Shifting role of the state
What the government needs to do depends on the stage of development. Depending on the development stage the government can play three roles to varying degrees.
One is to lead - to lead because there are market failures - the market is not actually working.
The second if the market is working and the people have the basic ingredients then your job is to enable, to enable a partnership to unleash the potential of our people, and
then there is a third role in a more mature market you may want to play the role of safeguarding. Safeguarding the opportunities for the next generation to unleash their potential.
These three are not either or, at any stage of development every government will have to do all these three in varying proportions. Arguably in a less developed economy it may need to do more of leading. In a more mature economy you may need to do less leading and more enabling. Chan Chun Sing, Minister for Singapore Ministry of Trade and Industry - 13 May 2016 St Gallen Symposium
In this section
Igniting vs sustaining growth
A quick scan of national metrics from the World Bank or the Legatum Institute reports presents a compelling picture that advanced economies have a number of attractive advantages compared to the developing ones. Examples include lower infant mortality, more widespread access to water, electricity and internet and higher reported life satisfaction (Legatum Institute, 2020 ; Miller, 2020). The Economic Freedom report presents a number of examples using statistical charts of the Economic Freedom Index and other performance areas such as innovation, health and education (Miller ,2020). People in economically free societies live longer, have better health, are able to be better stewards of the environment, and push forward the frontiers of human achievement in science and technology through greater innovation. - Miller, 2020 Economic Freedom Index report
The World Bank Economists emphasized that “growth strategies must be informed by the critical distinction between igniting and sustaining growth” (Birdsall, 2020). They draw a contrast between two phases of institutional development - first an “igniting” phase - experimental phase situated to the local conditions with delicate institutions in their infancy followed by a “sustaining” phase of cumulative strengthening of these institutions to “endow the economy with resilience to shocks over the long term” (Birdsall, 2020). Singapore Minister of Ministry of Trade and Industry Chan Chun Sing described the three roles of government - leader, enabler and safeguard. His assessment was that at any point in development the government fulfils each of these roles simultaneously in respect to the market, but in different proportions. He contrasted the demands for leadership in early development with the demand for safeguarding against the mature market in the advanced phases (Chan Chun Sing, 2016).
A nonlinear relationship
Based on some general statistical trends there is an apparent correspondence of general social improvements of advanced economies compared to developing ones with the comparative maturity of institutions of capitalism - property rights, credit markets. However this correspondence alone is not sufficient evidence to claim that a universal set of policies favoring these institutions will continue to produce the same results. While both the Legatum Prosperity Index reports and the Economic Freedom Index reports present a number of relationships using linearized indexes, a number of these relationships are nonlinear. A nonlinear relationship could indicate that instead of one continuous relationship, there are multiple relationship regimes and transitions that connect these regimes. An illustrative example of nonlinear dynamics is from the field of biochemistry for enzyme kinetics known as Michaelis-Menten. In enzyme kinetics, the reaction occurs only once the substrate and the enzymes are joined. A consequence is that there are two regions in the chart - one region that is substrate-limited, and the other region of substrate saturation that is enzyme-limited (Lehninger 2005). The practical implications is that in a substrate-saturated regime, further addition of substrate does not improve the reaction rate as another factor - the concentration of enzyme, is more limiting.
A way to test for such a relationship is to check for linearity on a Linweaver-Burk plot (1/x vs 1/y) (Lehninger 2005). Figure 5.3 illustrates an example of such a test between energy (kg of oil eq) per capita and Human Development Index (HDI).
In this case energy inputs could be considered equivalent to the substrate and HDI as the reaction rate. Beyond approximately 2,000 kg of oil eq per capita, energy consumption may saturate, and is no longer a limiting factor for further HDI improvement. Saturation can also be considered a diminishing return to scale relationship. Another relevant consideration that could explain the nonlinearity is that HDI is a normalized index with maximum value of 1.0.
The prevalence of nonlinear relationships of diminishing returns to scale over a wide range of development scales are not unique to energy-HDI. As illustrated in Figure 5.4, the relationship between GDP-HDI and GDP-well-being also show diminishing returns to scale. Other nonlinear relationships have the opposite - increasing returns to scale - such as energy-GDP and a number of relationships related to urbanization.
Three transitions are presented here in Figure 5.8 as a possible explanation for an evolving role of the state with the market - the relative abundance of different forms of capital, growth of externalities costs and postmaterialism values shift. Analysis in the Appendix B of the Legatum Prosperity metrics looks for evidence of these transitions by breaking up the statistical analysis into different development stages and testing for stability of the relationships to institutional factors of the market and the state across different stages.
Transitions between developing and advanced economies
Shifting roles of different forms of capital
As a country develops different forms of capital - physical, human and intellectual can shift in their relative contribution to growth. Economist Robert Barro explored the potential for shifting forms of capital in the diminished rate of economic growth to physical capital and declining population growth with increasing income (Barro, 1991). He found evidence of the convergence hypothesis which states that developing countries initially experience a fast rate of growth, but then converge on the rate of growth of the advanced economies (Barro, 1991). His analysis highlighted the importance of human capital formation in that growth to explain why some lower income countries grew at slower rates than the theory predicted (Barro, 1991). He linked the higher cost and returns from human capital formation to a declining fertility rate (Barro, 1991).
Becker, Murphy, and Tamura [I990] assume that the rate of return on human capital increases over some range, an effect that could arise because of the spillover benefits from human capital that Lucas [1988] stresses. The return to some kinds of ability, such as talent in communications, is higher if other people are also more able. In this setting, increases in the quantity of human capital per person tend to lead to higher rates of investment in human and physical capital, and hence, to higher per capita growth. A supporting force is that more human capital per person reduces fertility rates, because human capital is more productive in producing goods and additional human capital rather than more children. - Barro, 1991 Economic growth in a cross-section of countries
The structural shifts in the economy from industrial to services and the nature of human capital have implications for costs and upper limits for productivity growth. The relationship of quality and human contact duration in essential service sectors such as healthcare and education resist productivity growth (Nordhaus, 2006). Over time due to this resistance to productivity growth the costs of these services and their relative share of employment tend to increase over time, shifting the structure of the workforce (Nordhaus, 2006). This dynamic is known as Baumol’s cost disease (Nordhaus, 2006). Just as physical capital can experience diminishing returns, so human capital has finite limits. There are only so many waking hours in a day and ultimately an upper bound on lifetime learning potential.
The other form of capital which potentially can continue beyond the bounds of human capital is intellectual capital. Economist Paul Romer extended the basic endogenous growth model to include an explicit representation of an R&D function. In doing so the three basic forms of capital - physical, human and intellectual could be studied in a formal analytical framework (Nobel, 2018). Unlike physical capital which is comparatively more conducive to enclosure and appropriation, human capital has spillover benefits for everyone in society so that it is not completely a private good but also has features of a public good. If the leakage benefits of human capital can spillover to the rest of society then the potential for intellectual capital as a public good could be even greater. The internet enables scalable spread of intellectual capital at near zero marginal costs and practical challenges for enclosure and appropriation. It is an open question whether the historical applications of the institutions of capitalism that associate with the accumulation of physical forms of capital which are conducive to enclosure would be appropriate for these new forms of capital.
Rising costs of externalities
The evidence presented in Weakness #1 is that the externalities costs which are neglected by the market build-up with increasing urbanization and GDP levels. For example in a study of the US from 1900-1998 over long time scales total energy consumption including the energy component of imports was reported to scale approximately linearly with GDP, meaning that for an x % increase in GDP there is an expected x % gain in energy consumption (Ayres 2003). A similar analysis specific to cities found a sublinear scaling with an exponent ~ 0.85 of energy consumption to urban population (West, 2017). For most countries the reduction in environmental cost per unit of energy reduces at a slower pace than the rate of energy consumption so that overall there is a net gain in environmental costs from higher energy consumption (Kubiszewski, 2013). When the social and environmental costs are added up together and subtracted from GDP as the GPI accounting does, the plot of GDP vs GPI is either a diminishing marginal return or a Kuznets inverted U (Kubiszewski, 2013 ; Delang, 2016). Thus, at some critical threshold the build-up of environmental and social costs of the externalities breaks-even with the market benefits.
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