Transcript Institutions, Governance and Globalization notes

Macroeconomic Topics in
Development & Transition
EC938
Sharun W. Mukand
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Four meta-theories of institutions
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Efficiency: institutions that are efficient for society (e.g., for
aggregate growth or welfare) will be adopted.
Ideology: differences in beliefs determine institutions (societies
choose radically different institutions because citizens or elites
have different beliefs about what’s good for economic growth).
Perhaps North Korea chose planned economy because its
leaders believed it was “better”.
History: institutions determined by historical accidents or
unusual events, and are unchanging except for random events
and further accidents.
Legal system today determined by past historical accidents.
Social conflict: institutions chosen for their distributional
consequences by groups with political power.
Which approach? (Efficient Institutions)
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Although, everything else equal, there would be a tendency to adopt
efficient institutions, everything else far from equal in practice.
Every set of institutions creates different losers and beneficiaries. Efficient
institutions require either the losers to be compensated or the
beneficiaries to impose their choice.
But in practice, losers generally not compensated ex post, and often can
be powerful enough to block institutional change that is beneficial in the
aggregate.
Empirically, efficient institutions view cannot help us understand why
some societies adopt institutions that were disastrous for economic
growth.
(approach not very useful)
Institutional persistence: some
things we know
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Institutions are by their nature durable:
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Bad institutions create bad incentives and self-sustain
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e.g., if controlling the state is a major source of rents, there will be
infighting to control the state as in Ghana.
Bad institutions affect the composition of assets and
distribution of income, contributing the persistence:
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e.g., an extractive state apparatus will give incentives to political
elites to use it for extraction.
Bad institutions create instability and self-replicate
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e.g., democracy more likely tomorrow if today there is democracy
than if dictatorship today.
e.g., bad institutions  greater inequality  political power of the
rich to sustain bad institutions.
Institutional change (1)
Towards a theory of institutional change:
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2.
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Recall:
political institutions  economic institutions
Thus important to understand change in political
institutions
Political institutions a way of regulating the
allocation of future political power
Two axes:
Elite-driven versus conflict-driven
Internal versus external
Institutional change (2)
Elite-driven: when the politically powerful elite wish to
change institutions in order to increase its
rents/utility.
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E.g., the U.S. Constitution or the imposition of different
systems of land relations in the Dutch East Indies.
Conflict-driven: when institutional change forced from
the non-elites. E.g.:
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Rise of democracy because of the threat of revolution.
Rise of constitutional monarchy resulting from the fight between
the crown and groups of merchants in Britain and the
Netherlands.
Institutional change (3)
Internal: because of internal shocks or dynamics.
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External: because of external imposition, shocks, or
external incentives.
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E.g., rise of democracy.
E.g., colonial imposition of institutions, Korean response to
threat of communism.
E.g., EU incentives for East European reform.
Even with external imposition, internal dynamics are
very important  the pitfall of ignoring internal
dynamics.
Conclusions (1)
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Institutions matter.
Although ideology and history influence institutions, in
many many cases institutions emerge because of their
distributional consequences.
Although everything else equal more efficient
institutions more likely to arise, there will typically be
major social conflict over institutions.
Then the choices benefiting politically powerful groups,
not the society as a whole, more likely to emerge.
Conclusions (2)
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Summary: towards a dynamic theory
De jure power
(Political institutions)t
De facto powert
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Economic institutionst
political
powert
Economic policiest
Political institutionst+1
Governance matters…
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Governance matters..
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Governance…
Some Considerations:
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Some countries are rich and others are poor.
Economic development/Institutional change is difficult:
(i)
Need for coordination  Role for Government.
(ii)
Political factors further impede government’s ability to carry out change.
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THE WASHINGTON CONSENSUS
Good governance in developing countries REQUIRES …
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1. Fiscal discipline
2. Reorientation of public expenditures
3. Tax reform
4. Financial liberalization
5. Unified and competitive exchange rates
6. Trade liberalization
7. Openness to DFI
8. Privatization
9. Deregulation
10.Secure Property Rights
The international capital market/IMF/World Bank – insisted in its policy
recommendations that there is a unique path to development…policy
reforms required…
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“In Search of the Holy Grail: Policy Convergence, Experimentation and
Economic Performance” (2005) American Economic Review
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Developing countries have undertaken “Washington consensus” style
reform during the eighties and nineties.
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Policy convergence  Economic convergence??
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Why the discrepancy?
(i)
Countries not implementing economic reform in first place (i.e. no policy
convergence).
Universal applicability of policy?? Is it a reasonable assumption.
(ii)
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Appropriate reforms and policies have a large element of
specificity and experimentation is required to discover what works
locally…..
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Two track reform worked well in Deng’s China but not in
Gorbachev’s Soviet Union.
Gradualism may work in India but not in Chile
Import Substitution may be appropriate in Brazil but not Argentina
Privatization may be necessary in Latin America but not Asia…..
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We distinguish between economic principles and their institutional
embodiment. Most first-order economic principles come institution
free…incentives, competition, hard budget constraints, sound money,
fiscal sustainability…are central to the way economists think.
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However, these universal economic principles do not of themselves map
into specific institutional solutions…
Property rights can be implemented through common law, civil law or
Chinese-style socialism…
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Are we implying that economic principles work differently in different
places…?
No.
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Countries located on unit circle: countries differ in terms of their “location”:
dictated by differences in history, geography, culture.
Country “location” given by zi.
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Country can either “Imitate” and adopt institutions developed and refined
in other countries or “Experiment” and engage in institutional innovation.
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Both “Imitation” and “Experimentation” have both an upside and a
downside.
Imitation  no uncertainty about the blueprint (+)
 may adopt institutions that are not appropriate for
local conditions (loss in output) (-).
Experimentation  uncertainty (-)
 institution may be adapted to local needs (+)
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If a country’s location is zj and the institutional/policy choice is ai
then the expected output is given by:
yi = -θ(ai - zj)2
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Government preferences: Vi = yi – λK;
where
λ = 1 if govt. experiments and,
λ = 0 if govt imitates policy/institutions.
K = private fixed cost paid by govt. if it
experiments.
Uncertainty with Experimentation: Government has imperfect
control: if it chooses ai’ = zi + η , where η ~N(0, σ2).
Imitation:
Eyi(IMIT)= -θ(a1 – z2)2
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Experimentation:
Ey(EXPT.) =E{ -θ(a’2 – z2)2 – F}
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Experimentation versus Imitation: Govt. in country i will prefer
imitation to experimentation if…
Ey(IMIT) ≥ Ey(EXPT.)
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In the immediate “neighborhood” of the successful leading country,
follower countries prefer to “imitate” the leader  growth pole across the
successful leader.
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Countries far from the leader – the “far-periphery” will experiment.
Economic performance is on average worse than that of the leaders 
but much greater “variance” than the followers.
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The worst performing followers should be at some `intermediate’ distance
from the leader country.
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Economic Performance should show a U shaped relationship when
plotted against distance.
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Institutional Adoption:
The Transition Economies as an Experiment
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Around 1990: socialism has failed! There is no ambiguity about whether
countries searching for new institutions to replace socialism.
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Set of countries searching for new institutions can be cleanly identified: all
former socialist countries.
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Plausible notion of “distance”….?...
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Provides a framework to think about the “specificity” of policy
implementation.
Economic Policy (universal economic principle)
+
Institutional Specificity
Economic Outcomes (e.g. economic growth, pcy)
In light of specificity, insistence by international K mkt., IMF, World Bank that
developing countries adopt the “Washington Consensus” set of
policies/institutions to be successful 
BAD ADVICE 
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In light of specificity, insistence by international K mkt., IMF, World Bank that
developing countries adopt the “Washington Consensus” set of
policies/institutions to be successful 
BAD ADVICE 
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Transition economies  even a decade later, had yet to catch up with
pre-transition levels of pcy
Sub-Saharan Africa did not take off despite significant reforms…
Frequent and painful financial crises in LA/East Asia/Russia…
Latin American Recovery of the90s was short-lived…crash of Argentina
(the poster boy for Washington consensus policies)…
(“Goodbye Washington Consensus, Hello Washington Confusion?” Dani
Rodrik (2006), Journal of Economic Literature
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IMF claim: Policy Reform did not yield sustained results in many
developing countries because
(i) genuine reform was skin deep with no `follow through’,
(ii) Reforms in face of poor institutions was not sustainable. Regulatory mkts
weak, Corruption endemic...
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New set of `Washington consensus’ reforms  heavy emphasis on
Institutional Reform.
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Are Institutions key to growth and development?
Comparative Growth Experience
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Per capita GDP
1960
Per capita GDP
1990
P.C. growth
(1960-89)(%)
South Korea
883
6206
6.82
Taiwan
1359
8207
6.17
Ghana
873
815
-0.54
Mozambique
1128
756
-2.29
Brazil
1745
4138
3.58
Argentina
3294
3608
.63
Globalization and Governance
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(1)
(2)
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Developing countries:
Weak political institutions  Political Selection weak  poor leaders 
Bad governments.
Poor Economic institutions  imperfect contract enforcement, rule of
law..
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Weak Economic and Political Institutions  Economic Insecurity  low
investment  low economic growth  poverty and underdevelopment.
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How do we develop new, better quality growth promoting institutions?
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What is the impact of globalization on a government’s incentive to
adopt good quality institutions?
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Globalization and Growth:
How to make poor countries grow when Governance poor?
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Attract capital…(one way)…
(i) attract Foreign Aid;
(ii) IMF help
(iii) Foreign Investment (FDI, Portfolio equity investment…)
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Bad Governance and the Globalization of Capital
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•
LDCs typically have a high marginal product of capital. So
investment should flow to developing countries.
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However, typically developing countries lack financial markets
that allow transfer of funds from savers to borrowers
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Weak enforcement of economic laws and regulations
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Weak enforcement of property rights makes investors less willing to
engage in investment activities and makes savers less willing to
lend to investors/borrowers.
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Weak enforcement of bankruptcy laws and loan contracts makes
savers less willing to lend to borrowers/investors.
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Over the past decade, emerging market bond markets have deepened
markedly.
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Volume of international securities by emerging market sovereigns and
corporates has increased from a level of $325 million in 1995 to roughly
$700 million in 2003.
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“Don’t Mess With Moodys” New York Times 1995.
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“In the 1960's the most important visitor a developing country could have
was from the head of AID, the U.S. agency that doled out foreign aid. In
the 1970's and 80's the most important visitor a developing country could
have was from the I.M.F., to help restructure its economy. In the 1990's
the most important visitor a developing country can have is from Moody's
Investors Service Inc.
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Because we now live in an age when governments are basically broke,
the only way for most countries to raise cash for development is either to
enforce savings at home or attract investors from the world's major bond
markets. Moody's is the credit rating agency that signals the electronic
herd of global investors where to plunk down their money, by telling them
which countries' bonds are blue-chip and which are junk.
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That makes Moody's one powerful agency. In fact, you could almost say
that we live again in a two-superpower world. There is the U.S. and there
is Moody's. The U.S. can destroy a country by leveling it with bombs;
Moody's can destroy a country by downgrading its bonds.
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Moody's rates the investment quality of countries today just as it rates
companies. Those that get their economic house in order will be rated
AAA and be able to sell bonds at low interest. Those that don't will be
rated C and have to pay pawnbroker interest rates
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….. Moody's and the bond market are now imposing on democracies
economic and political decisions that the democracies, left to their own
devices, simply cannot take.”
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(Thomas Friedman in the New York Times, 1995)
Disciplining and the International Capital Market
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Disciplining effect of the international capital market?
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Can the international capital market improve global governance through
punishing poor governance and rewarding good governance?
Foreign Direct Investment Stocks
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International integration of product markets may be fostered by FDI
stocks (FDI is long term and flows are volatile)
World FDI Stock as a % of World Output
----------------------------------------------------------------------1913 1960
1975
1980
1997
--------------------------------------------------------------------9.0 4.4
4.5
4.8
11.8
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FDI/GDP ratio highest for France/UK in 1914
and UK/Germany in 1997.
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Traditionally FDI/Foreign Aid main form of capital flows to developing
countries. In recent decades things have changed….
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Net capital flows to developing countries, 1996-2004
Net inflows ($ billions)
200
Foreign direct
investment
150
Worker
remittances
Bonds
50
ODA
Portfolio equity
0
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 FDI and remittances dominate
unofficial flows
 FDI is becoming increasingly
concentrated
100
-50
1996
 Unofficial flows to developing
countries far outstrip official
flows
Bank loans
1997
1998 1999
2000
2001
2002 2003
Source: World Bank Global Development Finance 2005
2004
 FDI outflows have surged
dramatically to $40 billion
(South-North and South-South
investment)
 Corporate bonds and portfolio
equity will also become
increasingly important in middleincome countries
External capital structure
Emerging and developing countries
230
200
Gross external debt
(pct of exports )
170
140
110
80
50
Official reserves
(pct of exports)
20
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
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The Fire Tomorrow: Sorting out the sheep from the goats
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The Confidence Game
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“Washington's preoccupation has been not economic fundamentals but
market confidence. And what does it take to restore confidence? Policies
that may not make sense in and of themselves but that policymakers
believe will appeal to the prejudices of investors--or, in some cases, that
they believe will appeal to what investors believe are the prejudices of
their colleagues” Paul Krugman
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“Governing the Global Economy: Does One Architecture Style Fit All” Dani Rodrik
(1999) available at http://ksghome.harvard.edu/~drodrik/papers.html
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“Globalization and the Confidence Game” Mukand in Journal of International
Economics (2006)
The Confidence Game: will the government always choose a policy in
accordance with its private signal?
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Unknown State of the World: {SL, SR}. Prior is that SR is more likely.
Different policies appropriate for different states of the world:
SL ------------ aL - GL
SR ------------ aR  GR
However, a mismatch results in low productivity, e.g. G = 0.
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Y = G f(k) = G. (k)α
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Government receives a private signal sj that is more reliable than the
prior.
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Govt. then chooses to implement either policy aL or aR. (Socially optimal
for government to use all available information in making making its policy
choice.)
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Foreign investors observe government’s policy choice and decide on how
much to invest.
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Realization of Public good productivity (or quality of economic
environment). Output realized.
Payoffs realized: Foreign investors (earn α.y) and national income is (1α)y.
-----------------------------------Case I: Prior versus the private information:
Prior = ω = P(SR)>1/2
Private Signal= sL of reliability Φ>ω
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Bayesian updating
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Reliability of signal: Φ = P(sR|SR) = P(sL|SL).
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Government should always choose a signal that
accords with its private signal if it wants to
maximize overall output P(sR|SR) > P(sL|SL) >1/2.
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Government may ignore private signal and go along with priors of the
international capital market, in order to attract foreign capital and (in
expected terms) maximize output.