Knowledge Problems and Free Zones

Triyakshana Seshadri and Virgil Storr have a new paper in the Review of Austrian Economics, “Knowledge problems associated with creating export zones” (ungated draft here):

Indian export promotion policies did not fail because of bad design or implementation. Indian export promotion policies failed because of the knowledge problems associated with a government planning agency determining where to locate a zone, what industries to promote within a zone and which firms to allow in the zone. They failed because the Indian government pursued a top down export promotion strategy rather than a bottom up strategy.

The consequences of ignoring the knowledge problem continue to add to the wastage of resources that can be better spent elsewhere. For example, zone bureaucrats spend considerable time and effort in attempting to select the “best” developers and entrepreneurs for their zones. Moreover, zone developers expend considerable resources developing infrastructure to promote the development of regions that might not be the best place to produce for industries that might be the best industries to promote in that region.

Due to the knowledge problem, any policy that is geared towards developing a region is bound to fail (or to be unnecessary). Regions and clusters develop due to several factors in the local economy which cannot be engineered by a central planner. Thus efforts to engineer clusters will continue to be frustrated as is demonstrated by recent efforts in India. Although India’s new zone policy intended to move business operations out of existing big cities, for instance, most of the zone-based business successes have been within existing cities. This is a clear indicator that the clusters that emerged spontaneously offer powerful incentives to entrepreneurs rather than newly government-created areas.

There are lessons here for competitive government more generally. Expecting to use existing governments to create enclaves of good governance is foolish. If governments could do that competently, they’d likely be able to do other things competently as well, and we wouldn’t need free zones at all. The problems of central planning apply to the creation of governance mechanisms as well as their operation. We need the small scale experimentation and ex post selection of competition in order to learn what works. That’s true of export processing zones deciding where to locate, what industries to promote, and which firms to admit. It’s also true of free zones, charter cities, and seasteads choosing a bundle of rules.

That’s what makes Michael Strong’s preferred approach of using private enterprise to found new cities so attractive compared to other approaches. Free zones don’t need to be creatures of the state, but merely accepted by them. That “merely” hides some pretty serious challenges, of course, but we have seen a large number of private, entrepreneurial free zones cropping up all over the place. According to this World Bank report, 62% of free zones in poor countries are privately developed and operated. As the knowledge problem argument would indicate, private zones seem to perform much better.

While entrepreneurial free zones are awesome, the fact that they need to deal with entrenched interests in existing states limits the possibilities. This is why I think seasteading is even more awesome: it allows for the creation of entrepreneurial communities without the need to deal with existing states at all.