Monday, May 16, 2011

Why governments are important in a market economy?

Wish I had written this! Dani Rodrik has a superb explanation of the role of governments in the successful functioning of modern markets.

"Modern markets need an infrastructure of transport, logistics, and communication, much of it the result of public investments. They need systems of contract enforcement and property-rights protection. They need regulations to ensure that consumers make informed decisions, externalities are internalized, and market power is not abused. They need central banks and fiscal institutions to avert financial panics and moderate business cycles. They need social protections and safety nets to legitimize distributional outcomes.

Well-functioning markets are always embedded within broader mechanisms of collective governance. That is why the world’s wealthier economies, those with the most productive market systems, also have large public sectors."

Once we recognize this, a few things naturally follow

1. Markets require basic physical infrastructure and rule of law to be effective. Regulation is necessary to correct market failures. In other words, Governments underpin markets.

2. This, as Prof Rodrik writes, also raises the issue of who makes the rules that govern this system and then administer them. Democracy and politics inevitably follow.

3. Development of good quality infrastructure and establishment of effective administrative and governance systems do not come cheap. People need to pay taxes in return for enjoying these services. And given the low tax base, especially in countries like India, those at the top of the income ladder need to pay more.

4. Ironically, and contrary to conventional wisdom, the rich and well-off benefit disproportionately from government and its activities than the poor. They use the physical infrastructure directly and derive much greater benefits from its use than the poor. Similarly, contractual regulations and rule of law undepin much of the transactions made by the rich. In fact, in countries like India, the transactions carried out by the poor are mostly done outside the formal government institutional channels.

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