Thursday, July 27, 2006

Dynamic ambitions

A common criticism of the State of the Nation Address (see previous post) is that there was little detail on how the grand public investment plan was going to be funded. This criticism is ill-founded. It was already a long speech, without all those financing details (which could get bloody).

Furthermore, thinking about financing when formulating a strategy is bad planning. Strategy is all about ambition ("vision" is the MBA-speak these days). While I don't recommend throwing reality entirely out of the window, it's healthy to be optimistic about the possibility of relaxing constraints.

So the first question is: are these projects worthwhile? If the answer is yes, only then does one ask: how am I going to pay for it? Because once you have reasonable expectations of value for money, then you can go and persuade someone to give you the money. In the context of government, that's either borrowing, or exacting tax revenue.

In evaluating a public investment plan, the level of analysis is important. It is easy to get mired in a micro, case-by-case evaluation. It may be that a project in isolation yields smaller benefits than a bunch of projects together making up a coherent development strategy. The reason is that there may be "dynamic externalities"; this is just fancy way of saying that in the long run a critical mass of the right investments could deliver proportionately greater benefits than individual projects.

Rural development is an important example. Perhaps an irrigation project by itself can't hack the required social rate of return (say, 15%). But what if it's part of a grand strategy of agricultural development? Suppose a widespread boost in agricultural incomes dramatically improves human capital formation - which investment did not take place previously because of poverty and various institutional failures. The human capital then becomes the base of a sustained industrialization drive. (If you think I'm dreaming, think "East Asian miracle.")

A similar issue is related to city formation. The interesting thing about a city are the so-called "agglomeration economies" - there must be some value in many producers and consumers all bunched up in a small space. That value seems obvious - proximity makes transactions easier for everyone - but on second thought it's not so obvious: because the "everyone" had to be there in the first place! ( Consider the problem of building a city in the middle of nowhere - there is little value in just one person making the move; some type of coordination is definitely required.) Once the critical mass of producers and consumers are clustered, then dynamic agglomeration economies take over, and we get increasing urbanization (economic growth) over time.

So how do you get that critical mass for a "take-off"? Some private sector developer consortium might do it. So could government. Rather than twiddling thumbs waiting for the market, why not support the ambitious State?

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