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Free Private Cities: Economic Growth and Prosperity?

by | Apr 21, 2022 | Academic Article

Free Private Cities: An Innovative and Logical Advancement of Special Economic Zones in Terms of Economic Growth and Prosperity

Foreword

The motivation for this article was my general enthusiasm for the Austrian School of Economics and the concept of individual freedom, which, unfortunately, is overshadowed by the current Zeitgeist. 

Free Private Cities (FPC) is an attractive concept for those people and investors already interested in freedom. However, I wanted to show how much more it can be. So I strongly emphasize that an FPC can also be a valuable political measure from the perspective of development economics for the countries concerned. Therefore, it is essential to convince the rulers and decision-makers of the respective nations of the advantages of an FPC. Fortunately, this persuasion work can draw on quite a successful and long-tested history of Special Economic Zones (SEZ). Thus, this paper aims to build on this long-standing experience and show why FPCs are a logical extension of these zones in terms of development economics. To this end, we’ll discuss how FPCs can further strengthen the existing advantages of SEZs while reducing their disadvantages.

Furthermore, this article strongly refers to the Austrian School of Economics (ASE) theoretical framework. It aims to clarify in more detail which preconditions are indispensable for long-term economic growth and material prosperity. In the center of this theoretical basis stands the scientific method of the ASE called “Praxeology.” With this logical-deductive method, complex economic relationships can be explained causally. Furthermore, I intend to demonstrate that praxeology cannot just be used to analyze human action abstractly. Instead, it is also possible to offer and justify practical solutions to complex problems in the real world with this method. Thus, praxeology provides an attractive alternative approach to the largely empirical-based studies of SEZs and their effects on society.

 

1. Introduction And Problem Definition

For several decades, foreign aid has been used as a means of fighting poverty worldwide and promoting economic growth in structurally weak countries. This mostly involves financial aid paid bilaterally or multilaterally to developing and newly industrializing countries. The economic track record of such foreign aid is often the subject of controversial debate in economic discourse. One criticism is that such aid payments only alleviate symptoms. This is attributed to the fact that many affected countries have a low degree of economic freedom and can only rely on weak institutions (König, 2015, p.22). Therefore, those aid payments seem not be able to sustainably consolidate growth potential.

A frequently discussed alternative approach to overcome this problem is the establishment of SEZ. These constructs are not intended to alleviate symptoms, but instead serve to address the root causes of economic failure. Particularly in the last decades, a real boom of such zones has been observed. According to current estimates, there are already more than 5,000 of such zones, spread over approximately 150 different countries and ranging from developing to emerging to industrialized countries (UNCTAD, 2019, p.129). Furthermore, there is also a clear empirical trend that such zones cover more and more comprehensive areas of society and tend to be organized more and more often on a partly private level (Hachmeier & Mösle, 2019, p.21-24). FPC can thus be understood as a logical conclusion of this empirical privatization and urbanization trend.

The following considerations are intended to shed light on the conditions necessary for a country to generate long-term economic growth and prosperity. Based on a theoretical framework of indispensable growth factors, the concept of SEZ in form of FPC will be taken up as a possible measure.

2. Special Economic Zones in General

Before outlining the theory of economic growth from the perspective of the ASE, let us first briefly refer to SEZ in general regarding their definition, intent, scope, and empirical track record. 

In principle, there is no generally applicable definition of SEZ. Accordingly, a definitional classification of FPC turns out to be somewhat fuzzy as well. The term “SEZ” can be used as a collective term. This includes a wide variety of zone types. Even though the individual zones can differ greatly in terms of design, scope, and objectives, they all have the following common features:

    • A physically delineated area within a country with its own administration…
    • …and an institutional framework that differs from the rest of the country.

The goals of such zones are usually congruent in their basic intent. However, different sub-goals can have different degrees of focus. The main objectives to be achieved by SEZ can be summarized as follows (Hachmeier & Mösle, 2019, p. 25-27):

    • Offer advantageous, regulatory, or bureaucratically efficient incentives for investors and companies to attract foreign direct investment (FDI)
    • Increase exports and export diversification
    • Increase employment or improve working conditions
    • Improvement of the state budget
    • Technological and institutional knowledge transfer and spillover effects in form of innovations
    • In total, the achievement of a higher level of industrialization and development of the own country

From this list of sub-goals, the article will focus on the following goals:

    • Attraction of FDI through an improved institutional framework
    • Technological and institutional knowledge transfers and spillover effects to improve the country’s own institutions and market conditions.

2.1. Empirical Track Record of SEZ and Methodological Difficulties

Due to the definitional ambiguities and the large number of different types of zones, a general track record of SEZ is extremely difficult to grasp. The empirical literature contains numerous case studies in which SEZ have had an extremely positive impact on the development potential of the countries concerned. At the same time, there are also many counterexamples in which the use of SEZ had hardly any statistically significant, only temporarily positive, or directly negative effects (Aggarwal, 2019, p. 35-43).

In principle, there are several difficulties in empirically evaluating SEZ and their effects. On the one hand, the respective countries often pursue different sub-goals that are to be achieved with SEZ. Accordingly, studies of such zones usually focus only on very specific, quantifiable measurement criteria, provided that the necessary data material is available (on an adequate scale). At the same time, these goals, and their chances of success as well as their dynamic development are dependent on the initial economic situation of the respective country. Investigations therefore usually take place in a specific country at a specific time. Similar types of SEZ in different countries or at different times can therefore only be compared to a limited extent. Furthermore, these comparisons are always of a counterfactual nature. This is because a direct/simultaneous comparison with the development situation of the same country at the same time without an SEZ is prevented by the establishment of an SEZ (Hachmeier & Mösle, 2019, p. 25-26; 28). Thus, it is not possible to causally explain economic relationships by evaluating empirically observable data points. This is because humans are undeniably able to learn and thus with every human action, the observable data points are changed in such a way that the observations themselves are always subject to new conditions and never remain constant in nature (Mises, 1998, p. 55-56); (Hoppe, 1983, p. 45-46). Consequently, a generalizing assessment of SEZ that can be derived from empirical findings is unsuitable to causally explain their effects.

Therefore, in the following sections, a firm theoretical framework from the perspective of the ASE will be presented to identify the four necessary preconditions for long-term economic growth and development potential. These four conditions are: 

    • Division of labor
    • Capital accumulation
    • Economic calculation
    • Institutions

These fundamental conditions will be used to examine how SEZ in general and specifically FPC as an innovative version can serve as means to improve the economic situation and long-term growth potential of a country. 

3. What Is Economic Growth And How Is It Generated?

3.1. Excursus: Praxeology in a Nutshell

The basis for any economic growth is human action. More precisely, the fact that with every action man always tries to replace his present state (before the action) with a preferred state in the future (after the action). Every action thus represents for the time being a final and subjective value judgment. This value judgment concerns both the end associated with that action and the means necessary to achieve it. Therefore, in each action, an end is aimed at from a set of alternative ends and, for this purpose, certain, scares means are selected from a set of alternative means that are considered suitable to achieve that end.

If the achievement of the selected end by the selected means was evaluated ex-post as satisfactory, a subjective, non-measurable and therefore “psychic” profit has been created. If the end was missed from the perspective of the acting person, a corresponding loss has arisen (Rothbard, 2009, p. 20).

The axiom “Man acts” is thus at the center of any investigation that seeks to causally fathom economic relationships. Like the axiom itself, its logical derivations cannot be negated without contradiction. A negation of the axiom would lead to an end- and future-oriented action, which would have been preferred from possible alternatives. In doing so, the unsatisfactory present state before negation would want to be overcome by a preferred future state after negation. By doing so the acting individual must always use certain scarce means, such as time and one’s own body. The axiom and its derivations are thus a priori true (provided that no logical errors have arisen in the process of derivation) and need not or cannot be empirically tested. The extent to which the action axiom can be used to determine the necessary conditions for long-term economic growth will be shown below:

3.2. Division of Labor

The occurrence and benefits of division of labor can be explained directly from the action axiom. The concept of division of labor (specialization) means nothing else than that people have different ends and preferences and seek to achieve these ends by different means. However, the benefits of division of labor can only be fully realized if it is followed by interpersonal exchange (barter). This exchange generates several effects, some of which directly and some of which indirectly make economic growth possible in the first place. On the one hand, interpersonal exchange, by definition, represents (ex-ante) an increase in utility. This is because the two parties to the exchange must necessarily value the other person’s good more highly than their own. Otherwise, the exchange would not have taken place (Rothbard, 2009, p. 85).

An indirect, but for the later analysis central effect, connected with such voluntary exchange, are the resulting market prices. The objectively visible market price resulting from such an exchange reflects the underlying, subjective value judgments or utility preference for the exchanged goods or services from the point of view of the parties involved in the exchange. This market price thus represents important information, e.g., about resource scarcities and associated preferences, which would not have been made objectively visible without the exchange. These market prices can then be used as a far-reaching knowledge base and information signal for further exchange relationships, which are constantly readjusted by the subjective evaluation of various exchange parties (ibid., 2009, p. 103 & 143).

Besides the creation of market prices as an objective means to evaluate products and services, specialization and exchange can also simultaneously increase the total productivity of the parties involved in the exchange. The reason for this is that, as seen from the action axiom, time is always scarce. The time spent on the production of a particular good or service is therefore not available to the same extent as for the production of other goods and services. Therefore, every action automatically causes opportunity costs, i.e., the utility forgone from certain unrealized goals and possibilities of action. Specialization in the production of these goods and services, which – relatively speaking – are associated with lower opportunity costs, and the subsequent exchange of these goods, thus generate ceteris paribus overall lower opportunity costs (ibid. p. 96-97). The economy has grown in this sense, as more or improved goods are available to achieve certain ends, compared to a situation where division of labor has not taken place (Mises, 1981, p. 299).

Specialization also results in learning effects within an area of specialization. This possible learning effect manifests itself in the fact that for a certain output quantity, the average costs, such as the working time or the error rate, decrease over time. This in turn leads to further productivity gains as learning effects can result in increasingly efficient processes and technological innovations (Block et al, 2007, p. 462). This knowledge can then influence other areas of specialization through the exchange mechanism in form of knowledge transfers. As a result of this process and ever-expanding markets, as it is happening for example through globalization, the network of division of labor is continuously refined. Thus, the reduction of opportunity costs overall and the informational accuracy of market prices regarding preferences of the market participants can be continuously intensified with every exchange.

Furthermore, Ludwig von Mises (one of the most important representatives of the ASE) especially stressed that division of labor creates the breeding ground for a peaceful and interdependent coexistence in the first place. This is because specialization and voluntary exchange ensure that individuals are increasingly dependent on each other. Therefore, the evolutionary process of division of labor and the general realization that this process is advantageous for the participants (Rothbard 2009, p.100) is the prerequisite for the emergence of a civilized society (Mises, 1998, p. 266).

3.3. Capital Accumulation

Besides the interpersonal exchange, there is another type of exchange that represents a cornerstone of long-term economic growth. We are talking about an intertemporal exchange between the present and the future. Since time is an integral part of every human action, the acting person must always subjectively evaluate how far his desired end in the future should be from the present. In economics, this evaluation is generally referred to as time preference. 

The higher the time preference, the higher the preference for reaching the end in the present. Vice versa, the satisfaction of an end can be shifted further into the future. How high or low a person’s time preference is can differ from person to person as well as per person from time to time. How scarce or valuable time is perceived can therefore depend on both internal and external factors such as culture and general living conditions (Hoppe, 2001, p. 2-4).

The extent of consumer goods production and its utilization is directly related to people’s time preference. This is because the production of consumer goods is part of a complex, time-intensive production structure. This structure is characterized by two basic types of goods. Higher order goods and lower order goods. Under this classification, consumer goods are referred to as first-order or lowest-order goods. These are created from higher order goods, which are used to produce these consumer goods (Menger, 1871, p. 7-9). Thus, the further a good is in time from the immediate satisfaction of consumption, the higher its order. It follows that the value subjectively attributed to higher-order goods arises from the subjective valuation of the lower-order- and ultimately lowest-order (consumption) goods that can be produced from them (ibid., p. 12-13).

In order to generate economic growth and make human labor physically more productive in the long run, entering production detours represents an absolute necessity. These detours are characterized by the fact that the targeted consumption good is not produced immediately. Thus, depending on the level of individual time preference, the end of consumption satisfaction is postponed further into the future. In the meantime, i.e., between the present and the postponed satisfaction of this end, labor power (and time) must be expended to produce the goods of higher order or capital goods (Hoppe, 2001, p. 2-4; Rothbard, 2009, p. 48). These production detours are tied to certain necessary preconditions. Before the detour can be tackled, the individual must have saved certain means. These means (e.g., consumer goods) must have been created by previously refraining from consumption by the acting person himself or, based on division of labor, by the saving of other individuals. These saved means then serve to satisfy the immediate needs within the time span of the capital accumulation. The size of the saved means depends on the length of the production detour. The length of this detour depends in turn on the expected benefit and the underlying time preference (ibid., p. 49). Again, if the benefit from the consumer goods that can be produced in the future via previously buildup production goods is ultimately valued higher than the benefit from the current consumer goods opportunities, a “psychic” gain and, vice versa, a corresponding loss has occurred.

How likely the success of an investment is can therefore not be answered ex-ante. Hence, both ex-ante and during the detour, the agent is always exposed to the risk that the subjective benefit ex-post will be lower than previously anticipated. If the agent is aware of this risk component, this factor and its probability are also subjectively evaluated. This evaluation then flows into the investment project in addition to the time/benefit evaluation. Therefore, the further away the satisfaction of an end is from the present, the greater the present consumption sacrifice and uncertainty about the achievement of the end. The price which reflects the intertemporal exchange therefore depends on both the individual’s time preference and uncertainty preference. Thus, in deciding in the present how much to save and consequently which investment project to undertake, individuals discount the expected utility in the future to its utility in the present on the basis of this price. In economics, this price for intertemporal exchange is generally known as interest. The activity of evaluating and anticipating is called entrepreneurship within the ASE (ibid., p. 60, 64 & 352-53).

If the creation of a capital good has been judged ex post as successful by the “entrepreneur”, three options for action are available. (1) The created capital good can be used to produce additional or technologically improved capital goods through further production detours (investments). (2) The capital good can be maintained/repaired to prevent wear and tear and thus loss of value. (3) The capital good is consumed or worn out. Option (1) and (2) require renewed savings and aim to maintain the economic growth gained or to increase it further (ibid., p. 55-56).

Technological progress alone is therefore not the direct driver of economic development. Rather, it is the combination of division of labor and capital accumulation that makes technological progress possible in the first place. This is because possible innovations can only manifest and technological knowledge can only be used or acquired if consumption is temporarily renounced, savings are built up and investment flows into the production of capital goods / technological advancements (ibid., 2009, p.542).  Underdeveloped countries therefore do not lack technological knowledge per se. Instead, they lack the ability or mechanism to build up appropriate capital goods through consumption foregone and to rationally integrate these capital goods into the existing production structure to transform or expand their economy. (Mises, 1998, p. 493). Capital accumulation is therefore not to be considered as a highly aggregated, homogeneous capital stock, which can be generally quantified or optimized as a monetary value. Rather, the wide-ranging heterogeneity of very specific capital goods is relevant. Because of their qualitatively different properties and possible uses as well as their intertemporal component, the entrepreneur must assess their use in detail arithmetically by using market prices.

3.4. Economic Calculation

If division of labor and capital accumulation are combined, their effects on potential economic growth are multiplied. At this point, at the latest, the question arises how supply and demand, i.e., the different ends and means of the individuals, can be coordinated interpersonally and intertemporally in an efficient manner. The short answer is money. This is because the use of this indirect medium of exchange leads to a reduction in the search costs for an exchange relationship in which there must be a double coincidence of needs. It follows that with money there are fewer transactions (and thus lower transaction costs) than would have been the case without money (Rothbard, 2009, p. 188).

If a generally accepted medium of exchange exists, all acts of exchange, whether interpersonal or intertemporal, can be expressed in monetary units. Without this “common denominator,” in a society based on the division of labor, the value ratio or market price of goods could only express itself in other, most different, material goods (Mises, 1990, p.15). The circumstance of a monetary market price system thus allows the possibility of uniformly representing the individual valuations of the most diverse exchange relations. From an intertemporal point of view, the use of money also makes it possible that savings no longer have to be carried out in specific types of goods. Thus, by allowing savings to be made in monetary units, money can also be explained by the sub-function of value storage.

Economic calculation then makes it possible that, within an interpersonal and intertemporal exchange economy, scarce resources can flow in a coordinated manner to the most urgent needs. This calculation function can thus be used to compare monetary input prices with the corresponding output prices. If the input prices used (costs) exceed the output prices (revenue) resulting from their use, a monetarily measurable, i.e., objectively visible loss and vice versa a profit has occurred. Since we know that market prices reflect then subjective value judgments of the market participants, the market prices provide the entrepreneur with the insight whether the means he used (inputs) were valued higher or lower on the market than the products he produced (outputs). If the outputs are valued higher overall, the means used have been used to create value. Vice versa, value has been destroyed in this process, since these resources could have been used at the same time in another, value-creating way. This objective comparison thus enables the entrepreneur to learn ex-post whether resources were wasted or used in a value-adding way in the enterprise he anticipated ex-ante. Without this possibility of comparison, no economically rational decision on the use of resources would be possible. The entrepreneur would be disoriented in his production decision and misallocations could only be avoided by chance (Mises, 1990, p.10 &14).

Therefore, in a world without market prices, no economic calculation in the true sense could arise. Ludwig von Mises sees the prerequisite for the creation of market prices in the fact that the available means of production (one’s own labor and resources) are privately owned and exchanged voluntarily. In a world where private property rights to the means of production do not exist but are owned by the community in total and are allocated by central planning, no efficient value comparison can emerge. Thus, for the resources to be allocated, no input prices can be rationally compared with output prices as the occurrence of these prices would require private property of these resources and voluntary exchange in the first place (Mises, 1990, p.19-21). In a world without market prices and centrally planned production decisions, there is always a knowledge problem about how to best meet people’s dynamically changing needs.

Considering the market dynamics, the market price system as a provider of information is so far the only known way to react flexibly to changing circumstances in the future and to be able to factor them in (Mises, 1998, p. 511). Hence, Mises provides another reason why technological progress alone cannot per se be regarded as a growth driver. This is because whether the use of a new technology ultimately proves to be value-adding or value-destroying can only be determined in retrospect by means of economic calculation. The result of this calculation process, in turn, provides information signals to other entrepreneurs. Based on this, they also must decide whether the use of such new technology or capital goods could be worthwhile in their situation. The growth-promoting process of creative destruction through technological innovations, as coined by Joseph Schumpeter (1942), is thus only possible through the entrepreneurial discovery process of trial and error based on economic calculation (Mises, 1998, p. 507).

3.5. Institutions

So how can we ensure that the growth effects from the combination of capital accumulation, division of labor and economic calculation can fully unfold? The answer lies in an economic system based on private ownership of the means of production. As we have just seen, without private ownership of such means, voluntary (interpersonal and intertemporal) exchange, the resulting market prices, and the subsequent competitive discovery process using economic calculation would be impossible (Rothbard, 2009, p. 1047). Therefore, a system is needed that clearly defines property titles and avoids property conflicts as best as possible. Such protection of property rights is what makes the growth factors possible in the first place and continually strengthens them. The absence of peaceful coexistence and thus the constant danger of property conflict, drastically reduces the possibilities of division of labor and exchange (Mises, 1998, p. 667-668 & 817).

Furthermore, the permanent uncertainty about the usage of private property distorts individuals’ time preference and incentive structure. Consequently (ceteris paribus) individuals save less and consume more in the present, since prospects for future profits or action possibilities are characterized by greater uncertainty. Therefore, the relative value of present goods increase. Such distortions are particularly evident when conflicts are associated with a high probability and cannot be averted or reduced or are considered legitimate by most of society. Under such systematic property conflicts, time preference also increases systematically (Hoppe, 2001, p. 11-14), which in turn leaves less leeway for capital accumulation.

In order to circumvent or minimize a world of permanent arbitrary property conflict, appropriate institutions are necessary. These have the intention to create a conflict solving and transaction cost reducing set of rules. The goal is to create a uniform information base that makes the behavior of other actors more predictable (Lachmann, 1971, p. 49-50). For this set of rules to be used successfully, it must be accepted by as many members of society as possible and be enforceable accordingly. Enforcement can be accomplished through decentralized self-regulation (private institutions) or through an external, centralized authority, i.e., state institutions (Schotter, 1981, p.11). Economic development is therefore only possible on the condition that private property and conflict-free action are supported by institutions (North, 1991, p. 98).

This leads to the following questions:

    1. Which rules best protect private property and promote growth, and which do not? 
    2. How can these rules be enforced efficiently? 
    3. What criteria or mechanism is appropriate to answer questions 1 and 2? 

The best way to approach these questions is to evaluate whether a centralized authority like a state or whether private initiatives are best suited to provide institutions that protect private property and established conflict-solving rules to support voluntary exchange.

Ludwig von Mises emphasized that isolated government interventions always tend to produce unintended consequences that defeat the very purpose of the intervention measures used. This creates the tendency of a path dependency (intervention spiral), which creates the inventive for further interventions to correct the preceding, non-intended effects (Mises, 2013, p.35; 41; 198). These interventions are only partially or temporarily controlled by central planning. Prohibitions, regulations, restrictions, or levies of any kind can be mentioned here as an example. The individual is thus forced under the threat of state violence to use his means differently than he would have done without the intervention. As a result, certain uses of the means of production and consequently the learning and innovation processes affected by them can be impeded or permanently excluded (ibid., p. 27 & 31)

The argument for state intervention is usually legitimized by the intent to increase social welfare. In order to do so, it must be established that the means of production used so far are inadequate or will prove to be inadequate in the future without corrective interventions. In theoretical literature as well as in real life, common examples of such intervention-legitimizing “market failures” include public goods and externalities.

In short, externalities describe a situation in which a particular action leads to consequences for uninvolved parties that are outside the contractual relationship of that action. These effects can be negative or positive in nature. Negative externalities are often referred to in order to legitimize interventions. In this context, the action of an individual, e.g., through pollution, leads to “social costs for the general public”. However, these “social” costs have not been considered in the action of the polluter and, accordingly, have not been priced in. As a result, the output of these externality producing goods/services is higher and the market price lower than it would have been (ceteris paribus) if external “social” costs had been included. Government intervention, e.g., through taxes or output restrictions in the case of negative externalities and subsidies in the case of positive externalities, attempt to bring the output quantity to a “social optimum” (Cordato, 2007, p. 2-3). 

The basis for mentioned market interventions above were made under the assumption that they were implemented with welfare-enhancing intentions. However, this assumption can be softened. The knowledge deficit of central decision-makers addressed in section 3.4 tends to ensure that policymakers rely on expert knowledge for their decision-making in certain subareas (Pasour Jr., 28 1987, p.135). The more centralized this decision-making authority is, the greater the knowledge deficits become. Depending on the decision area, these experts (stakeholders) may come from academia, organized associations, or the private sector. 

In economics, “rent-seeking” is the term used when these interest groups exert influence on the centralized decision-making ability of politicians. This influence can arise, for example, from certain monetary, but also non-monetary incentives. As a result, there is always the possibility that individual self-interests will be imposed on the whole society. These self-interests can manifest themselves in the form of direct or indirect monetary transfers from public funds. Moreover, certain competitive advantages are also conceivable. Examples could include regulatory barriers to market entry or regulatory facilitation for certain stakeholders (Buchanan et al., 1980, p. 9; Pasour Jr., 1987; p.136). This corporative interaction then leads to a constant incentive for both, politicians as well as rent-seekers, to further expand state powers and intervention possibilities. Free market competition is thus not only distorted by interventions intended to increase social welfare. In addition, these well-intentioned intervention decisions are also distorted by self-interested individual incentives.

Besides continuous government intervention, the concept of public goods is also highly relevant for the following analysis of FPC. This is because these types of goods do not require isolated state intervention in the narrower sense. Instead, they are usually provided by the state from the very beginning. Within the conventional doctrine, the justification for the government provisions of certain goods is seen in their special properties. These properties can be classified as “non-excludability” and/or “non-rivalry”. In the case of non-excludability, it is argued that for certain goods no additional consumption can be excluded, or only by means of too high costs. Non-rivalry, on the other hand, is when one person’s consumption is not reduced by another person’s additional consumption. In both cases, it is argued that there would be no incentive in a private sector organization to provide such goods efficiently and to a socially appropriate extent (Holcombe, 1997, p. 1-2, 6 & 21). Thus, a private provision would lead to a systematic underproduction of these kind of goods.

The following analysis will therefore examine in more detail the extent to which, within an FPC, the private-sector provision of institutions and other government services can have an impact on the growth drivers named here. More specifically, it will be analyzed how FPC can be used to overcome economic development deficits for the respective country. First, however, it will be briefly explained to what extent SEZ in general can influence the economic improvement of a country.

4. Comparison: Classic Special Economic Zones And Free Private Cities

4.1. General Growth Effects Through SEZ

At the heart of the SEZ concept is the provision of improved institutions and regulatory frameworks. This is intended to enable a broader and more secure scope for economic activity (Zeng, 2019, p.12). Thus, in addition to improved conditions for domestic companies, SEZ are meant to attract FDI. The advantage of FDI for the developing countries concerned is that they can now access certain capital goods much faster than would have been the case with a self-sufficient savings and investment process. The rationale for this is that in the past, developed countries had more opportunities to build up savings through sounder institutions. Thus, they able to take longer production detours. With FDI, therefore comes the opportunity to participate in the prior accumulation of capital and the resulting technological progress of industrialized nations based on the division of labor (Ritenour, 2019, p. 22). Furthermore, through the removal of restrictive trade barriers or protectionist measures associated with SEZ, foreign investors and companies find also easier access to the domestic market outside the SEZ. This makes it easier to keep foreign capital in the country in the long term. In principle, enhanced growth effects could occur primarily if the companies newly located in the SEZ integrate into the local economy outside the zone. This integration into the local production structure of the country is thus the prerequisite for broad spillover effects such as technological innovation and knowledge transfers (Hachmeier & Mösle, 2019, p.41 & 44).

In addition to technological knowledge transfers, institutional knowledge transfers are also highly relevant, especially for developing countries. These knowledge transfers are given when certain reform adjustments are tested within SEZ for the time being. Then, the effects of these institutional changes can be used as a knowledge base for subsequent country-wide economic policy reforms. Therefore, SEZ are also used as experimental fields of institutional learning (ibid., p. 48). Particularly in the case of multifunctional SEZ that can encompass whole cities (e.g., Shenzhen in China), such learning effects can have an even stronger impact. This is because, depending on their scale, these zones may represent small economies of their own with institutional setups very different from the national institutions. This can then generate an institutional competition with the national economic system (Wrobel, 2008, p. 12). As a result, there is a strong incentive for the relevant decision-makers in the country to improve or adapt their own national facilities. The reason for this is that if the decision-makers do not respond to this new institutional competitor, there is a risk of continued migration (of productive resources) to this zone. These competitive effects can be further intensified the more independent and autonomous the zones can act from the political influence of the host state.

4.2. The Effects of Private Zone Ownership And Management

In the literature, the failure of SEZ is often attributed to its uneconomical operation. In this context, attention is often drawn to the occurrence of misallocations regarding an appropriate infrastructure and institutional framework (Hachmeier & Mösle, 2019, p. 28-27 & 68-69). These failures can often be attributed to the incentive and knowledge deficits of central planning which were already mentioned section 3.4 & 3.5 (ibid., p. 91; Moberg, 2015, p. 6-11).

In order to continually attract FDI and harvest their effects on economic growth for the whole country, avoiding these deficits is particularly relevant when it comes to planning, financing, implementing, and operating SEZ. If the mentioned deficits manifest themselves, financially the SEZ may represent an extremely risky project for the country concerned. This, in turn, would generate counterproductive effects on economic development potential. Specifically, to mitigate these incentive and knowledge problems, FPC represent an interesting option. Unlike classic SEZ, where politicians and rent-seekers decide upon the institutional framework and design of these zone, an entrepreneur (Private City Provider – PCP) who bears full responsibility for this zone is far less guided by political goals. This results in less susceptibility to rent-seeking attempts by certain interest groups. Moreover, unlike political decision-makers who can rely on tax funding, the PCP must ultimately always base his decisions on the profit and loss account. This, in turn, is largely dependent on general customer satisfaction. This is because the FPC seen as a product or service package (i.e., the private provision of government services) is evaluated by residents based on their willingness to pay. Rent-seeking influences therefore play only a subordinate role in decision-making process and are basically only relevant if they do not have a negative impact on long-term profit prospects.

The PCP as a profit-oriented individual then has the incentive in all business transactions to keep costs as low as possible, such as the use of resources in infrastructure and administrative processes. At the same time, he must try not to reduce the quality of the end products, such as infrastructures and institutional services, but at best to keep it constant or increase it. Therefore, unlike publicly owned SEZ, there is a greater incentive to make the zone as attractive as possible to customers and investors. Consequently, this can further enhance the effect hoped for with such zones of attracting FDI and knowledge.

This incentive is particularly reinforced by the entrepreneurial risk that occurs when the PCPs are held liable with their private property. If the zone is privately owned, the entrepreneur or shareholders are (ceteris paribus) exposed to a lower time preference than temporary political administrators within a legislative period. The reason for this is that private owners have a greater incentive to maintain or increase the capital value of the zone (or the private capital invested in it) over as long a period as possible. Temporarily responsible political decision-makers would have a much lower incentive to do so. This is explained by the fact that politicians themselves cannot be held liable (privately) for their decisions or can be held liable to a much lesser extent. In the case of private insolvency of such zones, unlike publicly funded SEZ, it is not the taxpayers of the respective country who are liable, but the investors with their risked capital investment (ibid., p. 9). Thus, private financing and liability of such zones represents an enormous cost and risk reduction for the public budget of the host nation. However, this is only the case if any insolvency that might occur is not prevented with public subsidies. This effect of cost relief is also one of the main reasons why the respective countries are already increasingly handing over their competencies in the establishment of SEZ to private players (Hachmeier & Mösle, 2019, p. 90 & 114). The extent to which (financial) risks are redistributed from the public to the private sector is thus particularly reinforced by the FPC.

This argument can also be used to offset another disadvantage of publicly funded and operated zones that has been mentioned in the literature. Sometimes the countries concerned are being accused of using public funds for SEZ only to avoid having to implement necessary and nation-wide costly reform measures or investments (Akinci & Crittle, 2008, p. 34). However, if these zones are largely privately funded and autonomously managed by the PCP, government funds can be used for “more necessary” alternative ends. With a public SEZ, these funds would be tied to its establishment and operation. A FPC could therefore be particularly advantageous for structurally weak countries with deficit state budgets. This is because, all other things being equal, an FPC would place no or a smaller additional burden on the public funds.

4.3. Private Institutions And the Public Goods “Problem”

As we know, in contrast to publicly funded and organized SEZ, FPC contractually offer concrete conditions that cannot be changed unilaterally. These are to be enforced by institutions in order to protect the private property of individuals and their freedom of action from arbitrary interference. To this end, rules must be created that can avoid and resolve property conflicts as effectively as possible. The goal of FPC is thus to ensure, by means of institutions, that the uncertainty and thus the time preference of individuals (e.g., companies and investors) has more room for systematic reduction. After all, the lower the time preference, the stronger the potential of capital accumulation.

In orthodox schools of thought, institutions such as public security and a functioning legal and regulatory system or certain infrastructure fall under the category of public goods. Thus, in line with the named characteristics of public goods in section 3.5, it is argued that private production of these types of goods would be insufficient. Instead, in order to generate a more optimal output quantity or use of resources, they would have to be financed with tax revenues and decided via a monopoly of compulsion (Fielding, 1979, p. 295). Therefore, in case of institutions, the mechanism in question of finding and evaluating appropriate rules and the corresponding resource allocation to enforce these rules (c.f. section 3.5) classically takes place through a political (majority) decision-process that can be influenced by rent-seeking.

This first question that must be raised here is: Are institutions public goods according to its own definition? In order to answer this, one has first to accept that the mentioned characteristics of public goods are not always clearly identifiable in reality. This is because they can occur both separately and as a combination. Furthermore, institutional goods and services, such as public safety and legal services, like all other types of goods, can have a wide variety of forms and characteristics. Thus, they do not represent a uniform homogeneity of goods. A fixed, generally valid categorization of these types of goods into “non-rival” and “non-excludable” is therefore not possible (Hoppe, 1989, p.30 & 35). At best, tendencies toward these characteristics can be identified. In the case of security and legal services it can be stated more importantly that these services are also performed and thus subjectively evaluated in marginal units, e.g., by performance of security- or justice personnel. Therefore, it is not possible to assign a general non-rivalry to these services, as e.g., every “security personnel” is always in short supply in terms of time and space and binds specific resources to itself with each action (ibid, 1989, p.35; Rothbard, 1981, p.73; 1032). 

Regarding the private provision of public goods, however, the argument of non-excludability weighs much more than that of non-rivalry. The reason can be seen in the fact that “non-rivalry in consumption” is less of a problem for the providers, given they can exclude additional, “free” consumption (Hummel, 1990, p. 92). If this exclusion is not possible or only possible at too high a cost, consumers have the incentive to become free riders. These would thus be able to consume and use the good without paying for it (in full). It is argued then that a tax-financed provision is the only way to prevent this free-riding behavior. This is because all potential users now must pay for these types of goods, whether they want to or not.

It must also be emphasized at this point that excludability is generally not a physically inherent property of a good. Rather, the degree of excludability results from economic calculation of the entrepreneur (Wiśniewski, 2018, p.43; Block, 2009, p. 144). If a certain degree of non-excludability occurs in the provision of goods, the entrepreneur must assess the extent to which this problem and a possible solution approach is transferred to the profit margin. If the effort to prevent free-riding results in an overall higher profit margin, the provider will be incentivized to solve this problem. If this effort to do so is too costly, the “problem” of free riding is not big enough to be solved. As long as the provider of such services can operate on a profit, value has been created. Tax-financed provision of such goods on the other hand can merely overshadow the free-rider problem by force and discourage ongoing, technologically innovative attempts by the entrepreneur to solve it.

Moreover, and most importantly, tax-financed provision of such goods prevents the objective measurement necessary to determine whether value has been created at all with those goods. Thus, the fundamental problem with tax-financed or subsidized goods is that they prevent (undistorted) output and consequently input prices from forming for these goods. People’s real willingness to pay for precisely these goods and services, generated by supply and demand, can no longer be determined qua voluntary value judgment (exchange). Furthermore, the very concept of tax-financed goods and services must presuppose a priori that the individuals concerned would have preferred other alternatives in the form of other goods and services (or different prices for the same goods/services) without this tax financing. Otherwise, tax financing would not have been necessary (Hoppe, 1989, p. 32). Therefore, the providers of tax-financed goods can only guess roughly what people’s preferences would have been for these types of goods. The decision regarding the allocation of resources for these goods cannot be made based on economically rational criteria. The decision is subject to pure (political) arbitrariness (Rothbard, 1981, p.73).

At the same time, tax financing also distorts the willingness to pay (the value judgements) for all those types of goods which would have been preferred with the disposable income in the absence of taxation. Therefore, tax financed provision of certain “public” goods, which seeks to prevent their presupposed underproduction, necessarily leads to a misallocation of resources and systematic underproduction of all other goods (ibid., p.83; Fielding, 1979, p. 296-97).

4.4. FPC as a Market-Based Discovery Process to Overcome Deficits of Government Services

The general pricing-problems associated with public goods laid out in the arguments above can be solved quite easily in a FPC. Typical public goods such as public security and a legal system are based on an exclusive contract that cannot be changed arbitrarily or through political means. This contract is the exclusive prerequisite for access and entitlement to these services. Residents who for instance request additional security services beyond the basic provision detailed in the city-contract can conclude separate supplementary contracts. These contracts could also be agreed individually with third-party companies (Gebel, 2018, p.201). If this is the case, residents would thus enter individual contracts according to need and preference in addition to the generally applicable social contract. However, legal and security services enshrined in the social contract as well as for instance necessary basic infrastructure can also be provided via contractually bound third-party companies. An example of this is an external company that enters a contract with the PCP.

Basically, the general advantage with a private security service provider or private court system is that there is a comparatively higher risk of customer dissatisfaction. It follows that in the case of private providers, especially due to competitive pressure, a drop in customer satisfaction is more strongly expressed by a lower willingness to pay. In addition, there is always the risk of contractual claims if the exchange services clearly defined in the contract are not met. The continued profit orientation therefore ensures a more customer-oriented willingness to provide services than would be the case (ceteris paribus) with a monopolized, tax-financed service. This is because private security service providers or private arbitration courts, for example, have a greater incentive to perform and monitor this performance due to reputational and competitive effects. These effects make it possible to ensure that rent-seeking attempts and corruption cannot take root within these companies. This is highly relevant in judicial decisions for example, because, unlike state court monopolies, these arbitrators are forced to exit the market if they perform poorly.

Thus, as a result of direct customer feedback and entrepreneurial trial and error, certain inefficient services and products that are less in demand can be sorted out according to more rational criteria. This means that the products, processes, services, and overall allocation of resources that offer the greatest opportunity to create value, i.e., meet the most urgent needs, can be more easily identified. FPC thus enable (technological) innovations in the production of goods and services that would have remained undiscovered in the rest of the country due to its tax-funded and centrally planned nature (Hoppe, 1989, p. 36-37).

This is especially important for institutions and the mechanism of finding appropriate, growth-supporting rules, as mentioned in section 3.5. A free market for institutions thus creates greater and more flexible room for finding a solution in case of property conflict (e.g., in case of externalities). Different approaches for resolving similar conflicts can be gradually tried out and continuously or incrementally adjusted. This mechanism allows the opportunity for the most marketable solutions to be filtered over time in the sense of “best practice sharing.” On the one hand, a secure regulatory framework that cannot be changed arbitrarily as offered in FPC can reinforce the growth drivers identified in Section 3. On the other hand, this “social contract” as a meta-rule still allows the market process to react flexibly and to find rules and conflict solutions at the micro level (Gebel, 2018, p. 188-9; Wiśniewski, 2018, p.82).

Therefore, underdeveloped countries in particular, which, as Paul Romer (noble prize-winning economist and originator of the charter city concept) points out, are characterized by weak institutions and dysfunctional rules that inhibit growth (Romer & Fuller, 2012, p. 16), can draw indirect learning effects from the regulatory discovery mechanism within the FPC. As with SEZ in general, these learning effects can then be used as a knowledge base for nationwide reforms and regulatory adjustments. Thus, by means of FPC, host countries can for the first time use a market-based discovery process that is, unlike the common political discovery process, much less influenced by knowledge deficits and rent-seeking. Therefore, SEZ which are publicly funded or politically influenced represent controlled “top-down” experiments for specific reform changes. FPC, on the other hand, can be used as “bottom-up” test laboratories of a dynamic and spontaneous order with less vulnerabilities to the incentive and knowledge problem mentioned in section 3.5.

4.4.1. Excursus: A Market-Based Discovery Process for Money

The arguments in favor of private institutions within a FPC and their effects on growth and development potential of a country can logically be applied to other types of classic government services (e.g., infrastructure, healthcare, and educational system). In principle, therefore, the discovery process described above is applicable to all those types of goods for which this process has been distorted or prevented by tax-financed provision, subsidization, or centrally planned regulatory interventions. Thus, at least in theory, basically all types of goods and services can be completely ceded to private third-party companies. 

That being said, FPC also provide a rare (if not the only) opportunity for mainstream economists to empirically test their hypotheses about the theory of public goods and their apparent inability to function (appropriately) on a private and voluntary basis. This is because, so far, all attempts to “empirically test” the provision of e.g., a systematic legal system and public security on a purely voluntary and private basis outside of taxation, have been distorted or prevented by government action. Therefore, FPC can also be used as scientific field experiments in the sense of Karl Popper and his followers of “Critical Rationalism” as the correct scientific method for economics.

Back to the actual topic. In addition to the types of goods and services already mentioned, the market-based discovery process for money is of particular importance. As mentioned in section 3.4, this medium of exchange is crucial for an efficient coordination of division of labor and capital accumulation by means of economic calculation. Although money in the strict sense does not have the characteristics of public goods, nowadays it is ultimately provided by governments in practically every country. Therefore, from the point of view of the ASE, state money is subject to the same deficits as all other government services. This is because the central definition of a legal tender prevents alternative means of exchange from forming and developing dynamically and undistorted according to people’s needs.

A currency competition (as suggested by Friedrich August von Hayek) in form of a market-based discovery process would therefore allow to find out which medium of exchange or banking system is preferred by individuals in their exchanges. Such competition can function particularly efficiently within an FPC. On the one hand, as with other types of goods, this discovery process takes place within a state-licensed and geographically limited test laboratory. Possible coordination problems and any initial friction with the state currency can thus be largely avoided. Especially for countries that want to undertake comprehensive reforms in their monetary system or for governments that are dissatisfied with the prevailing monetary policy, a market-based currency experiment within the FPC can provide the necessary orientation points. A recent example is the government of El Salvador which has allowed Bitcoin to be used as additional legal tender. To be sure, the centrally planned adoption of a private and decentralized means of payment, as is the case with certain cryptocurrencies, is certainly a possible approach to a currency competition. Nevertheless, as only one possible money-alternative is selected by government authorities, the actual market-based search process for appropriate money is still severely inhibited in this case. A money discovery process initiated by a local FPC in e.g., El Salvador for the time being would make it possible to find the most marketable form of money that can later be introduced as legal tender.

4.5. Knowledge Transfer Through Market-Based Pricing of Government Services

The market-based discovery process within the FPC allows for yet another economically crucial learning effect. Since all goods and services within the FPC, especially those usually provided by the state through taxes, are exchanged voluntarily at the private level, objectively visible market prices can be derived for these services. As pointed out several times in the course of this article, crucial information about preferences generated through market prices are the one thing all governmental services must lack. Thus, FPC allow governments for the first time to roughly price their own services according to economically rational criteria. The conclusion is that these objectively visible market prices for governmental services generated in the FPC can be used by the host countries as relative reference points or benchmarks to economically rationalize their own services.

This principle is similar to the mechanism of the former Soviet Union where central planners could access both international market prices and national black-market prices. These prices served as informational aid to their own economically irrational use of resources. Therefore, central decision makers had the option of adopting certain aspects of economic calculation. Nonetheless, the prices used for this purpose were only of limited value because they contained less information than the real, but not available market prices for the actual services provided (Rothbard, 1991, p. 73-74). Ludwig von Mises in particular emphasized that the use of resources in the Soviet Union could only be planned and coordinated at all because of the availability of these international market prices (Mises, 1998, p. 698-99). 

Using these benchmarked market prices then allow governments to better estimate if the resources for their services were used economically or not. This can be of particular importance in order to rationalize the own state budget and the resource deployment of public funds. Therefore, FPC offer not just concrete learning effects through a discovery process of government services itself (e.g., institutional set ups). However, governments are also able to access the subjectively hidden value judgments of recipients of government-like services due to being provided privately and voluntarily by FPC. More concretely, the relative willingness to pay of residents within the FPC can be extracted. Thus, it can be seen what the actual value preference is between certain “government services” and all other goods. Furthermore, it becomes apparent how much people are willing to pay relatively for security, jurisdiction, infrastructure, education, etc., outside an environment of coercion and force. At the same time, it also becomes clearer which other classic private good types, such as housing, food, entertainment, etc., are preferred at what price with the disposable income. Moreover, with the availability of market prices, it is not only the preference between certain types of goods that can be seen. Government decision-makers can also find out which allocation of resources within a particular type of good or service has the greatest potential to create value. For example, how much personnel, at what time, in what place, with what qualifications and equipment can be efficiently deployed to ensure public safety and the administration of a legal system in value adding way.

In summary, the growth drivers mentioned in section 3 can only develop their full potential in a closely interlocked and mutually reinforcing network. Therefore, on the one hand, institutions and thus the protection of property and the possible emergence of market prices through voluntary exchange are the preconditions for the coordination of division of labor and capital accumulation through economic calculation. At the same time, however, institutions are not to be regarded as exogenous constructs detached from the other three growth drivers. Rather, institutions represent nothing more than specific services and goods. And like all other goods and services, institutions can only be efficiently or economically-rationally provided, enforced, and improved in the long run (and thus on a sustainable basis) through a market-price coordination mechanism of division of labor and capital accumulation.

Conclusion

The main objective of this article was to compare the impact of FPC with classical SEZ from a perspective of development economics. It was found that FPC can further strengthen the actual goals of SEZ and overcome many fundamental challenges associated with governmental services, funding, and organization of these zones.

On the one hand, FPC can be an option with a comparatively low financial burden on the public budget of a country as it is the private city provider or its shareholders rather than the taxpayers of the respective country who bear the risk of financing and operating the zone. In addition, FPC provide a clear, contractually defined legal framework that is much less influenced by arbitrary, political (majority) decisions and rent-seeking. Within this contractually agreed framework, FPC also offer a wide scope for entrepreneurial flexibility. This in particular makes FPC highly attractive for FDI and resulting technological innovation and knowledge transfers to the rest of the country. 

In addition, the FPC can play a major role in promoting the goal of institutional learning associated with SEZ in general. Especially, structurally weak developing countries with institutional deficits, counterproductive rules and inefficient budget management have with FPC the opportunity to use for the first time a market-based discovery process for growth-promoting rules. Furthermore, by being able to access actual market prices for governmental services, host states of FPC can use this crucial information to economically rationalize the use of resources for their services. Nevertheless, not just developing countries, but also industrial states may be interested in using FPC. These countries can also use the FPC as a guide to streamline and economically rationalize their own over-bureaucratized and over-regulated processes and services. This is because there is no market price-based discovery process for government services and goods in both developing and industrialized countries.

The possibility of continuous improvements of such zones and their contractual conditions (both for the contract with host states and with the inhabitants of the zone) lives on competition. This trial and error will ensure that the benefits of such zones are further extended and their challenged minimized. Thus, additional providers of similar zone concepts generate a kind of meta-discovery process. Especially in zones where private ownership and voluntary exchange are encouraged, the resulting market prices can provide increasingly more accurate information about the actual preferences for government services.

The success of FPC can hopefully serve as a positive example for new projects. A corresponding competitive dynamic could thus lead to far-reaching imitation effects which could already be observed with SEZ in general. A clearly visible success of these zones could also bring about a fundamental rethinking not only among politicians, but also among the local population. From an economic point of view, one could see the general advantages of market-based processes, which unfortunately are being pushed more and more into the background nowadays. From the perspective of political philosophy, the success of a clearly defined and voluntary “social contract” on an equal footing rather than dictated unilaterally might encourage the individual to question the necessity for authority and state power in the first place.

 

 

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