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The Efficiency-Equity trade-off

July 24th, 2008 · No Comments

A news snippet on July the 9th tells about a demonstration in booming Peru, where the poor feel left out of the economic growth, wich is enjoying China like rates of 9%. Alan Garcia, once the hero of the left, was called ‘right wing’ and a ‘traitor’. This is a manifestation of a wider issue that is one of the most important in the world.
First, a remark on Alan Garcia, that president under siege. He is now defending free trade, and argues that it will rise incomes. It will, it already has (although the issue here has more to do with whose incomes are actually rising, and who is being left out).

For those sceptical about that message, one should perhaps realize that this is Alan Garcia 2.0, sort off. That means that there was an Alan Garcia 1.0, and he used to be president of Peru in the 1980s, making a complete mess of things with much more left-leaning policies.

Another example would be Hugo Chavez in Venezuela. Or a century of experience in Argentina, once one of the five richest countries of the world.

In a continent in which there is still a considerable political division and left wing ideologies and policies that have gone out of fashion (Europe, Asia) or never got a foothold in the first place (US) are still quite popular.

In part, this has to do with simple anti-Americanism, and we won’t go into that here. But there is another quite legitimate explanation, neo-liberalism works, but not necessarily for everyone.

Chile was a bit of a trendsetter in this respect. In many respects, the country was a brutal experiment, it was exposed to market liberating shock therapy, policies that could only survive because there was a military dictatorship as they certainly did not achieve much (if any) success for quite some time.

However, two stylized facts should be immediately obvious:

  • Chile’s economy is now one the most stable and prosperous in Latin America, and widely considered a success story (althouth this year doesn’t seem quite so good with growth slowing to 3% and inflation almost in double digits)
  • But, once again, not everybody joined the party. It has reduced, but certainly not eradicated poverty.

If people would force us to make a choice between neo-liberalism and the leftwing policies that have been so unsuccessful (mostly) then we would certainly chose neo-liberalism over socialism. However, as the British (left leaning) philosopher John Gray has argued, neo-liberalism is itself a belief not unlike socialism.

It’s central concept is that of the market. But, to use a term Karl Marx himself was rather fond off, it reifies the market. Under the neo-liberal ideology, the market is a mythical, abstract entity that basically involves “the forces of supply and demand”, and “the price mechanism”, these are abstractions.

Like we have argued in other contexts here, as soon as one talks about real-world markets, rather than the textbook abstract markets of which the neo-liberals are so fond off, one realizes that there are many differences in markets, and hence that they often need tailor made institutional environment to function properly. Only then can they work their magic.

Anyone trying to get a taxi in the Dutch city of Amsterdam will testify to that. The Amsterdam taxi market was once a neat little monopoly (with accompanying monopoly profits that popped up in unexpected places, like houses in the red light district). The wave of neo-liberalism even reached the Dutch (fortified) shores (no Hans Brinker to put his finger in a dyke here), so the local authorities liberalized the market.

The effect was complete chaos, and years of taxi wars. After several interventions, the market still hasn’t improved a whole lot. Drivers are often rude, con tourist, refuse to take you for a short trip, and taxi’s are so expensive that we stubbornly refused to make use of them while living there.

We’ll spare you a complete analysis, but take in this simple observation. For there to be a market, there has to be some choice. Now all taxi’s worked with the same meter (although driver’s creativity to work them varied greatly), and you as a customer was forced to take the first one in the queue, no choice, no (outward) price differentials, little to choose, so therefore little disciplinary competitive forces at work (if any).

To any institutional economist this would not have come as a surprise. But the amount of botched liberalization and privatization that has been performed in the name of neo-liberalism is mind boggling.

Now, back to those Peruvian demonstrators. In Latin America, something akin to the Amsterdam taxi market has been taken place, that is, liberalization and privatization have often been botched. The result, inefficient public monopolies became inefficient private monopolies, but apart from being inefficient, they start to increase prices and tariffs, and hence hurt the poor, who feel conned, even if the inefficiencies are reduced.

Or, in the name of neo-liberalism (and not infrequently helped by some foreign institution like the IMF or Worldbank), subsidies on staple foods or fuel are reduced, hitting the poor the hardest. Or job securities are diminished or abolished, or trade is liberalized, flooding the market with (often subsidized) agricultural products from richer countries.

There is no doubt that market forces, when enlisted properly (that is, fine-tuning the institutional environment they require) will invariably raise efficiency and economic growth, and there is also little doubt that free-trade is better than a closed economy (there is overwhelming evidence for that and).

But unleashing market forces unleashes competition, and competition produces losers as well, even if they would only be losers in relative terms as the overall economy will almost certainly benefit.

Competition disciplines and forces companies to become more efficient and more innovative. One of the great dangers (but by no means the only one) of protectionism is that instead of expanding energies towards creating better products and conquering markets, companies expand their energies into improving relationships with state agencies. This is what economist know as ‘rent-seeking behaviour’, as we explained in another article.

How to deal with that fundamental problem between overall increased economic efficiency and growth and the plight of the losers of the competitive process unleashed by freed-up markets?

Economic theory has long argued that as long as the overall economy benefits from liberalizing and opening up, the winners can, in theory, compensate the losers and still be better off.

Neo-liberalism is just not perceived as being in their interests.

We need a “new” neo-liberalism, neo-liberalism 2.0 so to speak. It must have the following broad characteristics:

  • Yes free markets are often bad, but just blind liberalizing and privatizing is often not the smart solution, much more thought should be given to the how, neo-liberals should learn that markets are not the abstract “forces of supply and demand” from textbooks, but real-world institutions
  • Markets create losers. In order to enlist their support, much more creative thought should be given to this, especially in those countries were neo-liberalism has gotten a bad rap.

Success of large swats of Asia demonstrates it’s possible for poor economies without resources to escape the poverty trap. Crucial ingredients:

  • Giving the poor a stake: good education and land reform
  • A public sector with a focus on the long-term national interest.

There are countries that have managed to lift themselves out of poverty by the bootstraps. South Korea was one of the poorest countries in the world in the early 1950s, devastated by a civil war, divided, and having no resources. Look at it now.

We’re not saying they got everything right, but they got things a lot better than most. And most notably, income distribution has actually been reduced during the spectacular growth.

It turns out that the trade-off between efficiency and equity economists are so familiar with needs good politics to be reduced to manageable proportions. It can be done.

Tags: Opinion