Chapter 5:States and Markets

University of MarylandDepartment of Economics

Economics 416Jeff WerlingSpring 2008

“Generic” economic regimes

• Capitalist/market economy

• Socialist/command economy

• Communist: USSR, Cuba

• Mixed economies: Modern Europe, Scandanavia

• Crony capitalist/corporatist/fascist: Spain before 1976

• “The Asian Way:” Korea, Singapore, Malaysia, etc.

Conventional Neoclassical Economics: markets most efficient way to interchange goods, services, and assets. Is government interfererence

or public investment ever justified?

Circumstances (market failures) where government intervention may be appropriate:• Monopoly/Oligopoly: regulation

– Economies of scale especially important in small, developing nations• External economies/public goods: government provision or subsidy

– public benefits > private benefits – education, infrastructure, clean air– public goods: non-rivalness/nonexclusion in consumption: defense

• External diseconomies/externalities government regulation or tax– private costs < public costs -- pollution– common resources (fisheries, etc.), environmental preservation, congestions

• Infant industry– Case for subsidies of protective tariff? Hard to graduate the infant, often ineffective.

• Underdeveloped institutions• Inadequate or asymmetrical information

– uneven friction in markets create Macroeconomic management for • Macroeconomic management: monetary policy/fiscal policy/exchange rate policy

– macroeconomic imbalances• Other national goals: status of minorities, women, children, elimination of dire poverty,

hunger, etc.

This long list must be interpreted carefully.

• Governments (especially LDCS) have limited capacity, competence and highly suspect motivations.

• Intervention if markets limited to where it is clearly necessary and also effective.

• China furniture exports, tropical forests, and U.S. consumers.

Principles of PostwarDevelopment Thinking

• Pre WWII: Because of Depression, Keynesian Economics displaces Classical economics and the “marginalist” school (laissez faire).

• Post WWII: Need to avoid return to depression with “demand management,” i.e. high faith in government intervention and competence.

Principles of Postwar Development Thinking

• Classical Growth Theory: Importance of Capital Accumulation– Need to jump-start (big-push, take-off) economies through “forced savings” or

foreign aid. Capital fundamentalism, Two Gap Model, Investment subsidies.– Socialism: govt. ownership of capital etc.– Efficiency of investment largely ignored, white elephants, too much capital

intensive technology.

• Surplus labor in the agriculture sector (Fei-Ranis model):– Could remove labor from agriculture and transfer to industry without cost.– Led to neglect and stifling of agriculture, price controls.

• Export Pessimism, Import Substitution, Infant industries– Previous healthy export sectors decimated, infants never grow up and

consumers cheated– Government tries to picks winners and losers?

• Tolerance of inflation with fixed exchange rates– Inflation tax regarded as viable strategy: MV = PQ– Appreciation of real exchange rates made imports cheap and exports

expensive– Multiple and serial BOP problems

Forced mobilization of savings:The Inflation Tax

• Government runs deficit and borrows money from central bank.

• Central bank lends to government by printing money.

• Inflation causes holders of money assets to lose value on assets.

• Govt. debt (and money) declines in value as prices rise.

• Given that LDCs have other, inefficient sources of tax revenue, inflation taxes were once regarded as a substitute for conventional type taxes. They are progressive, and could be more efficient than other tax types.

• For forced mobilization of savings to work must assume:– Government propensity to invest out of income exceeds the private sector.– Government invests more efficiently than private sector.– Revenue elasticity of the tax structure unity or greater.– Efficiency costs for inflation tax are less than those for conventional taxes.

• Problems:– Govt. investment is rarely more efficient than private sector.– Reduction of money holdings and invest. in land, gold, etc.– Curtails private investment by increasing uncertainty, available savings.– Expectations of inflation will decrease collection.

Early days of Development EconomicsGhana Independence 1957 – 1966 (Nkrumah era)

Policies Reflect Contemporary Development Thinking

• Capital Fundamentalism – use foreign capital/domestic savings to create capital.

• Export Pessimism - commodity exports will never earn enough foreign capital to allow growth and investment (terms of trade), Ghana case: cocoa and gold.

• Electricity important primary industry to create linkages: Akomsobo Dam

• Industrialization: Aluminium factory/downstream linkages to port of Tema.

• Import substitution: textiles, apparel, food processing, etc.

• Inward looking strategy

• Surplus labor theory: led to neglect of agriculture, especially cocoa (main export) which was heavily taxed through government cooperatives.

• Socialism: Govt ownership in many sectors including retailing, transport, manufacturing.

• Education – especially primary and secondary.

• Economic development was uneven and halting. Nkrumah became increasingly authoritarian, detention w/o trial, control press, etc. 1964 change to one party state

• Feb. 24, 1966 coup, (Nkrumah tying to end Vietnam War) tried to restore democracy, but policies roughly the same. National Liberation Council – Afrifa, Busia as Prime Minister.

Overvaluation of cedi• How does a currency become overvalued? In 1950s and 1960s,

currencies were fixed under Bretton Woods system (increasingly under stress.)

• Central Bank Financing of Government deficit: MV = PQ

• High inflation (possible hyperinflation) undermines exports competitiveness, makes imports cheap: real exchange rate = ER*Pt/Pn, increase in prices has the same competitiveness effect as appreciation.

• Domestic demand > domestic supply: Current account deficit, foreign borrowing goes to finance consumption.

• Leads to Black Market/Parallel market for foreign exchange. Export industries greatly harmed. Eventually, not enough foreign exchange to import consumption goods & intermediate products. Rationing of intermediate materials and consumer imports. Price and wage controls, especially on essential commodities. Balance of Payments Crisis, pressure to devalue.

• Rent-seeking – market regulation (price controls, rationing, permits, etc.) create opportunities for monopoly profits (rents). Nonproductive activity to capture these rents through bribery, etc.

Ghana in 1970’s• Subsequent devaluation in 1971: inflationary pressure and discontent led to

January 13, 1972 bloodless coup.

• General Acheampong and NRC (National Redemption Council) then SMC (Supreme Military Council): nationalism, economic development, self-reliance. Predictable results: mismanagement and rampant corruption. (mostly Ashantis.)

• Another Coup: 1978: Lt.-Gen. Akuffo (chief-of-staff) SmC-2. (Same as the old boss.) Plans made to return to democracy.

• June 4, 1979 Flight Lt. J.J. Rawlings (AFRC): execute 8 senior officers including Achempong and Akuffo, sentenced many others to long prison sentences and confiscated properties.

• Who was Rawlings?

• September Limann elected President on constitution modeled on U.S. constitution.

• Devaluation a taboo subject: Same old problem of overvalued exchange rate. (3cedis/$) BM: 40cedis/$ -- 100cedis/$ by May 1983.

• December 31, 1981. Beginning of PNDC era. Council was a mixed bag of radical socialist and more rational capitalists.

• 1981 - 83 Bush fires, severe shortage of food, raw materials, everything. No foreign currency for imports. Ghana hits bottom.

Typical BoP Crisis(acute macroeconomic imbalance)

govt deficit > print money > inflation (Pn ) > appreciation of real exchange rate > imports surge, exports fall > current account (trade) deficit > borrow foreign exchange > no more lending! > cannot import essential imports > economy grinds to halt.

RER = E*Pt/Pn

Quantity of Forex

Demand (Imports)

Supply (Exports)

Trade deficit

Rawlings Era• May 1983: Kwesi Botchway goes to IMF for loans and structural

adjustment program.– Devalue and eventually float cedi (adopt auction technique).– Get government spending and tax collection under control.– Remove price controls.– Privatize parastatals.– Pay attention to rural income and production.– Invite FDI.

• Idea was to raise factor productivity. Rawlings started with agriculture sector by removing price controls on food and “deregulating” cocoa production by reforming government cooperatives.

• Changed “terms of trade” between city and countryside.• Challenged industry unions.• Attempted to attract foreign investment.• Growth per capita is once again positive. Development prospects remain

mixed, but political and social culture also improved greatly.

Development Thinking:The Neoclassical Backlash

• Starts in earnest by 1980 (Thatcher/Reagan).

• Labor markets distorted and financial markets suppressed and immature. Market driven economies more efficient, more flexible (even in presence of market failure): Get the Prices Right!

• Harrod Domar model’s emphasis on savings and capital formation invalid. Solow model suggest efficiency of investment and appropriate technology important. Therefore, investment needs to be channeled through market signals.

• Labor surplus theory is bunk. LDCs took agriculture for granted. Severe disruptions in agriculture production leads price controls, food imports, food crises, rural poverty.

• Outward export orientated strategy clearly superior to inward looking import substitution.

• Lots of bloated budgets financed by printing money, inflation, chronic inflation. In turn, inflation often led to overvaluation of exchange rate.

• Governments have limited capacity, competence and highly suspect motivations (Buchanan). Results of early development thinking: Distorted price signals, severe misallocation of resources, inefficiency, inflexibility, rent-seeking corruption, low growth.

The Washington Consensus1. Fiscal Discipline. avoid inflation and BoP problems and capital flight.

2. Change public expenditure priorities. Less subsidies, less military, more infrastructure, education, health.

3. Tax reform. improve incentives, equity, modest marginal tax rates broadening of tax base.

4. Liberalization of interest rates. Interest rates need to be positive in real terms.

5. Competitive exchange rates. Determined by market forces and at level to maintain balance-of-payments equilibrium and exports.

6. Trade liberalization. Elimination of quantitative restrictions (import quotas and import licensing) and a move toward uniform and low tariffs on imported goods.

7. Foreign direct investment liberalization. Restrictions on FDI removed so as to facilitate the inflow of needed capital, skills, and know-how.

8. Privatization. Relieve pressures on the govt budget from subsidies to loss-making public enterprises and promote greater efficiency.

9. Deregulation. Promote competition, especially limitation on entry and exit of firms. Regulations to ensure safety, environment, banking supervision remain justified.

10. Secure property rights. Assure private property rights, espec. providing at reasonable cost to the small-scale, informal sector.

Implementing Market Reforms

Stabilization Program (short term)

• Usually supervised by IMF after BoP crisis, often with lending (standby credits) and conditionality (strings).

• Unwind inflation by reducing govt budget deficit (higer taxes or lower spending).

• Regain control over money supply.

• Devalue or float currency.

• Remove price controls.

• Restrain real wage increases.

• Decontrol interest rates (so they reflect cost of funds in real terms).

Implementing Market ReformsStructural Adjustment (medium to long run)• World Bank or other IFIs supervision.

• Get prices right: remove controls, subsidies, promote markets.

• Ensuring competition thru deregulation, reduced import barriers.

• Privatization.

• Institutions: property rights.

• Timing and Magnitude– Sequencing (ex: liberalize capital controls before or after

current account or financial system (Thailand vs. China)).– Shock Treatment (Poland vs. Russia), (Sachs vs.

Easterly).– Gradual is Better? (China, Vietnam)

• Credibility of reform: use FTA agreements (NAFTA), currency boards, cover of IFIs, etc. to convince citizens of permanance of reform.

Conclusion

• Have the Washington Consensus (sometimes called Neoliberal) Policies been Successful?

• Necessary but not sufficient?

Institutions and Development

• All information was derived from Johannes Jütting’s 2003 paper, “Institutions and Development: A Critical Review”.

• The complete paper on the OECD website can be located at:– http://www.oecd.org/dataoecd/19/63/4536968.pdf

• Johannes Jütting, Senior Economist and Principal Administrator at the OECD Development Centre, leads research dealing with institutions, health, poverty, other important topics.

Economics 416Jeff WerlingSpring 2008

Introduction

• Institutions are defined as “constraints that human beings impose on themselves”. (North, 1990)

• Other definitions include organizational entities, procedural devices, and regulatory framework (Williamson, 2000).

• Encompass cultural context including traditional (informal) institutions and suitability of formal institutions.

• Why doesn’t capital flow from rich to poor countries?

• Institutionalist: developmental successes or failures can be traced largely to institutional setups.

• Reduce transaction costs, facilitate information distribution, shape expectations, provide security, protect rights, more responsive government and better policy.

Institutions: Unsettled Questions• No settled definition.

• We will use: “Institutions are rules that shape the behavior of organizations and individuals in a society.”

• Include restraints and the conditions or regulations governing specific activities.

• They can be formal (constitutions, laws, regulations, contracts, internal procedures of specific organizations) or informal (values and norms).

• Different than organizations (often called social capital): Political, economic and social organizations that influence society and its institutions: political parties, firms and corporations, trade associations, NGOs, PTAs, religious groups, etc.

Why has interest in Institutions increased?• Why doesn’t capital flow from rich to poor countries? (As

predicted by convergence theory.)

• Even good policy does not seem rewarded with high growth. (Ghana).

• Reinforced by development experience of the 1990s: Neoclassical paradigm produced uneven results in E. Europe, Latin America, etc.

• Poland vs. Russia

• Latin America vs. Asia

• Ghana vs. South Korea

• Neoclassical (policy-based) explanations for development seemed insufficient.

• No real news for political scientists, sociologists.

Institutionalists

• Trade or steal?

• Institutions are linked to growth and development. “Institutions matter” or “New Institutional Economics”

• Institutionalist: developmental successes or failures can be traced largely to institutional setups.

• Causal links and mechanisms still up for debate.

• Policy implications are vague and often based on strong assumptions of causality.

• Now emphasis is how can we transform institutions.

Classification of Institutions• Formal

– Written rules– Constitutions, laws, property rights, contracts, charters, and

regulations– Enforcement characteristics (sanctions, etc.)

• Informal– Often non-written– Extensions, elaborations and modifications of informal rules.– Socially sanctioned norms of behavior (trust, customs, taboos,

traditions)– Internally enforced standards of conduct

• Informal institutions relatively more important in poor countries, where formal institutions are less developed.

• While formal institutions can change overnight due to political decisions, informal institutions (customs, traditions, and codes of conduct) are much more difficult to change.

• Ideally, informal & formal institutions should complement each other. Especially important for societies in transition.

Classifications of Institutions• Levels of Hierarchy: Different levels are interconnected.

• Level 1: Social structure and conduct.– Includes most of the informal institutions such as traditions, social

norms, and customs.– Marriage, caste, hierarchies, etc. Hardest to change.

• Level 2: Rules of the game, overall institutional environment..– Formal rules defining property rights and judiciary system.– Constitution.

• Level 3: Governance, play of the game, building organizations.– Build the governance structure of a society, leading to the creation of

local, state, or national agencies .– Contracts, laws, regulations.

• Level 4: Economic allocation mechanisms.– Markets regulation, employment, social security system.– Easiest to change

Classifications of InstitutionsAreas of Analysis• Economic Institutions

– Rules that define production, allocation, and distribution of goods and services and markets.

• Political Institutions– Details about elections, electoral rules, type of political system,

measures of checks and balances, and political stability.

• Legal Institutions– Refer to the type of legal system, the definition and

enforcement of property rights and legal origin.

• Social Institutions– Rules involved with access to healthcare, education and social

security arrangements.– Also have an impact on gender balance.

Classifications of Institutions

Institutions

Formality Hierarchy Areas

Formal

Informal

Level 1

Level 2

Level 3

Level 4

Economic

Political

Law

Social

To Summarize…

Why are Institutions Important for Development? What do they do?

• Information problems (asymmetric): used car maket, financial markets.

• Adverse selection (Wikipedia): a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. – Example: Market for lemons (Akerloff)– Example: Good vs. bad borrowers at average interest rate.

6% for deposits, 50/50 chance at default good will borrow at 10%, bad will borrow at any level. Loan rate is 12%, only bad borrow.

– Example: Health insurance premiums that are independent on health levels/behavoirs. Can private health insurance market exist?

• Moral hazard: a party insulated rom risk (with insurance for example) will act more risky. – Example: FSLIC (Savings and loan insurance), health/auto insurance.

Institutional solutions to information problems

Modern:• Finance and insurance: disclosure rules.• Regulation of access (licenses).• Regulation of standards (food, cars).• Rating agencies, credit reporting.• Warranties, returns, brand names, chain stores.

Traditional:• Reputation, repeated transactions, relational contracting.• Not what you know, but who you know.

What are the benefits from upgrading to more modern institutions?

The Commitment / Hold-Up Problem

• (Wikipedia) A situation where two parties (such as a supplier and a manufacturer) may be able to work most efficiently by cooperating, but refrain from doing so due to concerns that they may give the other party increased bargaining power, and thereby reduce their own profits.– Example: Exxon invests $10 billion into an LDC oil field, which

then raises the royalty rate previously agreed upon. Subsequently, Exxon refuses to invest in that country (or others).

• Expropriation was once very common.• Institutional Solutions: Binding legally enforcable

contracts, specification and protection of property rights.• Non-formal: social norms, family ties, witness (marriage)

Cooperation Problems

Examples:

• Public goods/free riders (taxes become obligatory).

• Pollution/Fisheries: regulations on common resources.

• Collective action: democracy

• How do we develop trust, absence of corruption, etc.?

How Institutions Affect Growth and Development:Cross-sectional Studies

• What is most important: Geography, Policy or Institutions?– Some researchers feel that institutions are the most

important factor for growth. – Others contend that geography and integration into the

trade system are important.

• GDP per capita (level or growth) as dependent variable.

• Sometimes investment, trade, stability, etc. as independent variable.

• Geographic variables: proximity to transport (water), natural resource endowment, prevalence of disease, temperate zones, etc. (always exogenous)

• Policy variables: Trade, inflation, exchange rate, etc.

How Institutions Affect Growth and Development:Cross-sectional Studies

• Institutions: Rule of law, independence of judiciary and civil service, government effectiveness, bureaucratic quality, corruption, security of property rights, democracy, checks on govt. power.

• Independent variables usually through surveys or rankings.

• Many studies show that high quality institutions have direct and indirect impacts on growth:– Increase in confidence, investment, capital stock.– More efficient transactions, less rent seeking.– High inventory of social capital.– Meritocracy means high return to education. – Greater govt accountability provides better policies.– Better management of ethnic diversity and conflicts.

Institutions: Survey data

Cross-section: Institutional quality and GDP per capita

Cross-section: Institutional quality and private investment growth

How Institutions Affect Growth

Institutions

Income and Growth

Investment

Integration/Trade

Stock of social capital

Political instability

Managing (ethnic) conflicts

Policies

Direct Effect

Indirect effectGeography

?

Cross-sectional Studies

• Problems…• It is sometimes difficult to analyze evidence due to

differences in definitions and causalities.

– Correlation and Causality: Does higher income facilitate the evolution of better institutions?

– Does trade and openness help institutions?

– Political stability contributes to growth, but what institutional arrangement led to political stability?

– Data and Methodological Problems: Are institutions exogenous or endogenous? (geography)

– Policy Conclusions: Can any concrete policy lessons be derived from the analyses?

Country Case Studies

• Studies focus on a single institution and its impacts.

• Stress importance of informal institutions.– Lower transaction costs– Sometimes lead to social exclusion

• Desirability of linking formal with informal institutions.– Informal institutions should be used as a “building

block” for formal rules.– Informal institutions are flexible and inexpensive,

while formal institutions can be enforced.

Country Case Studies

• Limitations and Deficits…

– A more precise definition of institution is needed as it is used in the researched context.

– The local setting and other variables that affect the outcome need to be accounted for during the analysis.

– A solution needs to be developed, instead of merely stating an obvious problem with an institution.

Conclusions

• Future studies should:– Include a clear definition of what an institution

is in a specific context.– Differentiate between exogenous and

endogenous variables that affect the outcome.

– Offer detailed policy recommendations.