Home-grown solutions for our economic woes

We can increase our potential output only by developing tailor-made solutions to our problems and implementing them

It seems illogical to expect that one can import policy prescriptions from abroad and expect them to work locally. However, this has been the history of economic policy in this country. There are two broad ways of economic thinking and our policymakers have aligned themselves repeatedly to one or the other. What we need to realise is that neither is a good description of our local reality, and what we really need are home-grown solutions. The two broad ways of thinking about economic issues in developed countries can be classified as the neo-liberal approach and the Keynesian approach and neither is a good description of challenges that a developing country like Pakistan faces.

To see why this is so, one needs to understand the concept of ‘potential output’, which refers to what a country can produce if it employs all its resources efficiently. The neo-liberal approach argues that competitive markets that are largely free of government interference bring about the efficient use of resources when there is free international trade and macroeconomic stability. So, the role of government is to ensure that there is free international trade, macroeconomic stability and free competition, and markets will take care of the rest. Not only will resources be employed efficiently, technological improvements will also be unleashed, pushing the limits of potential output. So, in this view, relatively free international trade, macroeconomic stability and free competition guarantee that the economy is producing all it can.

In contrast, the Keynesian approach states that economic activity can temporarily fall below its potential even if we have all of that. The argument is that one person’s spending is another person’s income, so if people curtail spending across the board due to an economy-wide shock, then incomes fall which is another way of saying that the output that is achieved is below potential. It is argued that if that happens, then the government should step in and spend money to increase output.

It is easy to see that the whole argument turns on whether an economy is at its potential output or below it. Neo-liberal adherents in the developed world could endlessly argue that economies are always at their potential, whereas Keynesians could argue that economies often fall below potential till the cows come home. However, this debate is largely irrelevant for us.

Our potential output is so low that it does not matter whether we are at or below it. What we need to do is find ways to aggressively expand it. Free international trade, macroeconomic stability and competition are all good things; however, they are not sufficient for an aggressive expansion in potential output. So, the neo-liberal economic policies coming from the IMF will not do the job for us. And, with such a low potential output, aggressive government spending that does not directly increase potential output will only create inflation, pushing more people into poverty. So, the Keynesian approach is not the answer either. The policy prescriptions in both approaches are responses to the needs of a developed country with high potential output, and say little about the challenges that we face in a low-income economy.

How can we increase our potential output? By developing tailor-made solutions to our problems and implementing those solutions. To take just one example, our small-scale manufacturing sector suffers from lack of skilled labour. Small businesses cannot afford to pay for necessary labour training, so we are stuck in a low-production equilibrium. The government can step in here and shoulder some of the training costs. Trained labour is an asset that clearly expands the potential output in small-scale manufacturing. Such targeted training programmes may lead to a rapid expansion in the small-scale manufacturing sector, and is an example of government spending aimed at improving the potential output.

Another example is from the financial sector. Majority of the financing takes place through the banking sector, and because of the nature of the debt contract, such funding is largely for the operational needs of large businesses. There are people who have the required skills and motivation to start a successful small business. However, traditional banks would never lend to them as they cannot provide collateral. And micro-financing is just too small for their needs. That is, there is a ‘missing middle’. The government may step in here, perhaps with profit-sharing contracts, which can make money available to the ‘missing middle’ in a sustainable way.

Of course, free trade, macroeconomic stability and competitive markets are worthy goals, however, it is important to realise that no matter how much we achieve along the three dimensions, the problems of lack of skilled labour and lack of financing for entrepreneurship will not go away on their own. Lack of skilled labour and financing for entrepreneurship are just two examples. Good policymakers should be able to add to this list easily. We need targeted government spending to solve problems like these. That way, we can achieve the aggressive expansion in potential output that we so desperately need and desire.

Published in The Express Tribune, March  25^th,  2015.

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