Coordination economics, poverty traps, and the market process: a new case for industrial policy?

• Author: Glavan, Bogdan
• Position: Essay

Market failure is the strongest reason for defending an active role for the state in the economy. Among other market-imperfection-based arguments, development economists widely use the theory of coordination failure to define a new case for industrial policy (Matsuyama 1997; Rodrik 1996, 2004, 2007).

The central pillar of the literature on coordination failure is the idea that the economy may fail to achieve coordination among complementary activities. Some investment projects are not undertaken because complementary investments do not exist, and these latter investments do not occur precisely because the former are absent. Coordination failure leads the market to an (equilibrium) outcome inferior to a potential situation in which resources would be optimally allocated and all agents would be better off.

The occurrence of such inefficient equilibria, or poverty traps, is supposed to present an opportunity for a positive state intervention. It is argued that such situations can be overcome only by massive coordinated investments, which are unlikely to be made if poor regions are left on their own. As Stefan Dercon puts it, "A poverty trap is an equilibrium outcome and a situation from which one cannot emerge without outside help, for example, via a positive windfall to this group, such as by redistribution or aid, or via a fundamental change in the functioning of markets" (2003, 5). In short, poverty traps can be removed by a "big push" strategy.

A number of authors have seriously disputed and criticized the merits of government intervention to accelerate economic growth. Authors such as William Easterly (2001, 2005, 2006a, 2006b), Benjamin Powell (2005), and Scott Beaulier and Robert Subrick (2006) have recently questioned the evidence for poverty traps and demonstrated the weaknesses of the case for "big push" industrial policy. However, the rising importance of "coordination-failure" models for the advocacy of industrial policy has received minor attention. In this article, I refute the idea that entrepreneurial coordination problems lead to poverty traps. I also criticize the claim that public intervention improves the coordination of economic agents.

Intellectual Pedigree: Rosenstein-Rodan, Nurkse, and Hirschman

The literature on coordination problems has a long tradition. A pertinent review of this literature appears in Hoff 2000 and in Hoff and Stiglitz 2001. Paul KosensteinRodan argued in his seminal 1943 article "Problems of Industrialization of Eastern and Southeastern Europe" that poor economies cannot grow because of coordination failure among complementary industries. If industrialization were achieved simultaneously in all economic sectors, industries would end up with profit, even though no sector would be profitable if it chose to industrialize alone. As a result, an underdevelopment equilibrium is possible. To solve this problem, a large amount of investment is required--the "big push" policy.

In the 1950s, many economists thought that underdeveloped economies would never turn into rich and prosperous ones if they were left to the impersonal forces of the market. Ragnar Nurkse (1953) argued that underdevelopment persists because of a so-called vicious circle of poverty: on the one hand, the domestic market is thin because of low incomes, and, on the other hand, the supply of goods is scarce because people are too poor to save. Thus, the level of capital accumulation, investment, and productivity is low.

The assumption was that the free market cannot direct capital toward the most socially efficient investment projects. Unlike Nurkse, who favored a uniform industrial policy--the doctrine of "balanced growth," which requires a massive investment program, a "big push"--Albert Hirschman (1958) maintained that developing countries also lack managerial and entrepreneurial capacities. Therefore, the optimal policy should have as a goal an unbalanced development, concentrating investments in those sectors with significant external effects, which can facilitate and promote complementary investments in the rest of the economy.

The disappointing results of state-led industrialization in underdeveloped countries and the collapse of centrally planned economies have convinced most economists to repudiate early development models. However, although it seemed as if "big push" strategies had been definitively expelled from the realm of development economics, they have recently begun to reclaim some economists' attention. "The big push has returned to favor in the development policy-making, after half a century of exile" (Easterly 2005, 3). A good illustration of this change is the United Nations' adoption of the Millenium Development Goals. Claiming that many Third World countries are caught in a poverty trap, proponents of these goals have argued for "a big push of basic investments between now and 2015 in public administration, human capital (nutrition, health, education), and key infrastructure (roads, electricity, ports, water and sanitation, accessible land for affordable housing, environmental management)" (United Nations 2005, 19).

"Big push" policy has returned to development economics because in the past few decades several economists have attempted to refine the case for industrial policy and ground it in more solid theoretical bedrock. Using the rational-expectations hypothesis, several authors have attempted to formalize the coordination-failure argument and to elaborate a multiple-equilibria theory of development. Murphy, Shleifer, and Vishny's (1989) reference work illustrates the resurgence of interest in coordination problems and formalizes some aspects of the Rosenstein-Rodan viewpoint. In addition, other development economists have emphasized a number of situations in which the interdependence of private agents seems to produce coordination failures that prevent economies from achieving a better equilibrium. (1)

Since the publication of the article "Ending Africa's Poverty Trap" (Sachs et al. 2004) and The End of Poverty: Economic Possibilities for Our Times (Sachs 2005), Jeffrey Sachs has quickly become the foremost advocate of "big push" industrial policy. Sachs's influence is phenomenal throughout the world. He is the guru of economic development, the spiritual father of numerous research institutes, initiatives, and projects, and advisor to economic development policymakers in many countries. Economists such as Dani Rodrik (1996, 2004) and Andres Rodriguez-Clare (2005a, 2005b) have used this particular market-failure argument as justification for a "new industrial policy" whose goal is to induce entrepreneurs to invest in the projects with the highest social return.

From Coordination Failure to "Big Push" Policy

According to the coordination-externality argument, the economy works like an ecosystem:

Whereas neoclassical economics emphasizes the forces pulling toward equilibrium--and with similar forces working in all economies, all should be pulled toward the same equilibrium, modern development economics focuses more on evolutionary processes, complex systems, and chance events that may cause systems to diverge. Thus, it tends to be influenced more by biological than physical models.... The economy is like an ecosystem, and Darwin was implicitly recognizing that ecosystems have multiple equilibria. Far more important in determining the evolution of the system than the fundamentals (the weather and geography) are the endogenous variables, the ecological environment. Luck--accidents of history--may play a role in determining that and, thus, in the selection of the equilibrium. (Hoff 2000, 152-53) And further, along the same lines:

In an ecosystem, a key factor determining how any individual will behave is his environment. One of the most important aspects of that environment is the behavior of others. Under some conditions, ecosystems have multiple equilibria, and individuals may fail to "coordinate" on the equilibrium that is preferred by everyone.... The basic mechanics of coordination failure are simple: An individual's behavior--for example, to produce or to prey on the production of others--creates externalities. The externalities affect not only the welfare of others, but also their decisions. The interaction of the slightly distorted behaviors of many different agents may produce very large distortions and can lead to the existence of multiple equilibria, some very good for every member of the economy, and some very undesirable. (Bowles, Durlauf, and Hoff 2006, 6-7, emphasis in original) For Kiminori Matsuyama, this coordination problem--like "the problem of hundreds of people, scattered in a dense, foggy forest, trying to locate one another--is of such fundamental difficulty that no algorithm can solve it. What the economics of coordination tries to show is that even the market mechanism cannot solve the problem" (1997, 134-35).

Rodrik (2004) and Rodriguez-Clare (2005b) provide a good explanation of this market failure. Rodriguez-Clare points out that the success or failure of an action depends on the context in which it is undertaken: "A firm's productivity depends not only on its own efforts and abilities, and on general economic conditions (e.g., the macroeconomic environment and the legal system), but also on the actions of other firms, infrastructure, regulation and other public goods" (3). In such a case, different agents' actions are said to be "complements."

On a more specific note, Rodrik notes:

Many projects require simultaneous, large-scale investments to be made in order to become profitable.... An individual producer contemplating whether to invest in a greenhouse needs to know that there is an electrical grid he can access nearby, irrigation is available, the logistics and transport networks are in place, quarantine and other public health measures have been taken to protect his plants from his neighbors' pests, and his country has been marketed abroad...