States have a wide range of tools they can use to manage their economies and promote economic prosperity.
First, states print money and manage the money supply through Central Banks. Increasing the money supply – by lowering the interest rate on loans or by printing more money – can boost consumer spending, but it also contributes to inflation (rising prices). States will also manage fiscal policy through the international exchange rate. While the United States lets the value of the dollar float freely in international markets, some states will set the value of their currency at a specific rate. For example, the Chinese yuan was for many years pegged to the U.S. dollar. Until 2005, it one yuan was worth just over eight cents. In 2005, it introduced “bands,” allowing the exchange rate to float within a few percentage points of the U.S. dollar.
Countries interested in promoting exports can keep their exchange rates artificially low. This makes the price of goods produced in that country lower than the price of the same goods in other countries. This something many developmental states (including South Korea and Japan) did to promote domestic industries, and is what the United States accused China of doing in 2019 – manipulating financial markets to artificially lower the value of the yuan.
Countries can also promote domestic industries through trade policies. They can place tariffs on imports, making foreign goods more expensive, as President Trump has done on steel and other goods. The risk is that countries will retaliate with their own tariffs (as China has done) and the World Trade Organization was established to mediate these types of disputes and facilitate the mutual reduction of tariffs.
Another important aspect of trade policy is regulation of foreign investment. Many countries pass laws limiting foreign ownership of domestic companies. For example, India almost completely banned foreign direct investment (FDI) until 1991, and then limited foreign ownership in certain sectors to 49% joint ownership. It has liberalized restrictions since then, but much foreign investment still requires government approval.
Looking at domestic policy, states can choose to support certain companies or sectors through tax breaks and subsidies. For example, the United States has encouraged innovation in and adoption of solar and wind technologies through tax breaks. Many European countries have adopted carbon taxes to discourage the use of fossil fuels. Subsidies are direct payments to companies (for examples, the U.S. pays farmers to plant corn).
Sometimes, states will consider a sector of the economy to be of such strategic value that they will nationalize it – take over ownership directly. For example, in 2007 Hugo Chavez nationalized Venezuela’s oil industry (followed by the cement industry and others). When countries sell state-owned companies, it is called privatization. Well-managed privatization can introduce competition into a sector, but more often privatization leads to the development of “crony capitalism.” For example, privatization in Russia in the 1990s involved rigged auctions and led to valuable state assets going into the hands of around 15 oligarchs.
Finally, states can promote economic development by supporting social development. Improving infrastructure (such as roads and transit) facilitates trade and quality of life, while improving health and education helps build a skilled workforce. In countries with high levels of inequality, some governments seek to go further and redistribute resources from the rich to the poor. The most common way to do this historically has been through land reform. Most states in Latin America redistributed land from large estate-holders (some of which had been U.S.-owned companies, like the United Fruit Company) to small farmers, with mixed results. Other countries, like Iran, direct money from state-owned oil companies to cash payments to citizens and subsidies to keep food prices low.
These are just a few of the tools states use to manage their economies, intending to clarify our discussion of how state institutions impact economic development. They all have advantages and disadvantages, and the choice of tools depends on the state’s ability to implement them (capacity) and its ideology or policy goals.