State & local economic development policy a zero-sum game ... or worse?

Arthur J. Rolnick | Senior Vice President and Director of Research, 1985-2010

Published January 1, 1993  | January 1993 issue

"If you read the Constitution, it specifies that there shall be no tariffs or restrictions or hindrances to trade among the states. Just as we speak of non-tariff restrictions on international trade, I regard [state and local economic development policies] as non-tariff restrictions on internal trade. I'm not a lawyer, but I would like to believe that a strict interpretation of the Constitution would render such actions by individual states illegal."

— Milton Friedman
The Region, June 1992

Recently, Arthur J. Rolnick, the Minneapolis Fed's director of research, participated in a forum on state and local economic development, sponsored by the Hubert H. Humphrey Institute of Public Affairs at the University of Minnesota, Minneapolis. Rolnick debated Timothy Bartik, senior economist at the Upjohn Institute, Kalamazoo, Mich., on the question: Is state and local economic development policy a zero-sum game? Bartik is the author of the book, Who Benefits From State and Local Economic Development Policies?

The following column is based on Rolnick's comments.

Before addressing the question, "Is state and local economic development policy a zero-sum game?" let's define our terms. By state and local economic development policy, I mean direct assistance from government to business, which often takes the shape of low-interest government loans. A zero-sum game is a game in which one player's gain is exactly another's loss.

Timothy Bartik answers the above question no, state and local economic development policy advances economic growth and does not just shift resources around. My answer is also no, but I contend that these policies are counterproductive and that they actually result in a net loss to the economy.

This doesn't mean that there is never a case for government involvement in a market economy. All economies need laws to help define and enforce private contracts, and it is generally agreed that governments should assist the indigent and the unemployed. In addition, governments can enhance the performance of an economy if market failures exist. Briefly, there are generally three instances when markets tend to fail: in providing goods that others can't be excluded from consuming (public goods, like national defense); in providing goods that result in side effects, both negative and positive (like when the production of goods results in pollution, and when education results in a better citizenry); and in providing goods that can be produced more cheaply in large quantities (utilities like water, electricity or gas).

The problem with many advocates of economic development policies is that they don't clearly identify the failure of the market and the justification for direct assistance from government to private business. Bartik is one of the few proponents of these policies who attempts to identify some market failures. Bartik advocates the following:

  • Some economic development policies can be productivity-enhancing.
  • Other economic development programs can produce net national benefits if concentrated in distressed areas.

Bartik rationalizes his "productivity-enhancing" programs—such as training, research, and aid in preparing business plans—because imperfect information may keep businesses from pursuing them in the private sector. That is, he says the market will fail to produce enough of these programs.

But there are many institutions already providing information to businesses; how do we know that they are producing less than the economically optimal amount of information and research? Even if Bartik is correct, how will government know what information and what productivity research to finance? Governments are political entities that are much more likely to allocate funds based on political considerations rather than on economic principles. Instead of targeting specific types of business research, the government should support our educational system. Supporting our nation's schools and universities is the best way to promote basic research in all fields, including business.

Bartik also says that financial markets may fail to provide adequate financing to businesses in distressed areas, but who better to determine whether financing is adequate than the markets? If it is difficult to get financing in a distressed area, does that mean that the markets have failed? More likely, it means that there is more risk than the markets are willing to bear. Prices will eventually adjust so that people in these areas will either leave or rebuild. The government should provide a financial safety net to aid individuals affected by the inevitable churning of a market economy. But it is not the job of government to resist that churning, to try to revitalize entire industries or regions against the better judgment of the markets. Moreover, it is not clear that the government can even perform such a task without diverting a large amount of resources from more productive enterprises.

Another rationale Bartik gives for state and local economic development policies is that the social benefits of creating a job in distressed areas may be greater than those gained by creating a job in more prosperous areas. But is the pain of unemployment greater for someone on Minnesota's Iron Range than for someone in Minneapolis' western suburbs? That is not so clear. Put in the hands of government, such decision-making smacks of political favoritism, and at the very least would mean an inefficient allocation of limited economic resources. Again, it is better to provide a financial safety net so people have the wherewithal to decide how best to improve their situation, for example, by moving to an area where economic conditions are better.

More generally, why should we believe that government agencies can do a better job of investing funds in business than the private sector? How do we know that businesses which were induced to relocate by government policy, may not eventually suffer significant costs associated with that move? Or, how do we know that businesses which used government loans to expand would not have expanded anyway? And how do we know that a state which uses tax dollars to fund private businesses would not have been better off if those tax dollars had been used to fund education or infrastructure (such as roads, bridges and sewer systems), or if those funds had been left in the pockets of consumers to spend or save as they desired?

Until proponents of state and local economic development policies can answer these questions, we should be suspect of such policies. Experience suggests that state and local economic development policies are counterproductive; while a few people benefit, society as a whole loses. The lesson here is that the market is the best arbiter of the use of scarce economic resources.

In the opening quote, Milton Friedman says that state and local economic development policies may be unconstitutional because they interfere in interstate commerce. By offering subsidies to businesses, states are, in effect, enacting a negative tariff against another state. On economic as well as legal grounds, such tariffs should be discouraged. Just as the federal government prohibits states from placing quotas and tariffs on interstate commerce, Congress should enact legislation prohibiting states from offering direct assistance to private firms to entice them to relocate or expand in their state.