The Political Economy of Financial Sector Reform

1
Tsinghua University Course on Financial
RegulationLecture 1/08

• The Political Economy of Financial Sector Reform
• Andrew Sheng
• Adjunct Professor,
• Graduate School of Economics and Management
• 12 March 2009

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Lecture Series

• Lecture 1 The Political Economy of Financial
  Sector Reform (2009)
• Lecture 2 The Global Financial Meltdown (2009)
• Lecture 3 Theory and Practice of Governance
  (2007)
• Lecture 4 Leadership in Regulatory Environment
  (2007)
• Lecture 5 Money, Property Rights and Markets
  (2006)
• Lecture 6 Practice of Financial Regulation
  (2006)
• Lecture 7 A Property Rights Framework (2007)
• Lecture 8 Practice of Bank Supervision (2006)
• Lecture 9 Asian and International Financial
  Markets (2006)
• Lecture 10 The Regulation of Listed Companies
  (2006)

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Content

• Financial System is an Institutional Arrangement
  to protect property rights, reduce transaction
  costs and improve social welfare, including
  through transparency
• According to Nobel Laureate Douglass North,
  economic development is a process of change.
• How do we achieve financial system reform?
• Objectives of Financial Sector Reform
• The Strategy and Execution of Reforms
• Chinese and International Experience
• Using Mancur Olson Power and Prosperity to
  illustrate

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Mancur Olson Key Questions

• What is it that makes some market economies rich
  whereas others are poor?
• What policies and institutions does a country
  need to change from a low-level market economy to
  a rich market economy?
• Why was economic performance so much better,
  especially in relation to expectations, after the
  defeat of fascism than after the collapse of
  communism?
• Why do the formerly communist countries suffer so
  much from official corruption and organized crime?

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What is a property right?

• Property right
• There is a property right when it is possible for
  someone to decide, without any significant threat
  of interference from others, on a particular use
  of an asset or resource (including services,
  physical yields, environmental phenomena,
  intellectual achievements, etc.).
• Contracts and rights of transfer
• Contract means all kinds of voluntary agreements
  between two or more persons to exchange property
  rights, or property rights for a payment
• Rights of transfer are second-level rights that
  concern what the person can do to with his
  property rights. Rights of transfer exist
  automatically unless deliberately abolished or
  restricted by law or custom.

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Property rights are defined legally and enforced
by regulators/market forces

• Property right
• Property rights are normally defined legally by
  law or by contract between various parties.
• Property rights normally comprise both rights
  (claims) as well as obligations (liabilities,
  either defined or undefined).
• Contracts and rights of transfer
• The rights to contracts are either enforced by
  agreement, or enforced by law. There are costs
  to defining a contract (eg legal costs and stamp
  duty) as well as enforcement costs.
• Although rights of transfer exist, they are
  subject either to contract, law or taxation in
  order to protect such rights of transfers.

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The Reciprocity Theorem

• If A holds certain property rights and doing so
  is to the detriment of B, then if the holding is
  transferred to B, Bs holding is to the detriment
  of A
• Example
• Pollution
• Implications
• Changes and fine-tuning of property rights are
  likely to involve redistribution of benefits and
  costs, which may not be so obvious when the
  changes are first considered but it is the root
  of resistance to changes

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Transaction costs(associated with contracts)

• Transaction costs are the costs of search,
  information, bargaining, decision, policing and
  enforcement associated with contracts
• More specifically, transaction costs comprise the
  costs parties to a contract incur in order to
  find each other, exchange information, delineate
  the property rights to be transferred, draw up
  the conditions of the contract, signal
  preparedness to fulfil their obligations, monitor
  each others performance and otherwise see to it
  that obligations are fulfilled
• Transaction costs will include taxes and are
  sometime used for all kinds of man-made costs in
  organizing interactions among people

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The Coase theorem

• If, in a two-party framework, a property right is
  well defined and the holding clear, and if there
  are no transaction costs and no wealth effects,
  then the right will end up with the party able to
  achieve the highest net wealth, regardless of
  whether it is the initial holder or someone who
  buys it from the initial holder. It follows that
  the use of the assets to which the property right
  pertains will be the same, irrespective of the
  initial holding
• If transaction costs prevent or seriously impede
  a transfer by contract, who the initial holder is
  matters for the way a property right will be used
  and for the wealth achieved.

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Information, risks and the firm

• The existence of transactions costs leads to the
  emergence of the firm. Coase
• Economic organization, including the firm, must
  reflect the fact that knowledge is costly to
  produce, maintain and useStigler
• In a condition of uncertainty, the entrepreneur
  is one who takes residual risks and the firm is
  an institution for risk sharingFrank Knight

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Types of interaction costs

• Transaction costs
• in a contract
• Administration costs
• in non-contractual interactions such as within a
  firm, in a political process, in the government
• Legal costs
• in running a legal system and in litigation
• Costs of delineating and protecting property
  rights
• in activities that are apart from a contract or a
  legal procedure such in establishing and running
  political process, government, regulation, etc.
• Costs of care
• in avoiding being exposed to legal sanctions when
  hurting others or in avoiding being hurt by other
  peoples acts

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The basic role of institutions

• The role of market institutions, such as firms,
  markets, judiciary, regulators, police, etc are
  to-
• Facilitate wealth creation while minimizing
  transactions costs
• Establish, protect, fine-tune, and enforce
  property rights and their exchange with least
  interaction costs
• Encourage entrepreneurial, socially beneficial,
  and innovative risk-taking while deterring
  socially costly stealing, rent-seeking, and
  redistribution
• Specialisation of institutions
• Institutions interact or work through processes,
  which incur costs
• Different institutions have different knowledge
  specializations

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Law relating to property rights

• Property rights and restrictions on rights of
  transfer are defined largely by three kinds of
  law-
• Judge-made law precedent or constitutional law
  which tend to protect property rights of
  individuals and tend to be efficiency-promoting.
• Policy-based or legislative-based law, which aim
  to promote distributional objectives, which are
  not necessarily efficiency-promoting
• Administrative law, in which bureaucrats
  determine how property rights are affected.

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Kenneth ArrowsImpossibility Theorem

• Decisions emerging from voting and other
  political processes cannot be regarded as firmly
  and indisputably derived from the preferences of
  the voters.
• In particular, the decisions are sensitive to
  strategic behaviour and hence in a sense
  arbitrary
• In conditions of uncertainty, sometimes arbitrary
  choices and judgements have to be made
• You can democratically allocate gains, but
  cannot democratically allocate losses.

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Power and Prosperity- Mancur Olson

• Chap.1 The Logic of Power
• Chap.2 Time, Taking, and Individual Rights
• Chap.3 Coasian Bargains, Transactions Costs,
  and Anarchy
• Chap.4 Rational Individuals and Irrational
  Societies
• Chap.5 Governance and Economic Growth
• Chap.6 The Sources of Law Enforcement and
  Corruption
• Chap.7 The Theory of Soviet-Type Autocracies
• Chap.8 The Evolution of communism and Its
  Legacy
• Chap.9 Implications for the Transition
• Chap.10 The Kinds of Markets Needed for
  Prosperity

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Chap.1 The Logic of Power

• Narrow interests vs. Encompassing interest (????)
• How does power generate property rights
  protection?
• Example of the Stationary Bandit
• If the Bandit maximizes public output but steals
  enough to maximize his own takings Robin Hood
• Bandit has incentive to have Rules amongst
  Thieves to prevent disorder and fights amongst
  thieves
• Social Organization.

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The Other Invisible Hand

• guides encompassing interests to use their
  power, in accord with the social interest, even
  when serving the public good was not part of the
  intention. p.13
• An Autocrat (stationary bandit) will protect his
  territory and maximize social welfare because it
  is in his personal interest to do so
• Princely (Government) Consumption helps stimulate
  social income, but so long as social
  revenuegtsocial costs

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Chapter 1 The Logic of Power

• Whenever there is a Superencompassing interest,
  the second invisible hand works with
  Pareto-efficiency, and even those with a capacity
  to take whatever they please, take nothing P.20
• Autocracy is stable, so long as-
• Personal gaingtPersonal Cost
• Social gaingtSocial Cost
• Risk of New Leader gt Net Social Cost of Status Quo

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2 Time, Taking, and Individual Rights

• a long-term view
• - An economy will generate its maximum income
  only if there is a high rate of investment and
  that much of the return on long-term investment
  is received long after. ..p25
• - To reach the maximum income, a society must
  Impartially enforce contracts and need a stable
  currency p25
• When and how do autocracies become replaced by
  other systems of government?

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The Autonomous Emergence of Democracy or
Representative Government

• Three necessary conditions
• - the absence of the commonplace conditions
  that generate autocracy.
• - rough balance of power in society that
  does not allow autocracies to form Magna Carta
• - the area in which democratic arrangements
  are emerging is spared conquest by neighboring
  regimes, whether because of geographical
  barriers, city walls, or other lucky
  circumstances.

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Representative Governments Institute Property and
Contract Rights

• When a peaceful order has been established,
  social good is best served by production and
  mutually advantageous trade
• Markets basically are representative, since
  buyers and sellers are voting on what is accepted
  by society or rejected in daily trade..
• Mechanisms for defining and protecting property
  rights, enforcing contracts, and resolving
  disputes are in the common interest - this
  requires third-party enforcement, hence a court
  system. p35

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Lasting Representative Government Implies
Lasting Property and Contract Rights

• Experience has shown that the longer lasting the
  government, the more secure the property and
  contract rights
• Therefore, the issue is back to Principal-Agent
  Problem How to align interests of the people
  with the bureaucrats or policy makers?

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3 Coaseian Bargains, Transactions Costs, and
Anarchy

• The reason why we need government is to deal with
  market failure, e.g. defence, pollution, property
  disputes, externality.
• Can Coasian bargains deal with market failure?
• Bad things often happen, even to rational people?
  p.58
• Therefore, the difference between rich and poor
  states is not due to natural resources, but the
  quality of governance

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The Dark Side of the Force .p.60

• Thomas Schelling it is easier to destroy than to
  create.
• If private gains are higher than social costs,
  then coercion, fraud, theft and social disorder
  will arise
• Governments are inherently compulsory and
  necessary to enforce and protect property rights
• Government Is Needed for Contract Compliance, but
  must be supported by taxation, otherwise
  corruption and abuse of power comes in
• Therefore, Government power to regulate and
  implement laws and policies must also be subject
  to checks and balances

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4 Rational Individuals and Irrational Societies

• Small group can engage in collective action, but
  Voluntary collective action must fail in large
  groups because of incentive structure.
• E.g. Typical individual gets only a miniscule
  share of benefit from collective action, then no
  incentive to act in group interest. P77.
  Chinese Large Number Divide and Multiply
  problem.
• The difficulties of collective action
• if a group is sufficiently large, its
  members will not have any incentive to engage in
  the costly bargaining and strategic interaction,
  instead, they try to be in a coalition of free
  rider obtaining the largest gains. p87
• Two circumstances can overcome the difficulties
• - when the numbers in the group are few,
• - availability of selective incentives.

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4 Rational Individuals and Irrational Societies

• Small Groups Often Succeed in Voluntary
  Collective Action
• -normally, when the number of potential
  beneficiaries of a collective good is small, the
  interests of each are significantly affected by
  the contributions or non-contributions of the
  others. p73
• - Premises communication enforcement of
  agreements
• The voluntary, unsubsidized provision of anything
  never reach a collectively rational level. p79
• Why Voluntary Collective Action Must Fail in
  Large Groups--- the individual share of benefit
  is minuscule
• An incentive to be a free-rider

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Selective Incentives and Collective Action

• Even When There Are No Transactions Costs
• - A Game Without a Core(????????) situations
  where some individuals are better off in a
  subgroup than in a coalition of the whole, even
  when total gains are greatest from a coalition of
  the whole. P84
• - in large group collective action problems,
  rational individual behavior implies that
  individuals will try to cut themselves out of
  Coaseian bargains and thereby often prevent the
  Coaseian bargains from occurring, even when
  transactions costs are zero.
• Selective Incentives help overcome the problems
  of collective action ? Reformer must bribe
  select groups vested interests to prevent
  blocking action.

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5 Governance and Economic Growth

• Usually some complementarity between the activity
  that can provide a collective good and that which
  produces income must be found or exploited
  lobbying power must be used in part to get
  favorable governmental treatment of the business
  activity. P97
• How do we ensure that representative government
  are controlled and not captive to vested
  interests or lobby groups?
• How can we push through short-term unpopular
  policies to some parties that are vital for
  long-term social stability or economic
  productivity?

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5 Governance and Economic Growth

• Rational Ignorance of Individual
• As society becomes more complicated, most
  individuals do not understand complex policies
  and decisions that affect their daily lives.
• It takes a long time for a society to accumulate
  many organizations for collective action, and
  that industry-specific, occupation-specific, and
  other narrow organizations for collective action
  are most harmful to economic efficiency and
  dynamism. p98
• Strong, secure, and relatively well-advised
  autocrats can perform impressive economic growth
• Question is how to have representative government
  without the costs of lobbying and inaction.

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6 The Sources of Law Enforcement and Corruption

• Governments with decent institutions and policies
  can maintain sufficient law and order for
  economic progress at relatively low costs because
  of the self-interest of private parties.
• The encompassing majorities have an incentive to
  choose good economic policies and institutions so
  as to obtain a reasonable degree of law and order
  at modest costs.

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Corruption comes from bad laws and incentives

• Legislation or regulation that is market
  contrary(??????) must leave all or almost all
  parties with the incentive to evade the law, and
  it is likely to promote criminality and
  corruption in government. p107
• - thus, one reason why many societies have a
  lot of corruption in government is that they
  prescribe outcomes that all or almost all private
  sector has an incentive to avoid, and no one in
  the private sector has an incentive to report
  violations to the authorities.

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7 The Theory of Soviet-Type Autocracies

• Soviet-type nationalization enabled regime to
• Expropriate essentially all of the national stock
  of tangible capital, land, and other natural
  resources, thereby adding the yield of all of
  these assets to tax collections.
• Avoid the collapse of investment by directly
  controlling the level of consumption and
  investment, getting a high rate of saving and
  investment.
• Raise taxes on labor income far above
  revenue-maximizing rates by tax-price
  discrimination.
• Reduce the ratio of marginal to average tax
  rates.

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How Corruption and Soft-Budget Constraint
Destroyed Soviet System

• Corruption is equivalent to high rates of
  implicit tax collections that add to transaction
  costs and cause great interference with markets.
• Wealth concentration goes to minority and
  therefore all those subject to high corruption
  tax has an incentive to collude either to
  maximize private gain at social cost or to evade
  tax altogether.
• Soft budget constraint on SOEs resulted in huge
  losses, so that State had no tax resources except
  through inflation
• Ultimate, government has no resources to finance
  legitimate functions of state, since corruption
  is tax leakage

34
Conflicts between narrow interest and social
interest

• Each of the vested interests has narrow
  self-interests little or no incentive to
  maintain social productivity because they obtain
  very little of the society output.
• Therefore, social productivity cannot increase
  or may even decline, so that there is less and
  less to share. Vested interests may increase
  their taxation, so that productivity declines
  further and social stability collapses.

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9 Implications for the Transition to Market
Economy

• Transition works well when incentives are changed
  to broaden public encompassing interests e.g.
  TVE, rural household contracting system,
  commercialization of state-owned industry.
• Dangers of slow transition - high inflation,
  Privitization of SOEs, nomenklatura block reforms
  that expose their collusive gains from no
  competition.

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10 The Kinds of Markets Needed for Prosperity

• Only two general conditions are required for a
  market economy that generates economic success
• 1) secure and well-defined individual rights.
• 2) the absence of predation of any kind.
• To realize all the gains from trade, there has to
  be a legal system and political order that
  enforces contracts, protects property rights,
  carries out mortgage agreements, provides for
  limited liability corporations, and facilitates a
  lasting and widely used capital market that makes
  the investments and loans more liquid than they
  would otherwise be. P185

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Contribution of Olson Analysis

• Uses Economic Analysis for Political Economy
  questions
• Realizes that rational game is being played
  between different interest groups in economy
• Questions whether Coasian bargains can be reached
• Reforms require sacrifice resources for
  bargaining and good timing, especially outcomes
  that reward reforms

38
Why many reforms fail

• Lack of clear reform objectives
• Under-estimation of Vested Interests that oppose
  reforms
• Lack of resources to implement or deliver reform
  promises
• Absence of External Threat or Crisis that force
  public to questions whether there is need for
  reform
• Inability to reach Social Bargains by trade-offs
  or pay-offs
• Inability to communicate and deliver on Reform
  objectives, benefits and necessities
• Require sacrifices and good timing, especially
  outcomes that reinforce reforms

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Building Market Economy means building a Robust
Property Rights Infrastructure (PRI)

• 1. Delineation of property rights
• Property rights need to be clearly defined and
  legally protected
• 2. Enforcement of property rights
• Property rights need to be protected and enforced
  efficiently, fairly, and predictably through
  independent judiciary and regulatory systems
• 3. Culture in respecting law, property rights and
  contracts
• Credit culture means respect of law, property
  rights and contracts, and they are rewarded for
  doing so
• 4. Reform market institutions that protect rights
• The accounting, regulatory, judiciary and
  property registration (eg land and equity
  registration systems) need to brought up to
  international standards in order for markets to
  perform efficiently, fairly and transparently

40
Efficient Markets Have Robust PRI Institutions

• Central Registry of property right e.g. land
  registry, share registry
• Trading Engine e.g. stock exchange
• Clearing, settlement and payment infrastructure
  clearing house and payment system
• Regulated intermediaries
• Clear Rules of Game norms, standards, codes,
  regulations, law
• Enforcement infrastructure enforcement costs
  cannot exceed benefits to market
• Independent and transparent judiciary to
  adjudicate property disputes
• ? Effective judiciary, enforcers police,
  regulators, enforcement agencies, accounting,
  legal and financial intermediaries are all part
  of PRI

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Free Markets Systems are prone to Financial Crises

• If Soviet type systems are subject to collapse,
  market systems are also subject to financial
  crisis.
• Governments in free market economy use monetary
  policy, fiscal policy and regulation to mitigate
  business cycles
• However, free market philosophy which stressed
  minimal government and minimal regulation gave
  rise to excess greed, financial bubbles and
  eventual collapse, including deflation in real
  economy

42
2009 Geneva Report the regulatory system stands
accused of

• Failed to mitigate the recent cycle in leverage,
  credit expansion and housing prices.
• Nothing was done to tighten regulations (e.g. on
  capital, liquidity or remuneration) in the
  upswing, nor to relax the pro-cyclical
  implications of the accounting/regulatory
  framework in the downturn.
• Provided little or no check, nor barrier, to the
  decisions taken by banks, and other financial
  operators, in their pursuit of (short-term)
  profit maximisation.
• It was not adapted to changes in the underlying
  vulnerabilities in the system as a whole, and
  allowed financial engineering to avoid its
  impact, e.g. SIVs and other methods of
  deconsolidating risks.

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Geneva Report Objectives of Regulation

• 1. to constrain the use of monopoly power and the
  prevention of serious distortions to competition
  and the maintenance of market integrity
• 2. to protect the essential needs of ordinary
  people in cases where information is hard or
  costly to obtain, and mistakes could devastate
  welfare and
• 3. where there are sufficient externalities that
  the social, and overall, costs of market failure
  exceed both the private costs of failure and the
  extra costs of regulation.
• What Lessons can we draw from Current Financial
  Crisis?

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Process to Manage Reform

• Asia has implemented many reforms, but outcomes
  may not always be on target.
• Reform fatigue could have set in resulting in no
  follow through to ensure successful
  implementation.
• Law of unintended consequences may frustrate
  reform efforts and generate reform resistance.
• Reform is a process, but we need a process to
  manage the reform process so that it stays the
  course and departures from path can be put back
  on track through set procedures.
• Reform needs ownership of the need for change.
• Process to manage change is an important area
  that deserves more attention by policy makers.

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Thank You
Questions to as_at_andrewsheng.net