One Economics, Many One Economics, Many RecipesRecipes

Dani RodrikDani Rodrik

IEA, June 2008IEA, June 2008

The new thinking on growth The new thinking on growth strategies (1)strategies (1)

Presumptive strategies Presumptive strategies – ISIISI– Washington ConsensusWashington Consensus– Big PushBig Push– Governance agendaGovernance agenda

Long laundry list of reformsLong laundry list of reforms– In a wide range of areas: trade, fiscal, social, legal, In a wide range of areas: trade, fiscal, social, legal,

regulatory, etc.regulatory, etc. Focus on complementarity of reforms rather than Focus on complementarity of reforms rather than

prioritization or sequencingprioritization or sequencing A bias towards universal recipes, “best-A bias towards universal recipes, “best-

practices,” and rules of thumbpractices,” and rules of thumb

The new thinking on growth The new thinking on growth strategies (2)strategies (2)

Diagnostic strategies Diagnostic strategies – We do not know ex ante what works and what doesn’tWe do not know ex ante what works and what doesn’t– Need to look for binding constraints Need to look for binding constraints

Which tend to be context-specificWhich tend to be context-specific– Experimentation central part of discoveryExperimentation central part of discovery– Monitoring and evaluation equally centralMonitoring and evaluation equally central

Focus on selective, more narrowly targeted Focus on selective, more narrowly targeted reformsreforms

Based on the idea that there exists lots of slackBased on the idea that there exists lots of slack– Well targeted reforms can produce a big bangWell targeted reforms can produce a big bang

Skeptical of “best-practice,” universal remediesSkeptical of “best-practice,” universal remedies– Looking for policy innovations that unlock local second-Looking for policy innovations that unlock local second-

best/political complicationsbest/political complications

The Litmus testThe Litmus test

Do you believe there is an unconditional Do you believe there is an unconditional and unambiguous mapping from specific and unambiguous mapping from specific policiespolicies to economic outcomes? to economic outcomes?– If yes, you are in the presumptive campIf yes, you are in the presumptive camp– If no, you must rely on the diagnostic strategyIf no, you must rely on the diagnostic strategy

Illustrations from three domains of Illustrations from three domains of institutional reforminstitutional reform

1.1. Contract enforcement: improving courts Contract enforcement: improving courts and judicial efficiency?and judicial efficiency?

2.2. Entrepreneurship: reducing entry barriers Entrepreneurship: reducing entry barriers and “cost of doing business”?and “cost of doing business”?

3.3. Outward orientation: low, uniform import Outward orientation: low, uniform import tariffs and WTO rules?tariffs and WTO rules?

In each of these areas, conventional best In each of these areas, conventional best practices may often be the wrong way to practices may often be the wrong way to go go

An African story (1)An African story (1)

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

Firms rarely resort to themFirms rarely resort to them They rely on They rely on relational contractingrelational contracting instead: instead:

– long-term, trust-based relationships with long-term, trust-based relationships with suppliers and customerssuppliers and customers

– screen potential business partners by screen potential business partners by gathering informationgathering information

– inspect goods on delivery prior to paymentinspect goods on delivery prior to payment– frequently renegotiate when contract terms are frequently renegotiate when contract terms are

not fulfilled not fulfilled

Source: Bigsten et al. (1999)

An African illustration (2)An African illustration (2)

An African illustration (3)An African illustration (3)

In view of the extremely poor contracting In view of the extremely poor contracting environment, it is natural to deduce that:environment, it is natural to deduce that:– The legal system renders doing business in The legal system renders doing business in

Sub-Saharan Africa extremely difficultSub-Saharan Africa extremely difficult– Poor economic performance of the private Poor economic performance of the private

sector in Africa is at least partly due to the sector in Africa is at least partly due to the weakness of the regime of contract weakness of the regime of contract enforcementenforcement

– And a program of judicial reform is an urgent And a program of judicial reform is an urgent priority priority

But are these conclusions warranted?But are these conclusions warranted?

Consider Vietnam (1)Consider Vietnam (1)

2000 2005 2006

GDP (current US$) 31.2 billion 52.9 billion 60.9 billion

GDP growth (annual %) 6.8 8.4 8.2

Exports of goods and services (% of GDP) 55 70 ..

Imports of goods and services (% of GDP) 57.5 75.2 ..

Gross capital formation (% of GDP) 29.6 35.4 ..

Merchandise trade (% of GDP) 96.6 131.2 138

Foreign direct investment, net inflows (BoP, current US$) 1.3 billion 2.0 billion ..

Consider Vietnam (2)Consider Vietnam (2)

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

Source: McMillan and Woodruff (1999)

How firms solve contracting How firms solve contracting problems in Vietnamproblems in Vietnam

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

In other words, they use exactly the same relational In other words, they use exactly the same relational contracting strategies as firms in Africacontracting strategies as firms in Africa

Even in the absence of courts, relational Even in the absence of courts, relational contracting can support high levels of contracting can support high levels of

economic activityeconomic activity Sort of like traffic in Hanoi…Sort of like traffic in Hanoi…

http://www.youtube.com/watch?v=eC4BN9kInXg

And intermediate levels of “legality” And intermediate levels of “legality” may not be an improvementmay not be an improvement

Source: Johnson, McMillan, and Woodruff (1999)

A little bit of improvement in the judiciary can A little bit of improvement in the judiciary can make things worsemake things worse

Sort of like traffic in St. Petersburg…Sort of like traffic in St. Petersburg…

http://www.youtube.com/watch?v=H2JFL1Sk21Y

Lessons from the Vietnamese Lessons from the Vietnamese experience and comparisons (1)experience and comparisons (1)

1.1. We can get a lot of economic growth in a We can get a lot of economic growth in a very poor institutional environmentvery poor institutional environment

– Formal institutions of property rights and Formal institutions of property rights and contract enforcement are not always a contract enforcement are not always a binding constraintbinding constraint

2.2. Poorly designed institutional reform can Poorly designed institutional reform can do more harm than gooddo more harm than good

– Taking Taking secondsecond-best interactions into account-best interactions into account

Lessons from the Vietnamese Lessons from the Vietnamese experience and comparisons (2)experience and comparisons (2)

3.3. Appropriate reform strategies are Appropriate reform strategies are inherently second-bestinherently second-best

– Working around existing constraints, building Working around existing constraints, building on existing strengthson existing strengths

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

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

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

Example 2: Entry regulation and Example 2: Entry regulation and entrepreneurship (1)entrepreneurship (1)

Entry regulations and barriers reduce competition Entry regulations and barriers reduce competition and generate rentsand generate rents

Is this good or bad for entrepreneurship?Is this good or bad for entrepreneurship? World Bank’s Doing Business Surveys based on World Bank’s Doing Business Surveys based on

the presumption that entry regulations are an the presumption that entry regulations are an unmitigated badunmitigated bad

Implied strategy of institutional reform: focus on Implied strategy of institutional reform: focus on reducing the regulatory cost of entryreducing the regulatory cost of entry– Reduce licensing requirements and costs, streamline Reduce licensing requirements and costs, streamline

procedures, speed up bureaucratic processesprocedures, speed up bureaucratic processes– Presumably even if this entails some costs in terms of Presumably even if this entails some costs in terms of

background checks, enforcements of regulations and background checks, enforcements of regulations and standards, and accuracy of tax registers. standards, and accuracy of tax registers.

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

Maintained hypothesis: entry barriers are Maintained hypothesis: entry barriers are the binding constraint on entrepreneurshipthe binding constraint on entrepreneurship

But entrepreneurship can also be But entrepreneurship can also be constrained by other factorsconstrained by other factors– High costs of contracting environmentHigh costs of contracting environment– Low private returnsLow private returns– Low level of public inputsLow level of public inputs

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

Example 2: Entry regulation and Example 2: Entry regulation and entrepreneurship (3)entrepreneurship (3)

Models where rents are required to stimulate Models where rents are required to stimulate private investment and entrepreneurship:private investment and entrepreneurship:– Hausmann and Rodrik (2003): rents as returns to cost Hausmann and Rodrik (2003): rents as returns to cost

discoverydiscovery– Hellman, Murdock, and Stiglitz (1997): franchise value for Hellman, Murdock, and Stiglitz (1997): franchise value for

banks as an incentive device for monitoring borrowersbanks as an incentive device for monitoring borrowers– Acemoglu, Aghion, and Zilibotti (2006): rent-sustained Acemoglu, Aghion, and Zilibotti (2006): rent-sustained

long-term relationship to sustain high investment early in long-term relationship to sustain high investment early in the development processthe development process

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

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

Relationship between entry rates Relationship between entry rates and economic performanceand economic performance

Source: Klapper et al. (2007)

Example 3: Outward orientation (1)Example 3: Outward orientation (1)

Best practice: low and uniform tariffs, no Best practice: low and uniform tariffs, no QRs, and WTO membershipQRs, and WTO membership

With few exceptions, successful globalizers With few exceptions, successful globalizers have pursued different strategieshave pursued different strategies– South Korea and Taiwan: export subsidiesSouth Korea and Taiwan: export subsidies– China: SEZsChina: SEZs– SE Asia and Mauritius: EPZsSE Asia and Mauritius: EPZs– In all cases, discretionary tariff and QR In all cases, discretionary tariff and QR

regimes, non-compliance with WTO rules on regimes, non-compliance with WTO rules on TRIMS and local-content regulationsTRIMS and local-content regulations

Example 3: Outward orientation (2)Example 3: Outward orientation (2)

What is the advantage of these alternative What is the advantage of these alternative strategies?strategies?

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

With the benefit of With the benefit of – Managing employment in the transitionManaging employment in the transition– Managing political economyManaging political economy

The Latin American pattern as the counterfactualThe Latin American pattern as the counterfactual The lesson: a given economic objective—outward The lesson: a given economic objective—outward

orientation—can be achieved through different orientation—can be achieved through different institutional designs, and sometimes it is worth institutional designs, and sometimes it is worth doing things in an unorthodox, round-about way if doing things in an unorthodox, round-about way if this serves to relax other constraints elsewhere in this serves to relax other constraints elsewhere in the system. the system.

Bottom line: “good” institutions serve Bottom line: “good” institutions serve similar functions…similar functions…

All successful countriesAll successful countries provide effective property rights protection and contract provide effective property rights protection and contract

enforcement enforcement maintain macroeconomic stabilitymaintain macroeconomic stability integrate in the world economyintegrate in the world economy ensure an appropriate environment for productive ensure an appropriate environment for productive

diversification and innovationdiversification and innovation provide effective prudential regulation of financial provide effective prudential regulation of financial

intermediariesintermediaries maintain social cohesion and political stabilitymaintain social cohesion and political stability ……

East Asian institutional “anomalies”East Asian institutional “anomalies”Institutional domain Standard ideal “East Asian” pattern

Property rights Private, enforced by the rule of law Private, but govt authority occasionally overrides the law (esp. in Korea).  

Corporate governance Shareholder (“outsider”) control, protection of shareholder rights  

Insider control

Business-government relations Arms’ length, rule based Close interactions 

Industrial organization 

Decentralized, competitive markets, with tough anti-trust enforcement 

Horizontal and vertical integration in production (chaebol); government-mandated “cartels”

Financial system Deregulated, securities based, with free entry. Prudential supervision through regulatory oversight.

Bank based, restricted entry, heavily controlled by government, directed lending, weak formal regulation. 

Labor markets Decentralized, de-institutionalized, “flexible” labor markets

Lifetime employment in core enterprises (Japan) 

International capital flows “prudently” free Restricted (until the 1990s)  

Public ownership None in productive sectors Plenty in upstream industries. 

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

How China did it:How China did it: Pragmatic, often heterodox solutions to overcome political Pragmatic, often heterodox solutions to overcome political

constraints and second-best complications constraints and second-best complications – Two-track pricingTwo-track pricing insulates public finance from the provision insulates public finance from the provision

of supply incentivesof supply incentives – Household responsibility systemHousehold responsibility system obviates the need for obviates the need for

ownership reforms ownership reforms – Township and village enterprisesTownship and village enterprises provide effective control provide effective control

rights when courts are weakrights when courts are weak– Special economic zones Special economic zones provide export incentives without provide export incentives without

removing protection for state firmsremoving protection for state firms– Federalism, “Chinese-style”Federalism, “Chinese-style” generates incentives for policy generates incentives for policy

competition and institutional innovationcompetition and institutional innovation

Strategic and sequential approach targeting one binding Strategic and sequential approach targeting one binding constraint at a timeconstraint at a time– First agriculture, then industry, then foreign trade, now First agriculture, then industry, then foreign trade, now

finance…finance…

Successful institutional reform is pragmatic Successful institutional reform is pragmatic and opportunistic…and opportunistic…

… it focuses on the binding constraintsProblem: Low levels of private investment and entrepreneurship

High cost of financeLow return to economic activity

Low social returns Low appropriability

government failures

market failures

poor geography

low human capital

bad infra-structure

micro risks: property rights,

corruption, taxes

macro risks: financial,

monetary, fiscal instability

information externalities:

“self-discovery”

coordination externalities

bad international finance

bad local finance

low domestic saving

poor inter-

mediation

And it does not disregard historical legaciesAnd it does not disregard historical legacies

Historical and geographic determinants of institutionsHistorical and geographic determinants of institutions Demand-side explanations: institutions are created by those Demand-side explanations: institutions are created by those

who stand to benefit from themwho stand to benefit from them– Colonial origins (Acemoglu, Johnson, Robinson 2001)Colonial origins (Acemoglu, Johnson, Robinson 2001)

Glaeser et al. (2004) critiqueGlaeser et al. (2004) critique– Initial factor endowmentsInitial factor endowments

Type of agriculture: small-holding versus plantation (Engerman and Type of agriculture: small-holding versus plantation (Engerman and Sokoloff 2002)Sokoloff 2002)

Size of educated middle class (Rajan and Zingales 2006) Size of educated middle class (Rajan and Zingales 2006) – Expanding international economic integrationExpanding international economic integration

Benign theoriesBenign theories– Trade and capital flows increase demand for “good” institutionsTrade and capital flows increase demand for “good” institutions

Malign theoriesMalign theories– Increased trade strengthens “regressive” elites (Latin America, U.S. South) Increased trade strengthens “regressive” elites (Latin America, U.S. South)

Supply-side explanationsSupply-side explanations– Imposition by foreign powersImposition by foreign powers

East Germany, North Korea, Japan(?),..East Germany, North Korea, Japan(?),..– Adoption of imported legal norms and rulesAdoption of imported legal norms and rules

““law and development” schoollaw and development” school– Institutional innovation and experimentationInstitutional innovation and experimentation

Chinese exampleChinese example

Bottom lineBottom line

““Rules of thumb” reform is not good Rules of thumb” reform is not good economicseconomics

Second-best institutional reform will often Second-best institutional reform will often produce “heterodox” resultsproduce “heterodox” results

That is not because it disregards That is not because it disregards economics, but to the contrary, because it economics, but to the contrary, because it takes economics seriouslytakes economics seriously