Do’s and don’ts: which economic policies will help and which will harm after-war reconstruction?
Beta

Do’s and don’ts: which economic policies will help and which will harm after-war reconstruction?

Photo: ua.depositphotos.com / mazzzur
19 July 2022
FacebookTwitterTelegram
994

In this article we list popular yet erroneous approaches to economic policies, explain what is wrong with them and elaborate on which policies would really help economic development.

Wrong approach: do what developed countries did 50-100-150 years ago. 

What is wrong with it? Proponents of this idea usually cite professor Erik Reinert who stated that developing countries today should use the same policies which developed countries used when they were less developed. These policies usually include protectionism, restrictions of international trade and state support of certain industries. Other variations of this logic may sound like “do what South Korea (or other Asian Tigers) did in the 1960s (1970s-1980s)”, arguing for formation of large state-supported conglomerates similar to chaebols.

However, this logic is wrong. First, it doesn’t take into account the survival bias, i.e. countries that used the same policies but failed. Second, it focuses only on some policies while failing to take into account the entire picture. Thus, proponents of protectionism usually do not take into account that other countries may retaliate, limiting access to their markets – and making the country that started the ‘trade war’ worse off. Or that while protectionism benefits certain producers, the society as a whole loses.

Furthermore, proponents of this approach fail to recognize that some 100 years ago in the majority of European countries people worked long hours for very little money (mainly in low productivity agriculture) and usually had no pensions or other social protection. The same is true for South Korea in the 1960s or China in the 1970s. It is unlikely that Ukrainians today would agree to this.

The world has changed and policies should be adjusted to the time and specifics of a country and the context in which it lives. Moreover, they should be forward-looking. 

Wrong approach: our country is unique and thus experience of other countries is not relevant

What is wrong with it? This argument is often used by governments of developing countries in response to the advice of the IMF or other international organizations. While this is true that each country has some unique features, economic laws work in every country. And when it comes to a small open economy such as Ukraine, economic science has a lot to say. For example, printing money always results in inflation – independently how this printed money is used (unfortunately, too often Ukrainians experienced that in their own pockets). Monopoly results in higher prices and/or lower quality of goods or services (at the same time protection of competition and regulation of natural monopolies is quite sophisticated). Failure to protect property rights results in higher interest rates and lower investment as investors price in the country risk or consider lower-risk countries. Fixed exchange rate in the absence of capital controls results in higher volatility of inflation and exacerbates the impact of external economic shocks (also proven by Ukrainian experience). 

And while taking into account the current context is important, one should also learn from mistakes – preferably from mistakes of other countries (although Ukraine has a rich collection of its own).

Wrong approach: looking for “growth points”/ supporting infant industries 

What is wrong with it? At first sight, the idea is simple and attractive – find one industry (or a few of them), e.g. automobile production, support this industry (provide subsidies, protect from imports), and it will spur development of both upstream and downstream industries, such as production of materials, spare parts or advertisement. However, as one digs deeper, a host of hard questions sprout. Who will select those industries? Which criteria will those people or agencies use? How will they know which industry will be profitable in 10-15 years? Why would we prefer automobile production to production of ships, for example? We can also remember that Ukraine spent huge sums to support and protect its automobile industry – with no tangible effect. 

Yet, we are still looking for a panacea that would cure the economy, failing to admit that there is no “magic pill”, only a healthy lifestyle that can gradually but certainly solve many problems.

Wrong approach: free (special) economic zones or technoparks; tax privileges

What is wrong with it? This is a variation of the “growth points” policy described above. Thus, if private capital is reluctant to enter some territories, we can offer favourable conditions in these territories (e.g. lower taxes). Or, alternatively, if private investors are reluctant to enter a country, we can create some oases in this country where, for example, British law rather than national law, is applied and bureaucracy is minimized (the Chinese model). 

In both cases, the ‘big question’ is – why is private capital unwilling to enter a certain territory or country? The reasons can be multiple – low demand, poor quality or insufficient labour force, lack of the rule of law etc. Without addressing these questions, creation of free economic zones or technoparks, the main advantage of which is tax privileges, will be just a waste of public money. And if bureaucracy deters investors, the logical question is – why do we reduce bureaucracy only in some territories and not in the entire country? Probably because rent-seeking bureaucrats want to preserve their rents? Moreover, the creation of ‘special territories’ or granting tax privileges will discourage investors who entered a country earlier or placed their facilities in some other region and thus did not have a chance to benefit from these privileges. 

There are only two cases when technoparks may be considered a reasonable solution. First – when they are organized by local governments who in this way compete with each other for the attraction of businesses. However we must remember that if there are two or more territories with a special status, the competition for investors between them often will result in undercollection of taxes by both the country and local communities compared to the “equal rules” situation. Second – when they are organized around a university and certain venture financing is provided to develop ideas produced in the labs of that university (these must be grants rather than tax privileges). 

In all other cases tax exemptions provided to certain industries, territories, goods or firms simply distort markets, lower government revenues and discourage other businesses that are not eligible for them.

Wrong approach: aiming at “higher in the supply chain” production

What is wrong with it? Those who argue that Ukraine should be producing “finished goods” rather than raw materials usually get the concept of value added wrong (to put it simply, value added is the price of the output minus the price of inputs). In fact, producing apples or honey can create more value added than assembling smartphones. In a similar fashion, high export tariffs on sunflower seeds distributed profits from farmers to sunflower oil producers rather than increased value added inside the country. This does not mean that Ukraine should concentrate solely on raw materials. However, we must understand that “being higher in the production chain” does not equal “producing high value added product”. 

If Ukrainian producers can offer a final product that is valued by the market – wonderful, but there is nothing wrong with exporting commodities or entering global value chains – as long as such decisions of entrepreneurs are not distorted by government policies.

Wrong approach: aiming at a small share of GDP redistributed by the state (so-called “small state”)

What is wrong with it? State budget must balance multiple conflicting interests. Understandably, taxpayers want to pay less. But at the same time they want public services such as healthcare, education or infrastructure. Besides, Ukraine has a rather developed safety net and a large share of elderly population which will increase in the upcoming decades. In 2021 Ukraine spent about 10% of GDP on pensions, 5.8% of GDP on education, 3.8% on healthcare (consolidated budget). General government expenditures amounted to over 40% of GDP in 2021. Since then, Ukraine’s military expenditures have grown and are likely to remain high for some time. Thus, Ukraine cannot copy those developing countries that have a young population, very lean social security system and no aggressive neighbours.  

In Ukraine, a “small state” should be understood as little administrative barriers to business activity and efficient provision of public services. This requires a lot of work on designing new processes for public policy development and interventions. This may not be cheap but an initial investment into proper “technologies” of public service provision will pay off in the future.

One more dimension of a “small state” is privatization. In recent years, Ukraine has made significant progress in terms of “small privatization”, however, large privatization remains stuck. Clearly, right after the war privatization will not bring a lot of money. Thus, the political leadership and the society should accept small privatization proceeds in exchange for more efficient SOE management. 

It is also an illusion that one can replace the government with some form of algorithm or deux ex machina. Some processes can be automated, and many of them can and should be streamlined. However, development of public policies is a highly qualified job which requires not only knowledge of economics, specific policy areas and analytical skills but also strategic thinking – an ability to identify and balance multiple interests to achieve an outcome that would be best for the society.

By now a reader perhaps has a question – what do we recommend? The simple answer is – “healthy lifestyle”. There is no shortcut to economic prosperity. But there are some necessary steps that must be implemented – and the sooner we start, the better. These are:

  • judicial reform to ensure enforcement of laws and protection of property rights 
  • reform of tax administration
  • development of the capacity of antitrust authority
  • reform of the public service aimed at much higher involvement of stakeholders into policy development
  • establishment and enforcement of clear rules for markets that today are either monopolized or overly regulated or generally in the shadow (such as energy or real estate)

Perhaps the most crucial for the future growth is the quality of human capital. Ukraine now has a unique opportunity to educate many of its young citizens abroad. But it should also provide a better education inside the country – using the increased interest of foreign educational institutions towards Ukraine. These institutions or individual academics may be willing to provide access to their online courses, libraries, deliver lectures etc. The government and Ukrainian universities should explore these opportunities.

The war has put on hold many activities and requires much more government intervention than usual. However, the war is also an opportunity to design the new rules and “reload” the social contract. This opportunity must not be wasted.

Authors

Attention

The authors do not work for, consult to, own shares in or receive funding from any company or organization that would benefit from this article, and have no relevant affiliations