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THE ROLE OF THE STATE IN ECONOMIC DEVELOPMENT
Guido Tabellini
‘... a wise and frugal Government which shall restrain men fr om injuring one another, which shall leave them otherwise free to regulate their own pursuits of industry and improvement, and shall not take from the mouth of labor the bread it has earned. This is the sum of good government, and this is necessary to close the circle of our own felicities’ (T. Jefferson, 1st Inaugural, 1801, Memorial Edition; 3:320).

I. INTRODUCTION
This is how Thomas Jefferson viewed the role of government in 1801. Is this minimalist view still relevant today? Or have we become wiser? This paper addresses this question, reviewing the recent literature on economic growth and on the role of the public sector in fostering economic development.
The central conclusion of this recent literature is that Jefferson was largely right. Not because a minimalist government is necessarily better than a big government. But because the key challenge for most developing countries is to create the basic legal and institutional infrastructures that protect property rights, enforce private contracts and allow individuals to freely take advantage of market opportunities. In principle there are many more things that governments could and should do: provide public goods, correct market failures, reduce inequalities in income and opportunities, stabilize excessive economic fluctuations. But these other government activities are not what make the difference between success and failure in economic development. The real difference is made by the basic institutional and legal infrastructures that protect property rights, enforce the rule of law and prevent abuse by governments.
This conclusion raises another, more difficult, question. What can developing countries do to facilitate the emergence of these basic institutional infrastructures and more generally to create appropriate government incentives? The paper concludes with a general discussion of this question, reviewing some recent results on the effects of economic and political liberalizations.
The outline of the paper is as follows. Section II discusses how history and institutions influence the current level of economic development. Section III reviews the recent empirical literature on how public policy affects economic growth. Section IV discusses the effects of economic and political liberalizations on economic performance and policy outcomes. Section V summarizes and concludes.

II. INSTITUTIONS AND ECONOMIC DEVELOPMENT
The idea that institutions protecting property rights are key to economic development is not new. North (1981) has built his analysis of economic history on this premise. More recently, Hall and Jones (1999) have shown the relevance of this idea in explaining contemporary differences in the level of economic development across countries.
Do better institutions and structural policies lead to more productivity, or does economic development lead to better policies and institutions? Hall and Jones (1999) argue that there is enough exogenous variation in structural policies and institutions to identify a causal link from institutional quality to productivity. They show that institutional quality is explained by historical and geographic features of countries (such as distance from the equator and percentage of the population speaking English or another European language).Moreover, these historical and geographic variables are valid instruments for institutional quality, in the sense that they influence economic development exclusively through their impact on institutions.
We return to the question of how to acquire better institutional infrastructures in Section IV. In the next section, we continue our review of the evidence on the role of the public sector in fostering economic development.

III. POLICIES AND GROWTH
The view that the current level of economic development of a country is determined by its institutions is important and plausible. But it has the disturbing implication that economic development is largely a legacy of history. What can governments do to rid themselves of that legacy, besides engaging in deep and difficult institutional reform? What kind of economic policies are more likely to accelerate the process of economic development? Motivated by these questions, a large literature has studied the link between growth (rather than the level of development) and public policy (rather than institutions). This section briefly reviews its main insights.
Now we review the main conclusions of the existing literature on the growth effects of specific government policies.

1. Macroeconomic Policy
A stable macroeconomic environment, with low and predictable inflation, a sustainable budget balance, and a stable and competitive currency, is widely believed to be one of the ingredients of economic success. Policy-induced macroeconomic uncertainty interferes with price signals of relative scarcity inducing misallocation of resources, and might discourage private investments. Moreover, a distorted foreign exchange market in the form of a high black market exchange premium acts as a tax on exporters and induces the expectation of future depreciation, with negative effects on investment and on the allocation of resources.
Several papers have asked whether these priors are indeed consistent with the data. Fischer (1991, 1993), in particular, estimated cross sectional or panel regressions wh ere the dependent variable is either the growth of per capita income, or its components obtained from a growth accounting exercise (capital deepening or total factor productivity); the macroeconomic policy environment is measured by the rate or the variability of inflation, the government budget surplus in percent of GDP, the black market exchange premium. His findings support the priors summarized above: inflation, budget deficits and a distorted exchange rate market all reduce growth; the effects operate through both lower investment and lower total factor productivity growth.
Can we interpret these empirical correlations as causal, and infer that a better and more stable macroeconomic environment would bring about more rapid growth? Unfortunately the answer is no, or at least not in all circumstances.
First, according to Easterly (2003), such empirical results are largely due to extreme observations. Once these extreme observations are removed from the sample, the effect of macroeconomic policies becomes statistically insignificant. This is confirmed by the simple plot of average growth of GDP per capita against the log of average inflation (linf) depicted in Figure below. The extreme observations reflect instances of very bad policies (such as inflation rates or black market premia in excess of 35%, or budget deficits greater than 12%of GDP). Several observations can be classified as extreme in this sense. Thus, Easterly (2003) is not pointing out a statistical fragility. Rather, the interpretation is that very bad macroeconomic policies can be very harmful to growth, but in a more moderate range the effect of the macroeconomic policy environment on growth seems negligible. To put it more bluntly, a very bad and unsustainable macroeconomic environment almost certainly kills growth; but sound macroeconomic policies do not seem to guarantee a satisfactory growth performance.

Second, the instances of very bad macroeconomic policies are not random, but probably reflect deeper failures of the institutional environment. Using the settler’s mortality variable discussed in the previous section, Acemoglu et al. (2003) argue that colonial history is responsible for weak political institutions, and that these in turn induce unstable macroeconomic policies and a low and volatile growth performance. Moreover, once they control for the effects of political institutions, macroeconomic policy appears to have only a negligible impact on the mean and volatility of economic growth. In other words, weak political institutions seem to be the ultimate cause of unstable and disappointing growth, while poor macroeconomic policy is only a symptom. Suppressing the symptom without curing the ultimate cause is unlikely to lead to lasting improvements.

2. Public Goods and Redistribution
Public spending is a crucial policy tool. Governments can use it to overcome market failures and accelerate development. Or they can abuse it and create additional distortions. At an abstract level, we can distinguish between three kinds of public spending: general public goods (spending that benefits all or a large number of citizens); targeted redistribution (spending that benefits a few citizens); rents for politicians (spending that benefits no-one except the politicians or their close friends). Public spending is more likely to be counter-productive as we move from the first to the last category. Useful government spending typically takes the form of public goods that benefit many citizens and that would otherwise be under-provided due to free rider problems or other market failures. Examples are security against external or internal threats, transportation, communication or urban infrastructures, general public services such as education and health, safety nets for the poor or against natural disasters. In principle, targeted redistribution can also remedy market failures. But more often, its true motivation is to provide benefits to powerful groups. Finally, rents for politicians are clearly counterproductive, as they introduce tax distortions at the voters’ expenses.

IV. ECONOMIC AND POLITICAL LIBERALIZATIONS
Trade liberalizations seem to play an important role in accelerating economic development. Perhaps this is the only positive and robust finding discussed in the previous section. But what is the channel through which this happens? Opening up the economy changes both private and government incentives. On the one hand, trade liberalizations remove economic distortions and create new opportunities for the private sector. On the other hand, opening up the economy acts as a discipline device on governments, because it increases the cost of pursuing inefficient policies. Which of these two channels is more important?
Giavazzi and Tabellini (2004) address this question by comparing macroeconomic policies and structural policies before and after episodes of trade liberalizations, also taking into account what happened in countries that did not liberalize. This difference-in-difference estimation reveals that the process of trade liberalization is accompanied by overall macroeconomic improvements (lower inflation and lower budget deficit), while the liberalization itself may also be triggered by a bad or unsustainable macroeconomic situation. Moreover, trade liberalizations are also associated or followed by improvements in structural policies and institutional infrastructures (such as better protection of property rights and lower corruption – the same institutional indicators discussed in Section II). This contributes to explain why trade liberalizations induce better economic performance: on average, a more open economic environment is accompanied by a generalized improvement in economic policies and other institutions.

V. CONCLUDING REMARKS
This paper reviewed a large body of empirical research that asked what kind of economic policies are more conducive to economic growth. In the end, we are left with the conviction that this is not the right question. At a general level, it is quite clear what kind of economic policies are good for growth: a stable macroeconomic environment, generalised access to the world economy, protection of individual property rights, spending in public goods that provide benefits to all. The really crucial question is why don’t governments pursue these sound policies? Lack of knowledge may be part of the answer. Sound economic principles do not translate precisely into unique policy packages, but need to be adapted to the specific economic and social realities, as argued for instance by Rodrik (2003). But lack of incentives is bound to be much more important. This is suggested by the finding in the literature that bad economic policies are generally associated with institutional failures, particularly failure of political institutions.
But what can be done to give the right incentives to the governments of developing countries, short of waiting until they become mature democracies? A practical conclusion of this analysis is that there are beneficial complementarities from political and economic liberalization. Political liberalization facilitates opening up the economy to international competition, probably because democracy increases the political influence of those that are more likely to benefit from international integration. But economic liberalization seems a necessary step towards economic success: without it, new democracies do not prosper.
The detailed interactions and feedbacks between economic and political liberalizations are still not well understood, however. Moreover, while economic liberalizations have been extensively studied, less is known about political liberalizations and episodes of transition towards democracy. Which specific features of democratic institutions are more likely to promote sound economic policies? And how do they interact with local conditions and with specific features of the economic and social environment, such as inequality, media diffusion, and structure of property rights? Making progress in answering these questions is essential, if we want to offer valuable advice to many countries that are not developing.

SUMMARY
This paper discusses the recent literature on the role of the state in economic development. It concludes that government incentives to enact sound policies are key to economic success. It also discusses the evidence on what happens after episodes of economic and political liberalizations, asking whether political liberalizations strengthen government incentives to enact sound economic policies. The answer is mixed. Most episodes of economic liberalizations are indeed preceded by political liberalizations. But the countries that have done better are those that have managed to open up the economy first, and only later have liberalized their political system.