are high, neglecting low-profit but high-utility socially necessary production;
4. IV.lead to increasing disparities in income and wealth;
5. V.do not ensure that prosperity at the top will trickle down to the bottom;
6. VI.fail in macroeconomic coordination;
7. VII.fail to control monopoly power;
8. VIII.problem of public goods and externalities; and
9. IX.existence of asymmetric information.

Besides the aforementioned types of market failure, reservations about the efficiency of capital and insurance markets, and concern for values other than efficiency, such as equity; including income; consumption; distribution; freedom; and human dignity; provide the analytical rationale for the role of government in a modern economy. There is no market force model that can show in a valid manner that it can make the poorest groups attain within a reasonable period an acceptable standard of life.

The debate on the respective roles of state and market continues unabated. The two extreme poles of views are the advocacy on the one hand of state minimalism and on the other of pervasive government intervention to foster rapid economic development.

The disputes relate mostly to the objectives and modalities of governmental interventions in these processes. In the 1960s, the transaction cost approach of Coase (1960) argued in favor of a superior authority that is essential for fair play in the market. The case for effective state intervention can also be found in the social choice theories of Sen (2008) and others like Arrow (1951). The effectiveness of the state or the market in economic intervention cannot be argued in a vacuum. Much depends on the nature of the state and the structure of markets.

It has also been argued that government intervention becomes more relevant in the provision of public goods that are nonrival and nonexcludable. Market failure can be corrected in a number of ways. In situations where markets do not perform their functions properly, the first task of the government must be to make the market work efficiently by appropriate institutional and legal changes. The 1950s were probably the heydays of government intervention. The interventionist state in many countries resulted in economic losses not only due to misallocation of resources arising from faulty investment decisions but also due to diversion of resources to rent-seeking activities because of the very regulations themselves. Analysts began to describe the situation as one of “government failure.”

Government failure: While the state took a lead in initiating the process of development, the adverse consequences of the process were many. The government machinery and bureaucratic apparatus went on expanding. The state stretched its arms even to areas where it was not necessary. The state took too much upon itself in the name of development. In the course of time, people came to depend upon the state for everything and lost their initiative. A top–down approach, insensitivity to differentiated needs at the local level, inefficient implementation, wastage and leakage in developmental spending are all very familiar consequences. The expansion in economic activities led, in due course, to intensive examination of the concept of government failure. Asher (1994) has provided the following reasons for such failures:

1. I.The consequences of many government actions are extremely complicated and difficult to foresee.
2. II.Government may promulgate policy measures, but it has only a limited control over relevant variables.
3. III.There is a gap between legislation and intention, and between those who set a broad policy framework on the one hand and those who frame detailed rules and procedures and who actually implement them on a day to day basis on the other.
4. IV.Different interest groups may vie with each other in a society, and this may complicate the task of defining what is overall public interest.
5. V.Due to regulatory capture, regulation may be serving the interest of the regulated; no incentive towards efficiency.
6. VI.The Dagli Committee on controls and subsidies (May 1979) pointed out several instances where controls had lost rationale or were working unsatisfactorily.

Emerging consensus on the changed role of government: A certain consensus seems to have emerged on the role the government is supposed to play on the economic front. As regards the modus operandi of government intervention, the tendency is to adopt measures operating through the market mechanism in preference to command and control measures. The issue today is no longer “rivalry” between the state and the market but how to achieve “synergy.” The assumption that the state has no role in economic activity and markets do not fail has proved to be incorrect. Several public sector enterprises (PSEs) continue to run efficiently in India. Both PSEs and private enterprises could achieve “efficiency” and “welfare” (United Nations 2008).

“In order to attack “market failures” public enterprises must avoid “government failures” as well as consequent “managerial failure” in their operation. Managerial failure invariably follows from the inability of governments to adopt sound policies on investment, prices, and financing as well as on new projects and several other areas affecting the management of PSEs. Inability of governments to build managerial cadres for PSEs and provide the managerial cadres with necessary autonomy to run PSEs with efficiency and welfare can also result in managerial failures” (Basu 2005). There is need for laying down clear guidelines on selective privatization as well as for institutionalizing the “partnership” between the government and PSEs without diluting the government’s accountability.

Rangarajan (2000) has rightly observed that

the decreasing role of the State as a producer of goods and services and the increasing role of the market in such areas simultaneously enhance the role of the State as a ‘regulator’. Tony Blair and Gerhard Schroder summed up the position by remarking, ‘The State should not row but steer’. The regulatory role of the Government in the financial and other sectors has assumed added importance in the context of the East Asian and other crises. The regulatory role also comes into play in order to maintain competitive conditions in the market. The ‘facilitator’ role relates to the provision of public goods. However, even here there is a changing perception. It is no longer necessary for the state to participate directly in the investment in physical infrastructure. Private investment under a suitable regulatory and tariff authority may yet fill the need, even though the role of direct investment by the State in the emerging economies in these areas will be dominant for quite some time. But in the area of social infrastructure such as health and education, the direct participatory role of the State is clearly seen. That is why the paradoxical statement ‘More market does not mean less government but different government’.

Given the respective roles of state and market in the economy, it goes without saying that in areas where direct state intervention is necessary, it is important to ensure that the state functions efficiently and fulfills the stated objectives.

According to Rangarajan (2000)

the major question of determining how much of state intervention still remains. One test for determining the respective roles of state and market is the application of the principle of comparative advantage. Given a particular objective, it may be possible to examine the comparative advantage of State intervention versus market intervention in achieving the objective. Within State intervention, it may be necessary to examine whether ownership by government or regulation is the most effective method for achieving the desired objective. In some activities, separating funding from providing the service can be attempted and the advantage of combining government and market in different proportions can be explored.

“One must make the point that the market and state intervention must go together in the interests of development with equity. There is neither magic in the marketplace nor divinity in the invisible hand of the market. Instead of jumping to oversimplified conclusions, it is essential to recognize that markets can only service those who are part of the market system. In rural India, about 300 million people who take out a bare subsistence, or live in absolute poverty, are not even remotely integrated with markets. For an economy at India’s levels of income and development, there is a vital role for the government, although there is a clear need for change in the nature of the intervention. The market is a good servant but a bad master. One would do well to remember the wisdom, lest there be confusion between means and ends” (Singh 1999).

Changing role of government in India: India has a mixed economy that is increasingly accepting the fact that government has to play an important role in the economy. The government has invariably felt at varying degree of intensity the need for a public policy that could direct, promote or control, or regulate business activities in accordance with the goals and objectives of the economy. Thus, public sector and private sector do exist with varying degrees of importance in the economy.

Planned approach meant that the State should take initiative in creating facilities and institutions that contribute to development. Necessary resources have to be obtained through taxation, through borrowing and, if necessary, through printing money for financing the development. Mixed Economy was acceptable to many but unidirectional in role of state approach was not. The approach to efficiency was to nationalize, expand public enterprise and centralize, and no attention was paid to outcome. From 1978 onwards, balance shifted somewhat in favor of private sector. It was good to be a planner, but some doubted (Reddy 2017b). World was changing, but India did not change much in terms of policies. There was some rethinking, however, about the controls. A number of reports by government committees were submitted to rebalancing the role of the state and the government and the private sector. In such a framework, goods in which the “price mechanism” is effective (“low public good characteristics”) need not be paid for by the government; however, the approach toward them would need to be calibrated depending on the levels of “market failure.” Where market failures abound, the government will need to take a more active approach in directing the provision of the goods with, where necessary, even using taxation-like tools to compel “poorly behaved” consumes to pay for the service. Where market failures are not very glaring in that case emphasis should be on mild regulation and ensuring competitive markets would be all that is necessary to produce welfare maximization. In the areas where the price mechanism is ineffective and measurability is low, as in the case of primary education, the government would need to both pay and provide, taking great care to address the challenges associated with provision by the public sector. Only when the need arises, however, would the public sector slowly expand into other areas.

Curative health care, despite being a “private good,” suffers from very high levels of market failure, and the government must intervene aggressively to direct the evolution of the health system. “Repealing obsolete laws is both obvious and relatively easy, and will free up some state capacity. The government has taken small steps in this direction. But the bigger gains will come from structural reform to streamline the regulatory process. Labor regulation is a particularly messy and entangled regulatory system. There is an opportunity to reduce the burden on the state by streamlining the current labor law system. Service law and tax codes are also obvious areas for reform. A rupee saved is a rupee earned, and state capacity freed is state capacity built” (Rajagopalan 2017). A classic example of overregulation was the license raj in India. In the 1980s, India began to reform its economy, adopting more probusiness policies.

In the Indian context, “market will not succeed unless they are supported by adequate governance institutions. Dixit (2004) has very succinctly analyzed the issue of state and market. He has observed that “most economic activities and interactions share several properties that together create the demand for an institutional infrastructure of governance. Conventional economic theory recognizes the importance of law for governance, but it takes the existence of a well-functioning law and legal system for granted. It assumes that the state has a monopoly over the use of coercion. It also assumes that the state designs and enforces laws with the objective of maximizing social welfare.” The usual implicit assumption is that the law operates in a costless manner. About 40 years ago, economists realized that these assumptions are not valid since there are transactions costs, information asymmetries, principal–agent problems, and incentives.

“In the economist’s ideal picture, the government supplies legal institutions that are guided solely by concern for social welfare, and such institutions operate at low cost, in the sense, they are too small to matter. In reality, the apparatus of law could be costly, slow, weak, and even biased. What happens if transaction costs are high and the legal system too slow or weak? Economic activity does not grind to a halt because the government cannot or does not provide an adequate underpinning of law” (Dixit 2004). “For many people, too much potential value would go unrealized. Individuals, groups, and societies, therefore, create alternative institutions, instruments, and practices to provide the necessary economic governance. For instance, it is widely recognized that it is difficult to have smooth business transactions without recourse to use of black money either directly or indirectly (say through input suppliers or liaison officers). It is easier to grow from a low level of income per head to a middle level than it is to remain a middle-income country and reach a high level. In the first phase of the growth or transition, economic activity is on a small scale, trade is localized, and economic transactions involve a relatively small group of people” (Reddy 2017b).

“In such a setting, networks of information flows, norms of behavior, and sanctions for deviants may already be present from the social environment, or can develop quickly as people interact economically among themselves. Self-enforcing governance is, therefore, feasible” (Dixit 2004). But for sustained growth, rule-based governance must prevail over relation-based ones. Relation-based and rule-based systems are conceptually pure categories that mix in different ways in practice. In some situations, the diminishing returns of a relation-based system can be countered without going to a fully centralized rule-based alternative. The processes of creating the institutions and the apparatus of state law, and of improving them to the point where rule-based governance dominates and functions well, can be slow and costly. The fixed costs of rule-based governance are a public investment; therefore, society must solve a collective action problem to put such a system in place (Dixit 2004).

“This is not automatic; there are the usual problems of free riding, underestimation of the benefits to future generations in today’s political process, and the veto power held by those who stand to lose from the change” (Dixit 2004). Even when the public investment for a rule-based system has been made, people used to the relation-based system who want to switch must make some private investments to learn the rules and their operation. Their benefit from the switch will depend on how many others make the switch. This positive feedback externality can lead to too few switchers, or even a lock-in that keeps the old system in use. In turn, the expectation of this can reduce the social benefits of the changeover, and therefore, delay or deter the initial public investment. The benefits of the new system may be unequally distributed, and some participants may even lose. The system of rules and their enforcement itself must at first establish a reputation for integrity and efficacy. This takes a long time and strict supervision even given much goodwill (Dixit 2004). There are inherent challenges in moving from relation-based systems to rule-based systems. In dealing with this issue, one cannot take a simplistic view of a benevolent state versus a malevolent market participant. It is interesting that people urge severe actions by government where government is reputed to be weak in governance systems. Reddy (2017b) has raised a very relevant question: If corruption is a consequence of weak governance, how could empowering precisely the same governance systems solve the problem on a firm footing?

Rebalancing the role of the State: Given the change in the state of the Indian economy, there is a need to rebalance the respective roles of the state and the market on the following lines (Reddy 2017b):

1. I.Reinterpretation of what constitutes public goods
2. II.Using of private sector for providing public goods through competitive mechanisms, but funding by government
3. III.Merit goods can have a combination of funding and provision by public and private sector
4. IV.Technology makes it difficult to get a “fix” on the product, its use, and so on; hence, “control”
5. VWhat constitutes a monopoly has been redefined, unbundling all natural monopolies
6. VI.Assessing relative efficiency of regulated private monopoly and state-owned monopoly
7. VII.With regard to externalities, whether externalities have been overstated, whether they can be measured, and if they cannot be measured, how can bureaucrats administer externalities

Two Is—Ideology and Investments—were driving the relative roles of state and market in the 1950s and 1960s, but the scenario is different now. The two Is will be replaced by the five Is (Reddy 2017b):

1. I.Interests
2. II.Incentives
3. III.Information
4. IV.Innovations
5. V.Institutions

The debate over state versus market has resurfaced and is being discussed vigorously in the context of the economic reforms being implemented in India. All governments have an urge to control, an urge to regulate, an urge to become overbearing. That is inconsistent with the post-reforms mind-set where governments had to become facilitators. The government’s urge to control has to be restrained.1 The idea that the state or the government can make up for failure of the market is not entirely correct. The state also has failures. So, it is necessary to weigh the strengths and weaknesses of state and market, and then define the boundaries of the state on that basis (Reddy 2017b).

Endnote

1. 1.The Statesman. July 24, 2016. “Govt Must Resist Urge to Control Everything, Says Arun Jaitley.” https://www.thestatesman.com/india/govt-must-resist-urge-to-control-everything-says-arun-jaitley-156059.html