JANUARY 2, 2014

Institutional Arrangements for Economic Governance

Summary of the basicsEconomic growth is a function of …

(i) Factor accumulation Increase in human capital, physical capital

… depends on saving, investment, schooling decisions

(ii) Productivity change Improvements in allocative efficiency (including within household!) Improvements in technical efficiency

… depends on decisions on where to invest, whether and how to adopt new technologies, etc.

Rates of economic growth determined by whether households, firms, and investors are making “appropriate” choices—i.e., those that are aligned with social optimality and higher economic growth. Markets … can help by aligning private incentives with social costs and benefits, provided:

(a) they are not missing (b) they are not distorted by inappropriate policies (c) they are not malfunctioning due to externalities (e.g., LBD), non-convexities (e.g., IRS),

imperfect/incomplete information (e.g., moral hazard), or incomplete contracting. When markets work poorly, low levels of accumulation and low productivity are the result.

Institutions of economic governance

Institutions … shape economic behavior by affecting constraints and incentives that households and investors face.

They do so both directly, and through their impact on markets. In particular, institutions determine when markets exist, how well they work, and how long their reach is. Appropriate market-supporting institutions are those that counter (a), (b), and (c). They enable markets to exist, restrain governments from inappropriate policy choices, and prevent market failures. (But not all institutional arrangements are “appropriate” in that sense.)

Definition of institutions: Institutions are “the rules of the game in a society” (Douglass North) Institutions are "a set of humanly devised behavioral rules that govern and shape the interactions of human beings, in part by helping them to form expectations of what other people will do." Lin and Nugent (1995, 2306-2307). Can be formal (laws, regulations) or informal (norms, patterns of behavior, conventions, moral codes) As such, they determine not just functioning of markets, but the quality of all social interactions (e.g., trust, cooperation). We will see examples from a broad cross-section.

Informal versus formal institutionsInformal versus formal institutions

Relative advantages of self-sustaining agreements versus formal institutions: The former have low fixed costs, high and rising marginal costs; the latter have high fixed costs, low marginal costs

As markets grow, number of participants increase, and mobility rises, the relative costs of informal agreements rise. Example: traffic and traffic lights Transitional costs

Outline

•A second-best strategy for institutional reform

•A typology of market-supporting institutions

•Multiplicity of institutional forms

•Where do institutions really come from?

An analogy: contract enforcementRelational contracting in Vietnam (I)

“The managers we interviewed said they did not believe the courts can help them. "They normally just create more problems . . . in Vietnam no one believes we have a good legal system“ … Another said, "The court is weak and no entrepreneurs use it" … These comments are corroborated by answers to our questionnaire about how disputes are managed. Responding to a question about third parties that can enforce agreements with customers or suppliers, 89% of managers said, "there is no one." Only 9% said a court or other government agency could help. Third parties are even less help for disputes over the quality of goods; only 2% of the managers said they would take such disputes to court or appeal to local authorities.”

Relational contracting in Vietnam (II)

“To compensate for the inadequacy of the courts, the firms use repeated-game incentives. Contracting is supported by the threat of loss of future business. Interestingly … the managers told us they are reluctant to sanction trading partners. If a customer reneges on a debt they often allow payment to be delayed and forgive part of the debt. As a result the retaliation is not as immediate or predictable as in the simple repeated-game story and therefore not as effective a sanction. To ensure compliance, the firms rely on other devices that supplement the shadow of the future… We find that more elaborate governance structures are used in transactions with a greater risk of reneging. Also, firms sometimes scrutinize prospective trading partners before beginning to transact, checking the firms’ reliability via other firms in the same line of business or familial connections.”

Relational contracting in Vietnam (III)

So:

• Courts are inefficient, costly to use, and potentially corruptible

• Firms rarely resort to them

• They rely on relational contracting instead:• long-term, trust-based relationships with suppliers and

customers

• screen potential business partners by gathering information

• inspect goods on delivery prior to payment

• frequently renegotiate when contract terms are not fulfilled

When intermediate levels of “legality” may not be an improvement: Former Soviet Union

Relational contracting in Africa

Some initial lessons

1. We can get a lot of economic activity in very “poor” institutional environment

2. Poorly designed institutional reform, following “best practice,” can do more harm than good

3. Appropriate reform strategies are inherently context-specific and may require second-best strategies

• Working around existing constraints, building on existing strengths

• If relational contracting is working decently, the focus of institutional reform might be not on improving judicial system, but on

• Improving information gathering and dissemination about “good” and “bad” firms

• Improving formal contract enforcement for specific categories of firms that do not have access to relational contracting, such as new entrants and foreign firms

A second-best strategy for institutional reform

• Additional illustrations• Property-rights reform

• Entry regulations

• Outward orientation

• Monetary policy regimes

Example 1: Property-rights reform (1)

• Problem: inadequate protection of property rights depresses private investment incentives

• Solution: private property-rights legislation and American-style investor protection rights?

• But what about difficulties of:• Enforcement?

• Politics?

Example 1: Property-rights reform Example 1: Property-rights reform (2)(2)

The example of Chinese TVEs

Objective What is problem? Institutional response

Prerequisites Institutional complements

provide “property” rights over profits of enterprise

courts and legal system too weak and corruptible for property rights and contract enforcement through third party (state) to be effective

Township and Village Enterprises: a form of enterprise where property rights (“residual rights over profits”) are formally vested in local governments

local governments as the main threat on property rights; expectation of future profit stream sufficiently high for local government not to want to “expropriate” private entrepreneur.

competition among local authorities for capital; sufficiently strong local governments to stave off other threats on property rights; …

Example 2: Entry regulation and entrepreneurship (1)• Entry regulations and barriers reduce competition and

generate rents

• Is this good or bad for entrepreneurship?

• World Bank’s Doing Business Surveys based on the presumption that entry regulations are an unmitigated bad

• Implied strategy of institutional reform: focus on reducing the regulatory cost of entry

• Reduce licensing requirements and costs, streamline procedures, speed up bureaucratic processes

• Presumably even if this entails some costs in terms of background checks, enforcements of regulations and standards, and accuracy of tax registers.

Example 2: Entry regulation and entrepreneurship (2)• Maintained hypothesis: entry barriers are the binding

constraint on entrepreneurship

• But entrepreneurship can also be constrained by other factors

• High costs of contracting environment

• Low private returns

• Low level of public inputs

• When problem lies with low returns, the presence of rents can play a useful role

Example 2: Entry regulation and entrepreneurship (3)• Models where rents are required to stimulate private

investment and entrepreneurship:

• Hausmann and Rodrik (2003): rents as returns to cost discovery

• Hellman, Murdock, and Stiglitz (1997): franchise value for banks as an incentive device for monitoring borrowers

• Acemoglu, Aghion, and Zilibotti (2006): rent-sustained long-term relationship to sustain high investment early in the development process

• In all these models, there are second-best reasons why maximizing free entry is not optimal

• Minimizing bureaucratic hurdles may not be optimal when other types of constraints bind as well—e.g., accuracy of tax registers and fiscal constraints

Example 2: Entry regulation and Example 2: Entry regulation and entrepreneurship (4)entrepreneurship (4)

The example of financial controls in East Asia

Relationship between entry rates and economic performance

Example 3: Outward orientation (1)• Best practice: low and uniform tariffs, no QRs, and

WTO membership

• With few exceptions, successful globalizers have pursued different strategies• South Korea and Taiwan: export subsidies

• China: SEZs

• SE Asia and Mauritius: EPZs

• In all cases, discretionary tariff and QR regimes, non-compliance with WTO rules on TRIMS and local-content regulations

Example 3: Outward orientation (2)• What is the advantage of these alternative strategies?

• They generate export-oriented incentives at the margin while keeping protection in place for pre-existing formal-sector activities

• With the benefit of

• Managing employment in the transition

• Managing political economy

• The Latin American pattern as the counterfactual

• The lesson: a given economic objective—outward orientation—can be achieved through different institutional designs, and sometimes it is worth doing things in an unorthodox, round-about way if this serves to relax other constraints elsewhere in the system.

Example 3: Outward orientation (3)Example 3: Outward orientation (3)

A non-Asian illustration: the Mauritian Export Processing ZoneObjective What is problem? Institutional

responsePrerequisites Institutional

complements

Reduce anti-export bias

Import-competing interests are politically powerful and opposed to trade liberalization

export processing zone (Rodrik 1999)

saving boom and supply of foreign investment

Dual labor markets: segmentation between male and female labor force, so that increase female employment in the EPZ does not drive wages up in the rest of the economy. 

Example 4: Monetary policy and credibility (1)• When monetary credibility is binding constraint, making

central bank independent and putting monetary policy on automatic pilot may make sense

• Extreme case: Argentina’s convertibility law

• More broadly, current best-practice of CBI and inflation targeting is based on first-best thinking which takes the only function of monetary authorities to be price stability

Example 4: Monetary policy and credibility (2)• But monetary credibility need not always remain the binding

constraint

• And in a second-best world there will be always be competing objectives

• Argentina’s collapse when binding constraint changes from credibility to competitiveness

• Countries with independent CBs and IT regimes currently face a similar tradeoff

• Free floats and capital mobility typically produce an “overvalued” currency from a developmental perspective

• Which independent CBs pursuing IT have little inclination to counteract

• Lesson: binding constraints change over time and no single set of best-practices will serve all countries well all the time

Caveats

Formal institutions (third-party enforcement)Formal institutions (third-party enforcement)

A typology of formal institutions: a. Market-creating institutions

i. Property rights incl. corporate governance

ii. Contract enforcement

b. Market-regulating institutions i. Regulatory institutions

Anti-trust, prudential regulation, environmental and safety regulations, etc ii. Labor market institutions

iii. Correction of market and coordination failures “Industrial policies”

c. Market-stabilizing institutions (macroeconomic management) i. Monetary, fiscal and currency arrangements

d. Market-legitimizing institutions

i. Redistribution ii. Social insurance

iii. Political democracy

Multiplicity of desirable institutional arrangementsOBJECTIVEOBJECTIVEProductive efficiencyProductive efficiency (static and dynamic)(static and dynamic)

UNIVERSAL PRINCIPLESUNIVERSAL PRINCIPLESProperty rightsProperty rights: Ensure potential and current investors : Ensure potential and current investors can retain the returns to their investments can retain the returns to their investments

IncentivesIncentives: Align producer incentives with social costs : Align producer incentives with social costs and benefits.and benefits.

Rule of lawRule of law: Provide a transparent, stable and : Provide a transparent, stable and predictable set of rules. predictable set of rules.

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTSPLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

What type of property rights? Private, public, cooperative?What type of property rights? Private, public, cooperative?

What type of legal regime? Common law? Civil law? Adopt or What type of legal regime? Common law? Civil law? Adopt or innovate?innovate?

What is the right balance between decentralized market What is the right balance between decentralized market competition and public intervention?competition and public intervention?

Which types of financial institutions/corporate governance are Which types of financial institutions/corporate governance are most appropriate for mobilizing domestic savings?most appropriate for mobilizing domestic savings?

Is there a role for “industrial policy” to stimulate investment in Is there a role for “industrial policy” to stimulate investment in

non-traditional areasnon-traditional areas??

OBJECTIVEOBJECTIVE

Macroeconomic and Macroeconomic and Financial StabilityFinancial Stability

UNIVERSAL PRINCIPLESUNIVERSAL PRINCIPLES

Sound moneySound money: Do not generate : Do not generate liquidity beyond the increase in liquidity beyond the increase in nominal money demand at nominal money demand at reasonable inflation. reasonable inflation.

Fiscal sustainabilityFiscal sustainability: Ensure : Ensure public debt remains public debt remains “reasonable” and stable in “reasonable” and stable in relation to national aggregates. relation to national aggregates.

Prudential regulationPrudential regulation: Prevent : Prevent financial system from taking financial system from taking excessive risk.excessive risk.

PLAUSIBLE DIVERSITY IN PLAUSIBLE DIVERSITY IN INSTITUTIONAL INSTITUTIONAL ARRANGEMENTSARRANGEMENTS

How independent should the How independent should the central bank be?central bank be?

What is the appropriate What is the appropriate exchange-rate regime? exchange-rate regime? (dollarization, currency board, (dollarization, currency board, adjustable peg, controlled float, adjustable peg, controlled float, pure float) pure float)

Should fiscal policy be rule-Should fiscal policy be rule-bound, and if so what are the bound, and if so what are the appropriate rules?appropriate rules?

Size of the public economy.Size of the public economy.

What is the appropriate What is the appropriate regulatory apparatus for the regulatory apparatus for the financial system? financial system?

What is the appropriate What is the appropriate regulatory treatment of capital regulatory treatment of capital account transactions? account transactions?

OBJECTIVEOBJECTIVE

Distributive justice Distributive justice and poverty and poverty alleviationalleviation

UNIVERSAL PRINCIPLESUNIVERSAL PRINCIPLES

TargetingTargeting:: Redistributive Redistributive programs should be programs should be targeted as closely as targeted as closely as possible to the intended possible to the intended beneficiaries. beneficiaries.

Incentive compatibility:Incentive compatibility: Redistributive programs Redistributive programs should minimize incentive should minimize incentive distortions.distortions.

PLAUSIBLE DIVERSITY IN PLAUSIBLE DIVERSITY IN INSTITUTIONAL INSTITUTIONAL ARRANGEMENTSARRANGEMENTS

How progressive should the tax How progressive should the tax system be?system be?

Should pension systems be public Should pension systems be public or private?or private?

What are the appropriate points of What are the appropriate points of intervention: educational system? intervention: educational system? access to health? access to credit? access to health? access to credit? labor markets? tax system? labor markets? tax system?

What is the role of “social funds”? What is the role of “social funds”? conditional cash transfers?conditional cash transfers?

Redistribution of endowments? Redistribution of endowments? (land reform, endowments-at-(land reform, endowments-at-birth) birth)

Organization of labor markets: Organization of labor markets: decentralized or institutionalized?decentralized or institutionalized?

Modes of service delivery: NGOs, Modes of service delivery: NGOs, participatory arrangements., etc.participatory arrangements., etc.

Where do institutions come from?• Demand-side explanations: institutions are created by those who

stand to benefit from them• Colonial origins (Acemoglu, Johnson, Robinson 2001)

• Glaeser et al. (2004) critique

• Initial factor endowments• Type of agriculture: small-holding versus plantation (Engerman and Sokoloff

2002)• Size of educated middle class (Rajan and Zingales 2006)

• Expanding international economic integration• Benign theories

• Trade and capital flows increase demand for “good” institutions• Malign theories

• Increased trade strengthens “regressive” elites (Latin America, U.S. South)

• Supply-side explanations• Imposition by foreign powers

• East Germany, North Korea, Japan(?),..

• Adoption of imported legal norms and rules• “law and development” school

• Institutional innovation and experimentation• Chinese example

• Institutional hysteresis, lock-in

Bottom line• “Good” institutions serve similar functions

• All successful countries provide effective property rights protection and contract enforcement

• maintain macroeconomic stability

• integrate in the world economy

• ensure an appropriate environment for productive diversification and innovation

• provide effective prudential regulation of financial intermediaries

• maintain social cohesion and political stability

• …

• But these general principles do not map directly and uniquely into specific policies

• Successful institutional reform is pragmatic and opportunistic

• It focuses on the binding constraints

• And it does not disregard historical legacies