Is A Strong Central Government Necessary for Economic Growth?

As the U.S. economy fell into the so-called Great Recession, U.S. policy policymakers and many economists argued that a strong central government response was essential to bolster economic growth. We’ve discussed the merits of industrial policy and the stimulus numerous times on this blog, but the idea of adopting a strong national industrial policy remains strong.

A keystone of President Obama’s economic agenda included (and remains) remaking the U.S. automobile industry as well as seeding and nurturing “green” industries. Often, U.S. pundits point to the success of Singapore and increasingly China (see Thomas Friedman’s column here as an example) as cases where strong central government has intelligently led economies to robust economic growth.

I’ve noted before some healthy skepticism is warranted when speculating on China’s economic future, particularly when we see the economic stagnation plaguing the Japanese economy and the misallocations of capital in the Chinese economy.

Another research paper by economists Timothy Kehoe and Kim Ruhl for the National Bureau of Economic Research (Working Paper 16580) sheds additional light on the challenges of taking low-income economies to middle-income status and then to high-income levels by examining the performance of Mexico (in comparison to China). The key, they find, is not necessarily the importance of strong central government, noting

We could also hypothesize that China has been able to grow because it has a strong central government that has been able to overcome some of the problems associated with poorly functioning markets, while Mexico has not been able to do this. This hypothesis is worth exploring, but it is worth pointing out two reasons for doubting it: First, Mexico became a democracy only in the mid-1990s; previously it had a one-party system that was in many ways as strong and centralized as that in China. Furthermore, the Mexican government controlled the banking system from 1982 through 1991, and Bergoeing et al. (2002, 2007) identify the inefficient allocation of credit during this period as a major factor in Mexico’s poor economic performance. Second, Bajona and Chu (2010) argue that until China joined the WTO, the banking system there served mostly to funnel savings into investment in inefficient state-owned enterprises. Allocation of credit by the government seems to have been the major problem in the financial systems in both Mexico and in China, not a remedy for other problems.

The key in Mexico, they find, as well as in China, will be loosening up institutions that foster economic growth, entrepreneurship and private investment. While their conclusions are speculative, they write:

Our theory suggests that the factors that currently impede growth in Mexico, such as inefficient financial institutions, and insufficient rule of law, and rigidities in the labor market, do not yet do so in China because China has not yet reached a sufficient level of economic development. We hypothesize that, as China grows, these factors will become more important and, absent significant reforms, growth in China will slow down sharply, as it has in Mexico.