The Political Economy of Special Economic Zones

Concentrating Economic Development

Lotta Moberg

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781315298931
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

Special Economic Zones (SEZs) have become a popular development policy throughout the world over the last half a century. These zones form designated areas where governments offer businesses lower taxes, tariffs, and often lighter regulations. Generally, SEZs aim to attract investments and raise a country's export and employment rates, but although success stories are often cited, there are numerous failed projects that have instead become burdens for their host countries.

This book examines SEZs from a political economy perspective, both to dissect the incentives of governments, zone developers, and exporters, and to uncover both the hidden costs and untapped potential of zone policies. Costs include misallocated resources, the encouragement of rent-seeking, and distraction of policy-makers from more effective reforms. However, the zones also have several unappreciated benefits. They can change the politics of a country, by generating a transition from a system of rent-seeking to one of liberalized open markets. In revealing the hidden promise of SEZs, this book shows how the SEZ model of development can succeed in the future.

Applying frameworks from various schools of political economy, this volume places SEZs in the context of their mixed past and promising future. It is essential reading for anyone with an interest in international economics, development economics, and political economy, including practitioners and consultants of SEZ policies.

PART I

The theory of zone politics

1 The political economy context

To see why SEZs succeed or fail, we need to understand the capabilities and goals of the people who govern them. Mainstream economic analyses generally assume a government introduces SEZs to maximize the welfare of the people it represents. The government is also often presumed to have sufficient information and capacity to do so. A political economy approach, by contrast, does not assume such perfections. Instead, it incorporates the imperfect knowledge and self-interested motives of policy makers in the economic analysis.

The following three chapters will explore the three main questions about SEZs.

When will SEZs be better than the status quo? This question can be divided in two parts. First, when are people in government able to introduce beneficial SEZs? And second, when do they want to do so? The government’s ability and incentive to introduce wealth-enhancing policies are the two pillars of the robust political economy framework, which is introduced in this chapter. I will assume that the government cares about the people’s welfare when discussing whether it is actually able to promote it. Conversely, I will assume that the government is capable of promoting welfare when analyzing whether policy makers have the incentive to do so.

A comparison between a country’s SEZ regime and the status quo implicitly assumes that, in the SEZs’ absence, the country would pursue all its other current policies, so that the only difference is the SEZ regime. This is in a way the crudest form of assessing the effects of SEZs. Nevertheless, it is not a simple task, and therefore requires some theoretical deliberation, which is the focus of the next chapter. Chapter 2 then applies this framework to SEZs.

What kind of political economy environment allows SEZs to be at their best? This is the focus of Chapter 3. In the best-case scenario, SEZs generate significantly beneficial countrywide economic reforms. The analysis in this chapter will not assume people in government have any intention to promote welfare for its own sake. They are purely self-interested. Nevertheless, they may promote wealth-enhancing reforms if the right incentives are in place. These incentives depend on the payoffs policy makers enjoy from the different economic systems they can promote.

To analyze this dynamic, it is necessary to recognize that the government is not a monolithic unit with a coherent goal but a network of individuals who face different incentives. Therefore, the policies that ultimately emerge from the government depend on the dynamics among different people who can influence the government and who have different wills and tools at hand to push for particular policies. SEZs can then be a potent tool for those opting for economic reforms.

How can a government use SEZs to avoid broader reforms in its attempt to optimize its rents? This is the focus of Chapter 4, where the government is treated as an organization that tries to maximize its rents. To examine the government’s incentive structure more closely, I simplify reality by treating the government as one coherent organization, rather than as comprising people with different preferences. While this may seem an unrealistic simplification, it is acceptable considering the government’s ability to act as a coherent organization if most influential policy makers agree on their main goals. In this case, they want to pursue higher rents and are ready to impose uncompetitive policies to achieve that.

The government is thus modeled somewhat differently throughout this book depending on the question in focus. The most accurate depiction of the government is that of a complex network of individuals who are also influenced by outside forces and advocates. Emerging from their interactions are policies that, to some extent, reflect their relative bargaining positions, power, and advocacy tools. From the outside, the government may look like a unified organization, but that is only a result of one political faction having won the political battle and thus having the privilege to set the agenda.

Therefore, I refer to the government as the individuals constituting it whenever feasible, while simplifying the picture by treating the government as a unified organization when necessary. This simplification is needed in Chapter 4, which discusses how the government may use SEZs to optimize its rents.

A crucial theme throughout this book is that a government is ultimately comprised of self-interested individuals. It can therefore not be assumed to be a benevolent organization. Policies are endogenous in that they emerge out of political discussions, negotiations, and battles. These interactions among officials result from their personal considerations, which in turn depend on a system’s institutional and policy environment.

Robust political economy

The two political economy aspects, what governments want and what they can do, have been combined in a framework labeled “robust political economy.” This framework is a way to separate and analyze the two core components of the political economy approach – the capability of policy makers to pursue beneficial policies and their incentives to do so.

A robust political economy analysis treats people in government as both imperfect in their knowledge and self-interested. While economic models usually treat ordinary market actors this way, they generally assume policy makers to have perfect knowledge and benevolent intentions.

The ignorance and self-interest of policy makers cause two different categories of problems. The first category of problems pertains to the difficulty of improving on markets through government interventions. Policy makers have a “knowledge problem” in that the knowledge needed to rearrange economic activity in a more efficient way than that obtained through a market process is so immense and complex that they cannot possibly amass it. Their best chance in improving outcomes through intervention is therefore to make some wild guesses, which inevitably risks imposing higher costs on the economy than the benefits it yields. The general lesson from the knowledge problem is that policy makers should be cautious about trying to fine-tune the industrial composition of their economy or in other ways steer development in any particular direction.

A second category of problem results from public officials’ incentive to serve their self-interest rather than the welfare of the people. These “incentive problems” come about as policy makers and bureaucrats do not benefit from increasing social welfare. The remedy to this problem is institutions that can align officials’ self-interest with promoting socially beneficial policies. Absent such institutions, officials should at least be scrutinized in their work and perhaps be deprived of some of their power.

A robust political economy analysis helps identify these problems, detect the environments in which they tend to occur, and identify possible institutional solutions. A robust system contains institutions and policies that solve both the knowledge problem and the incentive problem. The knowledge problem can be solved by delegating decision-making to those with the most knowledge, and the incentive problem by providing the right incentives to policy makers and bureaucrats to introduce and execute beneficial policies.

The next sections take a closer look at the logic behind the knowledge problem and the incentive problem. They rely on fundamental political economy assumptions and extend common notions about people’s imperfections to government officials. An important point is that these human weaknesses have more severe consequences when residing with people in the public sphere than with market actors. Readers familiar with political economy and its scholarship may want to skim or skip the rest of this chapter and jump to the next, which applies the robust political economy framework to SEZs.

A government with imperfect information

A political economy analysis extends assumptions about ordinary people’s ignorance to people in government. While economists often model market actors as having complete information, many models do include components of uncertainty or imperfect information. To increase their knowledge, economic agents need to search for information or act on the basis of probabilities. A person looking for a job, for instance, does not know which job application will lead to a position. The job seeker can only assess the optimal search time, which depends on factors such as the probability of finding a job and the salaries on offer for different jobs.

When assumptions of ignorance are applied to government officials, they can no longer be seen as capable of stepping in and improving matters whenever ignorant ordinary people make mistakes. Because officials are just as likely to misjudge any situation, they may end up doing as much harm as good when trying to intervene.

The case for market interventions is often made by referring to market failures. Take, for example, a polluting industry. It will pollute more than is socially optimal when the costs to the people living nearby are not taken into account. An all-knowing government could then step in and force a reduction in the pollution. The problem is that the government does not know the optimal level of pollution for the area, and therefore risks aiming at an inefficient pollution target. It cannot weigh the benefits of production against the discomfort of the people, let alone the unknown heightened risk they face of lung diseases and cancer.

In essence, these kinds of market failures come about due to a lack of institutions that allow for trading of rights. If the industry could compensate the residents for polluting, they would essentially be buying their emission rights from them.¹ Still, the only recognized “solution” is generally for the government to limit the pollution through regulation.

Other situations of lack of trade are rarely identified as market failures but cause similar inefficiencies. People often lack the mechanism to transfer wealth that would make an exchange worthwhile. Peter may be willing to do the dishes one night for Paul, who is willing to part with 20 bucks to get the job done. Or he may want to sell his old candleholder for five dollars to Paul, who would love such a bargain. Instead, Peter throws his old stuff away and Paul does his own dishes, simply because it would be too costly and take too much time for Peter and Paul to find each other.

In situations like these, improvements are theoretically possible if people could abolish the transaction costs and perform the trade. In theory, the government could perform this task if it knew the optimal allocation of resources. Due to the knowledge problem, however, it does not know where the opportunities for improvements are or how a given situation should be altered. It cannot know who wants to sell old junk and who wants to buy it. The government also cannot know what institution could generate more efficient allocations. It may introduce an old-candleholders exchange, but the benefit of such an operation would not warrant the costs. The government is therefore not in a position to resolve the situation.

The knowledge problem implies that the government should be careful about intervening, even when a possible market failure is detected. One reason for this is that new policies can have negative unintended consequences that may overshadow the benefits. There might be some scope for policy makers to act by trial and error, just as a person looking for a job goes to several interviews that lead nowhere. In the context of policy making, though, the costs of failed attempts are unknown and millions of people may suffer if they go wrong. Policy makers cannot calculate these risks, even with policies that have been previously implemented. As Robert Lucas argued, governments cannot predict the effects of policies based on historical evidence of their effects. People will never react exactly the same way to a policy the second time it is executed. Their plans change from one period to another, and they also learn to expect the effects of various policies.²

Ludwig von Mises was similarly skeptical of the benefits of interventionism. Even though policy makers intervene with the best of intentions, he explained, they tend to do more harm than good. Not only do they often fail to solve the problem, but one intervention begets new problems, with more interventions being called for as a result.³ For instance, in the case of pollution, the government may force the polluting factory to shut down, forcing people to drive far away to buy goods from another factory, with even higher emissions as a result. This, in turn, calls for higher taxes on gasoline, and so on.

If a market can be created economically when one is missing, non-government actors tend to figure this out. Previously unfulfilled exchanges come about thanks to innovations such as TaskRabbit, a marketplace where Peter can announce his willingness to do some extra dishes, and eBay or Craigslist, where he can sell his candleholders. Besides avoiding harmful actions, another reason for the government to refrain from solving market failures is therefore to leave the field open for market participants to find efficient solutions.

If regular people and companies can find the solution, why cannot people in government do so, given that they are made of the same stuff? Friedrich A. Hayek explained this best. Nobody in isolation can figure out solutions to problems like these because each person has limited knowledge. Knowledge is dispersed among millions of market participants, each holding only a tiny fraction of the total knowledge of society. Amassing all that knowledge is a tremendous task that is likely impossible for any organization. And even if somebody could amass all current information in a giant computer, the information pool would constantly need to change along with economic development. A government cannot possibly make all the trade-offs among different forms of production, technologies, and the like. Even if it could list all prevailing prices of inputs and goods in the economy, it would still not be able to keep up with the multiple price adjustments that constantly take place in the market.⁴

Competition in the mar...