Institutional Arrangements for Economic Governance

1. Institutional Arrangements for Economic Governance January 2, 2014

2. Summary of the basics

3. Institutions of economic governance

4. Informal versus formal institutions

5. Outline • A second-best strategy for institutional reform • A typology of market-supporting institutions • Multiplicity of institutional forms • Where do institutions really come from?

6. 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.”

7. 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.”

8. 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

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

10. Relational contracting in Africa

11. Some initial lessons • We can get a lot of economic activity in very “poor” institutional environment • Poorly designed institutional reform, following “best practice,” can do more harm than good • 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

12. A second-best strategy for institutional reform • Additional illustrations • Property-rights reform • Entry regulations • Outward orientation • Monetary policy regimes

13. 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?

14. 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 1: Property-rights reform (2) The example of Chinese TVEs

15. 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.

16. 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

17. 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

18. Example 2: Entry regulation and entrepreneurship (4) The example of financial controls in East Asia

19. Relationship between entry rates and economic performance

20. 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

21. 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.

22. Objective What is problem? Institutional response Prerequisites 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 3: Outward orientation (3) A non-Asian illustration: the Mauritian Export Processing Zone

23. 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

24. 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

25. Caveats

26. Formal institutions (third-party enforcement)

27. Multiplicity of desirable institutional arrangements OBJECTIVE Productive efficiency (static and dynamic) UNIVERSAL PRINCIPLES Property rights: Ensure potential and current investors can retain the returns to their investments Incentives: Align producer incentives with social costs and benefits. Rule of law: Provide a transparent, stable and predictable set of rules. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS What type of property rights? Private, public, cooperative? What type of legal regime? Common law? Civil law? Adopt or innovate? What is the right balance between decentralized market competition and public intervention? Which types of financial institutions/corporate governance are most appropriate for mobilizing domestic savings? Is there a role for “industrial policy” to stimulate investment in non-traditional areas?

28. OBJECTIVE Macroeconomic and Financial Stability UNIVERSAL PRINCIPLES Sound money: Do not generate liquidity beyond the increase in nominal money demand at reasonable inflation. Fiscal sustainability: Ensure public debt remains “reasonable” and stable in relation to national aggregates. Prudential regulation: Prevent financial system from taking excessive risk. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS How independent should the central bank be? What is the appropriate exchange-rate regime? (dollarization, currency board, adjustable peg, controlled float, pure float) Should fiscal policy be rule-bound, and if so what are the appropriate rules? Size of the public economy. What is the appropriate regulatory apparatus for the financial system? What is the appropriate regulatory treatment of capital account transactions?

29. OBJECTIVE Distributive justice and poverty alleviation UNIVERSAL PRINCIPLES Targeting:Redistributive programs should be targeted as closely as possible to the intended beneficiaries. Incentive compatibility: Redistributive programs should minimize incentive distortions. PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS How progressive should the tax system be? Should pension systems be public or private? What are the appropriate points of intervention: educational system? access to health? access to credit? labor markets? tax system? What is the role of “social funds”? conditional cash transfers? Redistribution of endowments? (land reform, endowments-at-birth) Organization of labor markets: decentralized or institutionalized? Modes of service delivery: NGOs, participatory arrangements., etc.

30. 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

31. 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