Macroeconomic Topics in Development

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Macroeconomic Topics in Development
TransitionEC938

• Sharun W. Mukand

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Four meta-theories of institutions

• 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 whats 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.

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Which approach? (Efficient Institutions)

• 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)

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Institutional persistence some things we know

• Institutions are by their nature durable
• e.g., democracy more likely tomorrow if today
  there is democracy than if dictatorship today.
• Bad institutions create bad incentives and
  self-sustain
• e.g., an extractive state apparatus will give
  incentives to political elites to use it for
  extraction.
• Bad institutions create instability and
  self-replicate
• 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
• e.g., bad institutions ? greater inequality ?
  political power of the rich to sustain bad
  institutions.

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Institutional change (1)

• Towards a theory of institutional change
• 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

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Institutional change (2)

• Elite-driven when the politically powerful elite
  wish to change institutions in order to increase
  its rents/utility.
• 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.
• 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.

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Institutional change (3)

• Internal because of internal shocks or dynamics.
  
• E.g., rise of democracy.
• External because of external imposition, shocks,
  or external incentives.
• 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.

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Conclusions (1)

• 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.

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Conclusions (2)

• Summary towards a dynamic theory

Economic institutionst Economic
policiest Political institutionst1
De jure power (Political institutions)t De facto
powert
political powert
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Governance matters
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Governance matters..
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Governance

• Some Considerations
• Some countries are rich and others are poor.
• Economic development/Institutional change is
  difficult
• Need for coordination ? Role for Government.
• Political factors further impede governments
  ability to carry out change.

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THE WASHINGTON CONSENSUS

• Good governance in developing countries REQUIRES
  
• 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 developmentpolicy reforms
  required

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In Search of the Holy Grail Policy Convergence,
Experimentation and Economic Performance (2005)
American Economic Review

• Developing countries have undertaken Washington
  consensus style reform during the eighties and
  nineties.
• Policy convergence ? Economic convergence??
• Why the discrepancy?
• Countries not implementing economic reform in
  first place (i.e. no policy convergence).
• Universal applicability of policy?? Is it a
  reasonable assumption.

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• Appropriate reforms and policies have a large
  element of specificity and experimentation is
  required to discover what works locally..
• Two track reform worked well in Dengs China but
  not in Gorbachevs 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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• Are we implying that economic principles work
  differently in different places?
• No.
• We distinguish between economic principles and
  their institutional embodiment. Most first-order
  economic principles come institution
  freeincentives, competition, hard budget
  constraints, sound money, fiscal
  sustainabilityare central to the way economists
  think.
• 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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• Countries located on unit circle countries
  differ in terms of their location dictated by
  differences in history, geography, culture.
• Country location given by zi.
• Country can either Imitate and adopt
  institutions developed and refined in other
  countries or Experiment and engage in
  institutional innovation.
• 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 countrys location is zj and the
  institutional/policy choice is ai then the
  expected output is given by
• yi -?(ai - zj)2
• Government preferences Vi yi ?K
  where
• ? 1
  if govt. experiments and,
• ? 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 ? ,
  where ? N(0, s2).

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• Imitation
• Eyi(IMIT) -?(a1 z2)2
• Experimentation
• Ey(EXPT.) E -?(a2 z2)2 F
• 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.
• 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.
• The worst performing followers should be at some
  intermediate distance from the leader country.
• Economic Performance should show a U shaped
  relationship when plotted against distance.

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Institutional Adoption The Transition Economies
as an Experiment

• Around 1990 socialism has failed! There is no
  ambiguity about whether countries searching for
  new institutions to replace socialism.
• Set of countries searching for new institutions
  can be cleanly identified all former socialist
  countries.
• 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 ?
• 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-livedcrash 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...
• New set of Washington consensus reforms ? heavy
  emphasis on Institutional Reform.
• Are Institutions key to growth and development?

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Comparative Growth Experience
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
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Globalization and Governance

• Developing countries
• Weak political institutions ? Political Selection
  weak ? poor leaders ? Bad governments.
• Poor Economic institutions ? imperfect contract
  enforcement, rule of law..
• Weak Economic and Political Institutions ?
  Economic Insecurity ? low investment ? low
  economic growth ? poverty and underdevelopment.
• How do we develop new, better quality growth
  promoting institutions?
• What is the impact of globalization on a
  governments incentive to adopt good quality
  institutions?

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Globalization and GrowthHow to make poor
countries grow when Governance poor?

• 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

• LDCs typically have a high marginal product of
  capital. So investment should flow to developing
  countries.
• However, typically developing countries lack
  financial markets that allow transfer of funds
  from savers to borrowers
• Weak enforcement of economic laws and regulations
• Weak enforcement of property rights makes
  investors less willing to engage in investment
  activities and makes savers less willing to lend
  to investors/borrowers.
• 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.
• 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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Dont Mess With Moodys New York Times 1995.

• 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.
• 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.
• 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
• .. 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.
• (Thomas
  Friedman in the New York Times, 1995)

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Disciplining and the International Capital Market

• Disciplining effect of the international capital
  market?
• Can the international capital market improve
  global governance through punishing poor
  governance and rewarding good governance?

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Foreign Direct Investment Stocks

• 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
• --------------------------------------------------
  ----------------
• FDI/GDP ratio highest for France/UK in 1914
• and
  UK/Germany in 1997.
• 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)

• Unofficial flows to developing countries far
  outstrip official flows
• FDI and remittances dominate unofficial flows
• FDI is becoming increasingly concentrated
• 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 middle-income
  countries

Foreign direct investment
Worker remittances
Bonds
ODA
Portfolio equity
Bank loans
Source World Bank Global Development Finance 2005
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External capital structureEmerging and
developing countries
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The Fire Tomorrow Sorting out the sheep from the
goats
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The Confidence Game

• 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
• Governing the Global Economy Does One
  Architecture Style Fit All Dani Rodrik (1999)
  available at http//ksghome.harvard.edu/drodrik/p
  apers.html
• Globalization and the Confidence Game Mukand in
  Journal of International Economics (2006)

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The Confidence Game will the government always
choose a policy in accordance with its private
signal?

• 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.
• Y G f(k) G. (k)a
• Government receives a private signal sj that is
  more reliable than the prior.
• 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 governments policy
  choice and decide on how much to invest.
• Realization of Public good productivity (or
  quality of economic environment). Output
  realized.
• Payoffs realized Foreign investors (earn a.y)
  and national income is (1-a)y.
• ------------------------------------
• Case I Prior versus the private information
• Prior ? P(SR)gt1/2
• Private Signal sL of reliability Fgt?

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Bayesian updating

• Reliability of signal F  P(sRSR)  P(sLSL).
• Government should always choose a signal that
  accords with its private signal if it wants to
  maximize overall output P(sRSR) gt P(sLSL) gt1/2.

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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.