institutions and development
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The Ronald Coase Institute
Institutions and Development
Mary M. Shirley
President, The Ronald Coase Institute
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The Ronald Coase Institute
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The Ronald Coase Institute
Institutions
• Institutions are the “humanly devised constraints that structure human interaction” (North, 1990).
• Institutions include formal rules (laws, regulations) and informal norms (habits, unwritten codes of behavior).
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• Institutional variables have large, statistically significant correlations with growth
• Trump geography or trade in horse races between variables (Rodrik, et al. 2002)
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The Ronald Coase Institute
Questions I’ll Address
1. How do institutions determine development?
2. Can foreign aid improve institutions?
3. Can foreign aid avoid institutions?
4. What can be done about damaging institutions?
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Why is this important?
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Development is the exception
• Most people in the world live in underdeveloped countries
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World’s population living in developed vs. underdeveloped countries, 2006
DC
LDC
World Bank, DC = >$11,115 GNP p.c. PPP in 2006
85%
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Underdevelopment persists
• Most people in the world live in underdeveloped countries
• This has changed little over the past two decades
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World’s population living in developed vs. underdeveloped countries
0
10
20
30
40
50
60
70
80
90
1979 2006
DC
LDC
DC
LDC
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Underdevelopment persists
• Despite large amounts of aid
• And large aid community
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Aid Community in 2005(gross aid* in billions of dollars)
0
20
40
60
80
100
120
Multilats. Bilaterals NGOs21 36 17,428
$51
$120
$15
*$188 gross vs. $121 net. OECD
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Role of institutions in development
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What Kinds of Institutions Are Needed for Development?
Encourage exchange by lowering transaction costs, providing framework for competition & transparency
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Reduce transaction costs
• Contracts & contract enforcement mechanisms,
• Commercial rules & norms, information disclosure
• Beliefs and norms that favor trust, shared values, etc.
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Institutions Needed for Development
Encourage exchange by lowering transaction costs, providing framework for competition & transparency
Direct the power of the state toward protecting property & individuals, not exploiting them
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Control the state
• Constitutions, electoral rules, federalism
• Political checks & balances
• Norms and beliefs encouraging civic mindedness, probity in public service, rule of law, etc.
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Institutional frameworks
1. Usually durable2. Endure because
• Powerful people benefit • Humans resist changes in habits &
beliefs
3. Changes are often idiosyncratic & experimental
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E.G. idiosyncratic change: China’s TVEs
• State owned enterprises run by private investors
• Overseas Chinese ties to village substitute for secure property rights
• Regular payments of profit shares to government officials
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“Capitalism with a red hat”
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Can aid improve institutions?
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No evidence aid can stimulate growth
Rajan & Subramanian, 2005 find no statistically robust association looking at:
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No evidence aid can stimulate growth
Rajan et al., 2005 find no statistically robust association looking at:
• 10, 20, 30, 40 time periods
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The Ronald Coase Institute
No evidence aid can stimulate growth
Rajan et al., 2005 find no statistically robust association looking at:
• 10, 20, 30, 40 time periods
• Only aid directed at growth
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The Ronald Coase Institute
No evidence aid can stimulate growth
Rajan et al., 2005 find no statistically robust association looking at:
• 10, 20, 30, 40 time periods
• Only aid directed at growth
• Only countries with good policies
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The Ronald Coase Institute
No evidence aid can stimulate growth
Rajan et al., 2005 find no statistically robust association looking at:
• 10, 20, 30, 40 time periods
• Only aid directed at growth
• Only countries with good policies
• Different regions, areas
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No evidence aid can improve institutions
• No effect on institutions (see cites in Burnside & Dollar 2004)
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Evidence aid can harm institutions
• Higher aid associated w/ lower bureaucratic quality, corruption, less rule of law (Knack 1997)
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Evidence aid can harm institutions
• Higher aid associated w/ lower bureaucratic quality, corruption, less rule of law (Knack 1997)
• Increased rent seeking in less open economies & those w/ large public sector (Economides 2004)
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The Ronald Coase Institute
Evidence aid can harm institutions
• Higher aid associated w/ lower bureaucratic quality, corruption, less rule of law (Knack 1997)
• Increased rent seeking in less open economies & those w/ large public sector (Economides 2004)
• Rent seeking, corruption, waste (Bauer 1991, Kanbur 2000, Easterly 2002)
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Evidence aid harms institutions
• Higher aid associated with slower adoption of market oriented reforms (Heckelman & Knack 2005)
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Evidence aid harms institutions
• Higher aid associated with slower adoption of market oriented reforms (Heckelman & Knack 2005)
• Negative association with democracy (Djankov et al, 2006) & transition to economic freedom (IMF 2005) – But, reverse causality?
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Cross Country Regressions
• Obvious flaws
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Cross Country Regressions
• Obvious flaws
• Problems in establishing causal relationships
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Cross Country Regressions
• Obvious flaws
• Problems in establishing causal relationships
• But – can rule out hypotheses consistently rejected in most specifications
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World Bank’s evaluation department judged its projects to improve public administration, rule of law, etc. to be “largely ineffective” (2005)
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Why?
• Samaritan’s Dilemma
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Why?
• Samaritan’s Dilemma (Buchanan 1977)– Payoff highest to Samaritan if Samaritan
provides aid and beneficiaries respond by exerting higher effort
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The Ronald Coase Institute
Why?
• Samaritan’s Dilemma (Buchanan 1977)– Payoff highest to Samaritan if Samaritan
provides aid and beneficiaries respond by exerting higher effort
– Payoff highest to beneficiaries if they get aid without increasing effort
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Why?
• Moral hazard:
“…aid helps to ensure incompetent governments from the results of their actions, thus weakening their incentive to find alternative revenue sources or better policies.” Ostrom, 2002
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Why?
Mismatch between characteristics of aid agencies & characteristics of institutional change
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Characteristics of Institutions vs. Aid
Institutional framework
• Deep rooted & usually durable
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Characteristics of Institutions vs. Aid
Institutional framework
• Deep rooted & usually durable
Aid
• Focus on policy, organization, sector rules
• Three year projects
• Staff rotates every 3 -5 years
• Rewards for approval, not sustainability
• Accountability?
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Characteristics of Institutions vs. Aid
Institutional framework• Supported by power
elites & beliefs
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Characteristics of Institutions vs. Aid
Institutional framework• Supported by power
elites & beliefs
Aid• Requires support or
permission incumbent government
• Staff incentives to cooperate to win more project approvals
• Revolutionaries would be asked to leave
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Characteristics of Institutions vs. Aid
Institutional framework• Changes are often
idiosyncratic & experimental
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Characteristics of Institutions vs. Aid
Institutional framework• Changes are often
idiosyncratic & experimental
Aid• Focus on Western best
practice – no support to TVEs
• Focus on changes that are:– rapid, – defensible, & – provide benchmarks
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Without improvements in damaging institutions aid
projects result in: pro forma reforms
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E.G. Performance contracts
Government
State owned enterpriseForeign aid
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Manager promises
productivityprofitabilityinvestmentother targets
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Government promises
autonomy to achieve targets
$ bonus or recognition for good results punishment for bad results
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Foreign aid agency promises
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Performance Changes After the Introduction of Contracts
Return on assets
No change
Deteriorated0
4
8
12
Number of state-owned enterprises
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Performance Changes After the Introduction of Contracts
Labor productivity
Improved
No change0
4
8
12
Number of state-owned enterprises
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Performance Changes After the Introduction of Contracts
Total factor productivity
0
4
8
12
Number of state-owned enterprises
Improved
Deteriorated
No change
Shirley & Xu, 2000
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G r a p h 7 : E f f e c t s o f P e r f o r m a n c e C o n t r a c t s o n T o ta l F a c to r P r o d u c t iv i ty i n C h in e s e S ta t e O w n e d E n te r p r i s e s
- 2 5 0
- 2 0 0
- 1 5 0
- 1 0 0
- 5 0
0
5 0
1 0 0
A v e r a g e P o s i t i v e N e g a t i v e
S h i r l e y & X u , 2 0 0 1
No Significant Positive Correlation with TFP in over 500 Contracts
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Why such poor results?
• Weak targets,
• Poor information,
• No bonuses for good performance,
• No punishments for bad performance, or
• No autonomy to lay off workers or close plants
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Why performance contracts?
Aid staff liked:
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Why performance contracts?
Aid staff liked:• Tangible action
(signing)• Tangible “success”
(achieve targets)• Projects possible w/o
privatization
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Why performance contracts?
Aid staff liked:• Tangible action
(signing)• Tangible “success”
(achieve targets)• Projects possible w/o
privatization
Government liked:
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The Ronald Coase Institute
Why performance contracts?
Aid staff liked:• Tangible action
(signing)• Tangible “success”
(achieve targets)• Projects possible w/o
privatization
Government liked:• Easy action (force
manager to sign)• Easy “success” (set
targets low)• Aid w/o political
costly actions (layoffs, privatization)
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Bottom line: Fundamental changes in deeply rooted institutions do not happen because of outsiders’ money or pressures
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Can aid avoid damaging institutions?
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Problems
1. Measuring reform in institutions
2. Combating incentive to “move the money”
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E.G. US Millennium Challenge Account
Created 2002
Assists only poorest countries that rank:
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E.G. US Millennium Challenge Account
Created 2002
Assists only poorest countries that rank:
• top 50% of eligible countries on controlling corruption
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E.G. US Millennium Challenge Account
Created 2002
Assists only poorest countries that rank:
• top 50% of eligible countries on controlling corruption
• top 50% on half of other criteria in each of 3 performance dimension
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Dimension Performance Criteria
Governing Justly
1. Civil liberties2. Political rights3. Voice and accountability4. Government effectiveness5. Rule of law6. Control of corruption
Investing in People
1. Immunization rates (diphtheria & measles) 2. Public expenditures on health3. Primary education completion rate4. Public expenditures on primary education
Promoting Economic Reform
1. Inflation rate2. Cost to start a business3. Days to start a business4. Trade policy5. Regulatory quality6. Fiscal policy
Source: MCA Data on the Web at www.MCA.gov.
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1. Current measures do not permit targeting aid to countries with improving institutions
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Problems with measurement
Measures are not “actionable”
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Problems with measurement
Measures are not “actionable”, instead they are
• Abstract – “rule of law”
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Problems with measurement
Measures are not “actionable”, instead they are
• Abstract – “rule of law”
• Static over time – governance
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Problems with measurement
Measures are not “actionable”, instead they are
• Abstract – “rule of law”
• Static over time – governance
• Uncorrelated with growth, e.g. political rights
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Not institutions -- outcomes
• Outcome = secure property rights
• Institutions = laws, commercial code, norms of business, electoral constraints on government power, etc.
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Problems with measurement
• Large margins of error
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Kaufmann & Kraay 2002
Impossible to say w/90% certainty where 51 of 61 countries rank
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2. Incentives of aid agencies are to “move the money”
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Selectivity conflicts with incentives to more the money
• Fewer countries – By June 2007: only 8
of 61
signedexcluded
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Selectivity conflicts with incentives to more the money
Little disbursed:– By June 2007: $71
million out of $3 billion allocated ($6 billion total to MCA)
DisbursedAllocatedUnallocated
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Selectivity conflicts with incentives to more the money
Incentives to disburse– 13 allocated $310
million as “threshold countries”
DisbursedAllocatedTotal alloc.Threshold
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What can be done about damaging institutions?
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What can be done?
Raise capacity of countries to reform their own institutions
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Societies cling to blatantly damaging institutions even when faced with crisis, but…
Institutional frameworks do change
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Ideas and learning are powerful forces in overcoming beliefs and norms that inhibit change in institutional frameworks (North)
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Intellectual capital
• New ideas in receptive environments, – E.g. Enlightenment in Europe
• Learning – E.g. Economists in China, Chicago
boys in Chile
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Critical mass of well trained scholars in receptive circumstances (Shirley and Soto, 2007)
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Case Studies
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Case studies1. Chile:1975 Chicago boys
2. China:1993 “Socialist Market Economy”
3. Korea:1980 EPB economists
4. Taiwan:1958-61/1986 S.C. Tsiang, T.C. Liu, others
5. Argentina:1991 Cavallo boys
6. Indonesia:1966/1983 Berkeley mafia
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Serious threat, economic problems Failure of past reforms
Change seen as
necessary by elites
Coherent alternative different from past reforms
Role model
Consensus view of group
Seen as experts?
Seen as not self interested?
Incentives to be truthful?
Local knowledge? yes
yes
yes
yes
Alternative paradigm
Channels to elites
Alternative is
known to elites
Alternative is
feasible
SCHOLARS RULING ELITES
Policy, paradigm changeParadigm is disseminate
d
REST OF POPULATION
Beliefs change
Institutional change
Outcomes seen as positive
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Serious threat, economic problems Failure of past reforms
Change seen as
necessary by elites
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Change seen as necessary by elites
• Threats & problems– E.g. Taiwan: Acceptance of China in UN
(1980’s)– E.g. Hyperinflation in Argentina (1989-1991),
Chile (1973-75),
• Failure past policies– Partial reforms in Taiwan, Menem’s &
Pinochet’s first efforts to stabilize in Argentina & Chile
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Coherent alternative different from past reforms
Consensus view of group
Scholarly group with alternative paradigm
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Scholarly group with alternative paradigm
• Coherent & different from past reforms– Liberalization in Taiwan– “Chicago Model” in Chile
• Consensus view of group– Five economists’ paper in Taiwan– Cavallo Boys and Chicago Boys
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Seen as experts?
Seen as not self interested?
Incentives to be truthful?
Local knowledge?
Scholarly group with alternative paradigm
Lupia & McCubbins
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Alternative paradigm Channels to elites
Alternative is known to elites
Alternative is feasible
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Alternative is known to elites
Channels to elites
• Think tanks
• Publications (Vover a Crecer by Cavallo)
• Conferences (Milton Friedman in Chile)
• Media coverage (El Mercurio in Chile)
• Personal ties (Cavallo & Menem)
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Paradigm is disseminated
Policy, paradigm change
Outcomes seen as positive
Beliefs, norms
change, new stakeholders
Public Elites
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Paradigm is disseminated
• Vigorous public debate (even in Chile)
• Early success (lowering inflation in Argentina, Chile, spurring faster growth in Taiwan)
• Treated as new ideology (e.g. China’s socialist market economy)
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Scholars in receptive circumstances:
• Identified barriers to reform
• Persuaded policy makers to adopt new paradigms and policies
• Informed public debate, contributing to changes in beliefs & institutions
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Conclusion
• To develop countries need institutions that lower TCs and protect property and individuals
• Aid cannot strengthen – and may undermine – such institutions
• Aid cannot avoid institutions
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Build Intellectual Capital
Local scholars and research can provide ideas and analysis that raise the potential for institutional change.