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3 03 UI World Bank Discussion Papers

Institutional Adj ustmentand Adjustingto Institutions

Robert Klitgaard

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(Continued on the inside back cover)

30 3~ 1z1 World Bank Discussion Papers

Institutional Adjustmentand Adjustingto Institutions

Robert Klitgaard

The World BankWashington, D.C.

Copyright © 1995The International Bank for Reconstructionand Development/THE WORLD BANK

1818 H Street, N.WWashington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing September 1995

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ISSN: 0259-210X

Robert Klitgaard, a professor of economics, t the University of Natal, Dalbridge, South Africa, was a consultant to theWorld Bank's Operations Evaluation Department.

Library of Congress Cataloging-in-Publication Data

Klitgaard, Robert E.Institutional adjustment and adjusting to institutions / Robert

K1s;gaard.p. cm.-(World Bank discussion papers, ISSN 0259-210X;

303)Includes bibliographical references (p. ).

ISBN 0-8213-3450-61. Institutional economics. 2. Africa-Economic policy.

3. Economic development. I. Tide. II. Series.HB99.5.K59 1995338.9-dc20 95-36053

CIP

Contents

Foreword vAbstract vi

1. Applying Institutional Economics to Development Problems 1

2. Market Institutions 3

3. Nonmarket Institutions 4The Incentives P-roblem: The Case of The Gambia 4Overcoming Constraints on Incentive Problems 7

4. Indigenous Institutions 8Guidelines for Adjusting to Institutions 9

5. Institutional Adjustment and Adjusting to Institutions 13Healing the Aid Relationship 14

Appendices 17

Table

3.1 Two Approaches to Incentive Reforms 5

Box

3.1 Designing an Experiment with Incentives: Outline for a Model Memorandum 6

iii

Foreword

This paper applies institutional economics to and finality threaten too many vested interests. Thedevelopment practice. Experience shows that the paper offers a selective, experimental or "learningqualitative insights of the new economics of by doing" approach in which government officialsinformation can yield practical guidance for define performance measures and set goals, andaddressing such classic problems as: plan cooperatively how to meet them. Experiments

that are limited in time and scope, and in which* markets that seem not to work well for poor people with vested interests can help design thepeople; ways to measure success, give reforms a chance.

* government agencies that seem corrupt, The paper also outlines a framework for takinginefficient, and overcentralized; indigenous institutions into account in develop-

ment efforts. Adjusting to indigenous institutions* how to "take account" of indigenous institu- will have many different forms; sometimes it istions in development interventions. appropriate, sometimes not. But systematic atten-

tion to them in program and project design,Drawing on experience as well as theory, the through frameworks such as the one proposed inauthor outlines frameworks for analyzing institu- this paper, will generate practical ideas we mighttions, both governmental and market, as a prelude not otherwise reach.to improving their functioning.

The heart of the paper deals with the crisis inpublic sector incentives. It recognizes that at- Robert Picciottotempts to craft once-for-all reforms-though often Director Generalprescribed-usually fail, because their complexity Operations Evaluation

v

Abstract

Institutional economics can make a positive therapeutic approach for addressing the issue ofcontribution when applied to such classic develop- corruption. The paper also advocates that develop-ment problems as markets that regularly fail the ment institutions not only adjust governmentpoor, corrupt and inefficient government agencies, agencies, but adjust to them. This means giving theand how to take account of indigenous institutions. institutions resources and respect, empoweringWell-functioning markets often depend on well- stakeholders, and working with them. Outsidefunctioning states. In order to improve how well institutions can sometimes help governmentgovernment institutions are functioning, one must officials address sensitive issues and make credibleunderstand the reasons for poor performance- commitments. The World Bank can play a catalyticcorruption, poor incentives, and, often, overcen- role in this regard. The paper suggests that the aidtralization. The paper proposes an approach for relationship is itself in need of adjustment, and thatovercoming constraints to incentive reforms and international development institutions may them-provides a model economic framework for resolv- selves benefit from the types of measures beinging the incentive problem. It recommends a proposed.

vi

1. Applying Institutional Economics toDevelopment Problems

Six years ago at the Annual World Bank Conference made contributions that are not generically differ-on Development Economics, Brian Van Arkadie ent from the kinds of studies that might be made oflamented the disconnected approach to the study of political or social institutions. That history andinstitutions in development and the lack of practical management idiosyncracy matter is a commonlessons and applications.' John Nellis commented thread running through these studies.that the subject, though "profoundly important,""lacks an analytical method, a conceptual frame- A third group includes critics of economic theorywork capable of rendering it coherent" and said the who use institutions as a means to attack prevailing"next and most crucial step . .. is to specify precise paradigms. "Institutional economists," writesoperational methods and tools by which to improve Warren J. Samuels, "also conduct protests againstperformance in institutions."2 Today, looking over both the established market economy and thea different intellectual landscape, one may be more established body of orthodox theory which theyoptimistic. see as too closely tied to existing institutional

arrangements."4

No doubt the field, or fields, are still diffuse. Onone side we have theoretical economists such as Finally, there are people interested in whatBengt Holmstrom, Paul Milgrom, John Roberts, might be called indigenous economic institutionsand Jean Tirole, some of whom-such as Pranab ranging from local systems of property rights andBardhan and Joseph Stiglitz-work on develop- exchange through to cultural norms and conven-ment.3 In various ways they are revolutionizing the tions understood in part as solutions to economictheory of the firm, industrial organization, and the problems of risk-sharing, communication, andstudy of market institutions by systematically credible commitment.5

inserting problems of imperfect and asymmetricallyheld information. Their tools are mathematical, but Given this diversity-and these four categories failmany of them produce models that offer fresh, to encompass the richness of the work, for example,qualitative explanations for phenomena that are of Douglass North, Elinor Ostrom, and Oliverhard to explain using elementary Williamson, and of the many superb institutionalmicroeconomics-for example, share-cropping economists who work at the Bank, such as Edarrangements, wages in firms that are below Campos, Brian Levy, Mary Shirley, among others-workers' marginal products early in their careers it is not surprising that institutional economists mayand above their marginal products later on, and a find themselves at odds. And this may also explainvariety of institutional mechanisms that trade off why development practitioners still judge that therisk and incentives. On the other hand, quantitative subject has little to offer of practical use.testing has been limited, since key parameters ofthe models are difficult to define and measure. In what follows, I summarize briefly some of my

own forays into institutional economics, which haveAnother brand of institutional economics includes as their objective the improvement of policy analy-empirical studies of market structures and the way sis and management in developing countries.economic organizations work. Here political Drawing on the contributions of others, particularlyscientists and business administration experts have the economists of the first camp mentioned above, I

1

2

have tried to show that the qualitative insights of 2. Comment on "The Role of Institutions in Development,"the new economics of information can yield PP 177, 179.practical leverage when applied to classic prob- 3. Two recent books contain many references and helpfullems such as:

bibliographical essays. Paul Milgrom and John Roberts,Economics, Organization and Mfanagement (Englewood

* markets that seem systematically not to work Cliffs, NJ: Prentice Hall, 1992), and J-J. Laffont and Jeanwell for poor people, including even highly Tirole, A Theory of Incentives in Procurement and Regulationcompetitive markets, such as those for agricultural (Carnbridge: MIT Press, 1993). For applications to develop-products but also credit, labor, and land; ing countries see The Economic Theory ofAgrarian Institu-

lions, ed. Pranab Bardhan (New York: Oxford University* government agencies that seem mired in ineffi- Press, 1989); The Economics of Rural Organization, ed.ciency and corruption, with tendencies toward Karla Hoff, Avishay Braverman, and Joseph Stiglitz (Newovercentralization; and York: Oxford University Press, 1992); and J.Y. Lin and J.B.

Nugent, "Institutions and Economic Development," in

a how to "take account" of indigenous institu- Handbook of Development Economics, Vol. 3, ed. Jere R.*ionw. to"ae con" fidieosintt- Behrman and T.N. Srinivasan (Amsterdam: North-Holland,tions. 1 995).

Notes 4. Warren J. Samuels, "Institutional Economics," inCompanion to Contemporary Economic Thought, ed. David

1. Brian Van Arkadie, "The Role of Institutions in Develop- Greenaway, Michael Bleaney, and Ian M.T. Stewart (Londonment," Proceedings of the World Bank Annual Conference on and New York: Routledge, 1991), p. 106.Development Economics 1989, Supplement to The WorldBank Economic Review and The World Bank Research 5. For example, Economic Anthropology, ed. Stuart PlattnerObserver, pp. 153-175. (Stanford, CA: Stanford University Press, 1989).

2. Market Institutions

Markets in developing countries can be liberalized institutions can participate in and even facilitatein the sense of freeing prices and yet not work well economic modernization.) In this perspective, onefor poor people. Conventional economics teaches emphasizes the importance for "making marketsthat there are various reasons why competitive work" of better legal systems and the uncorruptedmarkets may not yield Pareto optimal results, such and efficient administration of justice. One stressesas decreasing cost industries and monopoly, such informational aspects as better weights andexternalities, public goods. The economics of measures and, more generally, better institutionsinformation adds others, such as adverse selection, for gauging, certifying, processing, and diffusingmoral hazard, and incomplete contracting. These information about the quality of products, people,last problems will be especially severe when risks, and services.information is scarce, difficult to process, andasymmetrically held; where property rights are Are there success stories we can learn from? Andunclear; and where legal systems do a poor job of are there usable frameworks that might help us indefining and enforcing commercially relevant rules, practice analyze market institutions and suggestsuch as loan repayment and contracts-in other ways to improve them? The answers are yes andwords, under conditions that characterize many yes. Several examples and an analytical frame-developing countries, especially in rural areas. work can be found in my book, Adjusting to

Reality.' Two general points deserve emphasis.Indigenous societies develop their own institutions The first is that well-functioning markets oftento address problems of adverse selection, moral depend on well-functioning states. For example,hazard, incomplete contracts, and the rest. Econo- property rights and contract laws must be wellmists have analyzed sharecropping as a rational specified and enforced-so must rules about thesolution to the need to balance incentives and risk repayment of debts. Since information has aspectsin a principal-agent relationship. The prevalence of of a public good, states play a central role insharing arrangements, indeed the relative strength helping markets overcome problems of informa-of extended family and of clan, can be partially tion asymmetry. The second point is that states areunderstood as a response to environments of great often ineffective in playing their roles of enforcerrisk. Rural people in Africa may "save" in the form and information enhancer. Indeed, the privateof cattle so as not to be subjected to harassment for sector, especially in developing countries, is lessnot sharing a more divisible resource such as grain constrained by states that intervene than by statesor money. Rotating savings and credit associations that intervene ineffectively, corruptly, or not at all.may reflect a similar need to save in a way that one And so our attention turns to the question, whatis credibly able to refuse kin and clan who wish to can be done to make the institutions of govern-borrow. ment-and more generally nonmarket institu-

tions-work better?Economic development can be understood assupplementing or even replacing these traditional Noteinstitutions and practices with more moderninstitutions for dealing with risk, imperfect infor- 1. Adjusting to Reality: Beyond "State vs. Market" inmation, credible commitment, and contract enforce- Economic Development (San Francisco: ICS Press andment. (Below I will discuss how indigenous International Center for Economic Growth, 1991).

3

3. Nonmarket Institutions

"Better states" does not only mean states that I have picked an issue that I believe is of centralspend modestly or states that respect rights. Nor importance and also susceptible to new ap-does it only mean states that adopt sensible proaches by organizations such as the Worldmacroeconomic policies. "Better" also means Bank. It concerns the crisis in public sectorovercoming chronic problems of poor incentives, incentives. Some "success stories" are outlined insystematic corruption, and overcentralization. Adjusting to Reality. In the first appendix to thisProblems with public agencies should not be seen paper, I provide a qualitative outline of a model ofas the simple result of evil or megalomaniac the incentives problem, which goes beyond thepoliticians nor of public servants who lack admin- framework of Adjusting to Reality. For now,istrative skills. An approach more in the eco- consider an example of current interest, one that isnomic spirit says that government agencies and not yet a success story: public sector incentives intheir employees are reacting rationally to the The Gambia.circumstances they inhabit.

The Incentives Problem: The Case ofPart of the problem is the nature of the outputs The Gambiaand production processes in the public sector. Inmany cases "products" are hard to measure and, As an enclave surrounded by Senegal, Theif they have aspects of public goods, hard to Gambia is in many ways atypical. But many ofcharge a price for. Production technologies-that the problems I learned about during a recent visitis, the way that inputs combine to produce public are generic.goods-are difficult to specify. For these andother reasons, it will often be more difficult to Low pay. A January 1994 government documentimprove internal structures of information and notes that in 1992-93 government "salaries in realincentives in public agencies compared with terms were still well below their 1984 levels .private agencies. Institutional economics predicts In addition, official public service salaries for high"weak" incentive systems, long-term employment positions are also extremely low when comparedcontracts or understandings, merit systems based with those in the parastatals and the privateon credentials but not performance, and a "pro- sector." A systematic study of salaries is plannedcess culture." for 1994-95. But even in the absence of compre-

hensive data about relative wages and the brainBut improvement is possible. Both the new theory drain out of public service, virtually every docu-of the firm and contemporary examples suggest ment I saw and every interviewee made the pointthat once the problems are identified and ad- that salaries were too low to attract and retaindressed, improvements (be they first-best or qualified professionals in many key areas ofsecond-best) can be devised. These will in turn be government.' In the just-completed May 1994subject to gaming, ratchet effects, influence high-level meetings between the government andactivities, and other phenomena; but these as- the Bank, it was estimated that governmentpects, too, can be creatively and productively salaries have fallen by 40 percent in real termsaddressed. over the past decade.

4

5

An example is the Accountant General's (AG) blueprints. Third, because such studies are techni-domain. Currently, two members of the AG's cally complicated, they must be undertaken byapproximately 175 central staff have a professional expensive foreign technical assistants. (Is it cynicalcredential in accounting; three are away on train- to note that this prevailing approach is pushed bying. None of the approximately 175 accountants in a number of foreign technical assistants?)the various ministries and departments, whichreport to the AG, has a professional qualification. The number of studies planned and underway in

The Gambia is remarkable. For example, in thePoor pay helps explain these problems. Even at Ministry of Finance's efforts to reform taxes, manythe technician level, employees can earn 100 recent meetings have had as a principal outcomepercent more in the parastatals and 200 to 500 the definition of a long string of studies to bepercent more in the private sector, plus perks. carried out by foreign experts. Government"The biggest headache is pay," lamented the documents in preparation for the World Bank'sAccountant General. "The government pays for the sectoral adjustment loan-documents themselvestraining and then when people come back, they go drafted in large part by foreign technical assis-off to greener pastures." tants-foresee many other new studies.

Weak pay-performance linkages. It is becoming The phenomenon of studies is not confined towidely recognized in The Gambia as in many other economic matters. In the course of a conversationcountries that there is something economically with the Solicitor General, she told me that a largeundesirable about pay that remains the same sector study of the legal system was to be under-whether one achieves much or little. taken with support from the US Agency for

International Development. I noted that I had readHow should one deal with the problems of low a review of the justice system that was done a fewpay and weak linkages between pay and perfor- years ago. Was it possible that the Solicitormance? The prevailing and mistaken approach in General and her colleagues already knew whatThe Gambia seems to have three components. was wrong with the legal system, without any newFirst, any reform should involve massive changes studies, and that they could in effect do a sectoracross the entire civil service. Second, such review themselves, working weekends for areforms require comprehensive studies and month?

TABLE 3.1: Two APPROACHES TO INCENTIVE REFORMS

Prevalent Approach Proposed Approach

Ends of reform Across-the-board pay increases; Selective pay increases thathorizontal equity across jobs eventually spread; incentives

linked to performance targets

Means Long-term studies leading to Experiments with a few keysystemwide reform; foreign technical elements of the civil service;assistants do the studies; learning by public officials define measures ofplanning success; learning by doing

Constraints Budgetary austerity; donor pressure Begin with revenue-raising andto reduce wage bill cost-saving experiments that can

pay for themselves; use aid tofund experiments

Facilitating conditions Studies; technical assistance; political "Institutional adjustment,"will to reduce the size of the public including better information,service more dient participation,

competition

6

Box 3.1: DESIGNING AN EXPERIMENT WVIH INCENTIVES: OUTLINE FOR A MODEL MEMORANDUNf

1. Quantitative summary of the current unsatisfactory situation. Because of X, Y, Z shortcomings(resources, incentives, capabilities), we are currently able to process only A%, of the cases we should, and ofthose, only B% are processed adequately. As a result the government and citizens forgo a, ,B, y benefits andincur A, qp, 0 costs.

2. Examples. Here are three recent examples of things we were unable to do that clearly led to forgonebenefits or additional social costs.

3. Measures of success. After considering our objectives and our organization's key tasks, here are themeasures of performance along which we believe it is fair that we be assessed. Some are quantitativeindicators of the tasks we perform and the results we obtain. Others are qualitative ratings, constrained bya curve so that not everyone can be rated "top one-third." Still others may be based on the detailedevaluation of a sample of particular cases.

4. Proposition. If we had x, y, z (additional resources, incentives, capabilities), we will in K time-period beable to achieve (even if qualitatively) the following measurable benefits and reductions in costs: 1, 2, 3, 4,and so on. We are willing to make such-and-such of the incentives conditional on the attainment of so-and-so performance targets, which will be monitored in the following transparent ways: i, ii, iii, iv, and so on.

She shook her head and smiled. "You're right. We Specifically, the government would select a fewcould do a study quickly that would identify six key functions, such as revenue raising, auditing,areas that need fixing. But that's a problem here; and the justice system. In each area, the govern-it's always more studies and more studies. Most of ment would challenge Gambian officials to definethe aid received goes for studies, and then the qualitative and quantitative performance mea-studies say what we already know." sures. These could include:

Policy research of course does have its place. It is * quantitative measures of (a) activities under-the reflex of calling for a comprehensive study that taken and (b) results achieved;deserves noting and criticizing. In contexts likeThe Gambia's, this approach generally takes toolong, costs too much (especially the salaries of the * contests designed by employees;foreigners who do the studies), runs into politicalroadblocks because of its "grand reform" nature, * estimates of the quality of a sample of activitiesand, in the case of the civil service, probably cannot by peer groups, outsiders, or clients, on the provisoengender enough savings to make a big enough that ratings also include "grades on a curve" sodifference to civil service pay to matter. that not every person and activity is deemed

"excellent";The different approach recommended here isselective and experimental. It is at once humbler m staff morale and turnover; andand bolder than the current approach. It is hum-bler because it recognizes that comprehensive * statistical controls that "adjust" measures ofstudies are limited in their ability to blueprint performance by the relative difficulty of the targetchange. It is bolder because it calls for learning group one is working with (for example, for taxfrom experiments, even from their negative lessons. collectors, which region, type of economic activity,It hopes to shock the entire civil service system into type of tax, and so on, all of which affect thechange by experimenting with indicators of perfor- amount earned).mance and pay. It would involve Gambianscentrally in the design and evaluation of the These ideas would be broached in participatoryexperiments, as opposed to their usually peripheral seminars. Then experiments would make rewardsinvolvement in grand studies. of various types contingent on the achievement of

7

performance targets. The rewards should include * Promote competition and countervailingpay, but also can mean training, travel, profes- forces-including civil society, the media, thesional recognition, reassignment, promotion, better legislature and the courts, and political parties-working conditions, more independence, and so and procedures that allow these different interestsforth. Some of the incentives could be for individu- and voices to make a difference in policy andals, but many would be for teams (offices, bureaus, management.even entire ministries).

* Launch a systematic campaign against corrup-As an example, Teneng Jaitah of the Ministry of tion.Finance and I worked with several groups ofGambian officials on the outline shown in Box 3.1. a Harden the budget constraint. One possibilityEach agency is challenged to work through this is to reduce foreign assistance. Another is tooutline, as a kind of preface to experiments with make aid contingent on progress in institutionalincentive reforms. adjustment.

Overcoming Constraints on Incentive Reforms This approach contrasts with traditional ap-proaches to institutional development, which are

The current approach to incentive reforms rightly based on the premise that what is needed is more:feels constrained by budget exigencies and pres- more training, more personnel and equipment,sures from foreign donors to reduce the overall more coordination, more studies and centralpublic wage bill. The approach recommended here planning, and more TA. My argument is thatmust also countenance these realities. But it has without improvements in information and incen-several decisive advantages. tives-and more broadly, without institutional

adjustment-the usual approaches can be expectedFirst, it proposes experiments, not wholesale to fail in the difficult environments now facingreforms. Experiments are less expensive. Some many developing countries.technical assistance (TA) money now used forstudies could instead fund learning-by-doing with Do we have analytical frameworks to guide us,better performance measures and new incentive and success stories to give us ideas? Again, Ischemes. believe the answers are yes and yes, although there

is still much to learn. Adjusting to Reality2 presentsSecond, because it is selective, this approach can details on the incentives problem (see also thebegin with sectors where the experiments are likely appendices, below) and ideas about economicto be self-financing, such as revenue-raising. Cost approaches to two other chronic problems of non-savings can be documented rather readily in market institutions: corruption and determriningcertain areas, such as tendering, public works, and the right level of centralization and integration oflegal costs. In other areas, such as auditing, public agencies.accounting, and investigating, the immediatebenefits may be less financially tangible but Notesessential to a campaign to improve government

management in general. 1. For example, a recent government document estimates thatsalaries in Inland Revenue are about half as great as those for

Third, this approach can be built into a broader similarly qualified people in the private sector. The averagenew strategy for institutional adjustment: monthly wage of a customs officer is so low that it is

"extremely difficult for staff to manage on their monthly* Improve incentives. Link incentives to infor- wages. This may well be a factor behind the widely publi-mation about the attainment of agreed-upon cized allegations of bribery and corruption within the Customsobjectives. and Excise Department." ("The Gambia, Administrative

Reform Program," January 1994, draft, pp. 27, 30.)

m Enhance information and evaluation. Put it in 2. Especially chapters 6-10. Also relevant is Robert Klit-the hands of clients, legislators, and those with gaard, Controlling Corruption (Berkeley and Los Angeles:official oversight (regulators, auditors, judges, and University of California Press, 1988). Both books includeso on). case studies of success as well as analytical frameworks.

4. Indigenous Institutions

Recently, my research has tumed to a third area These may include organizations we can see andthat involves institutional economics, although study, such as rotating savings and credit associa-other disciplines quickly enter. How can one tions or age groups or water-users associations, asunderstand and "take into account" what might well as other "institutions" that are less tangible,be called indigenous institutions in economic and such as rules of enforcement of repayment andpolitical development? agreement, norms for aiding people in distress

(when negative risks become realities), and evenConcern for indigenous institutions is increasing, belief patterns.6 The economics of informationand we have seen in recent years remarkable helps (or should help) anthropologists get beyondexamples of relevant research. For example: their debate over whether primitive economies can

be understood as having markets, and instead* The rigorous documentation of the high correla- analyze many institutions in terms of risk-sharing,tion between the density of civic institutions to the overcoming problems of imperfect information,quality of government in Italy.' and the like.7

* The combination of qualitative and quantitative Second, economics can help us to see that indig-methods to show that the "fit" between traditional enous institutions are part of a complicated systeminstitutions and modem structures distinguishes of relationships, wherein the institutions are"successful" and "unsuccessful" Native American themselves a function of such things as the socio-reservations.2 economic setting and conditions, the particular

paths of local history, and public policies, and at* New studies of successful African management the same time those institutions change with somewhich emphasize the roles of indigenous institu- lag and themselves condition the "productiontions.3 function" for development.

* Studies suggesting that indigenous institutions (1) Indigenous institutions = f (socioeconomicare crucial to the success of many rural credit setting, history, policies, ... )programs.4

(2) Development outcomes = g (socioeconomic* One of the first applications of the cross- setting, history, policies, indigenous institutions,cultural information about local institutions from ... )an anthropological data bank to a practicalproblem of development policy.5 (3) Utility function for development outcomes = h

(socioeconomic setting, history, indigenousTwo sorts of economic insights are relevant. First institutions, . . .)is the idea that, in the absence of formal legalsystems and well-developed markets, people The third equation states that the utility functionsolve problems of incomplete contracts, adverse for various kinds and levels of so-called develop-selection and moral hazard, and risk-sharing ment may also vary as a function of indigenousthrough a variety of indigenous institutions. institutions, among other variables. Thus, indig-

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enous institutions enter in many ways: shaping what is local and unique, seeming thereby towhat is desired, interacting with policies to devalue it. And to overcome this phenomenon,mediate outcomes, and themselves undergoing "taking us into account" means "consult us, talkchange in the development process. An analytical with us, listen to us." To many intellectuals, theapproach derived from economics may help needed "respect" has a different connotation:formulate useful questions for sociologists, the recognition of the "symbolic motor," or theanthropologists, and others. What do these autonomy of meaning from material causality,equations look like in fact? What sorts of interac- that culture provides and indigenous institutionstions are there among policies and indigenous embody. Not coincidentally, this text can alsoinstitutions? How do such institutions change- be a cri du coeur from noneconomists andand how might local peoples resist those changes nongovernment organizations vis-a-vis econo-or accelerate them, if they so desire?8 mists, quantitative approaches, and large formal

institutions.Guidelines for Adjusting to Institufions

3. Enable them. An insight of this text is thatHow might indigenous African institutions be institutions, even traditional ones freighted with"taken into account" in the improvement of meaning as well as functions, are not exogenousgovernments, markets, and management? The or static. They respond to, among other things,Bank's ongoing research under the label "Africa's conditions of risk and opportunity, and to bothManagement in the 90s" is exploring this question market and nonmarket failures. They will bethrough a series of fascinating studies.9 As we optimally enabled-in some cases strengthened,have seen, indigenous institutions can among in others perhaps replaced-by creating a well-other things respond to market and nonmarket functioning democracy, the rule of law, incentive-failures of various kinds. Their effects are not driven and output-oriented governmentsimple, however. They contain their own dynam- bureaucracies, and vigorous competitive marketsics of meaning and perhaps also of inefficiency with ample information. In other words, afterand market power. Thus, they potentially have structural adjustment, democratic reform, andboth benefits and costs, and both should be "taken "institutional adjustment," indigenous institutionsinto account." will be optimally "taken into account" via correct

incentives for the public and private sector to doBut what exactly do the words in quotes mean? I so. Therefore, says this text, we don't have todiscern very different answers to this question- figure out how to take them into account; we justwhat might be called different "texts" in the sense have to create a system with lots of informationof literary criticism, namely something akin to and correct incentives so that local actors willintellectual reflexes or templates. Let me distin- themselves do so.guish, artificially but I hope recognizably, foursuch texts. 4. Connect with them, reconcile with them. Dia's

work hypothesizes that at the core of Africa's1. Give them resources. To some, taking indige- development problems is a "disconnect" betweennous institutions into account means giving them modern and traditional institutions. The corollaryresources and agreeing to go along with whatever is that a "reconciliation" of these institutions is thethey come up with. If one asks why such institu- answer. Two features of these propositions as ations should not simply be left alone, the answer is text seem important.that they have legitimacy but lack "capacity." Adanger here is a kind of "traditional fundamental- One is akin to "I'm okay and you're okay." Bothism," and what many Africans apparently per- indigenous and modem institutions have some-ceive as inefficiency and unfairness in many local thing to offer; they must be reconciled, merged,institutions, even when "legitimate." For ex- creating something new. As a consequence, toample, some possible costs of relying on indig- those relying on this text it is uncomfortable to askenous institutions come to the fore when a gender whether for some tasks and in some settings theperspective is taken. problem is too much merging of traditional

practices into modern institutions, or that in other2. Give them respect. To some observers, both circumstances merging may lead to co-optationdonors and governments systematically bypass and even demise.

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Another feature is the robust mysticism of merger: taking indigenous institutions into account also be"Don't just give them resources, don't just talk, and part of the strategy?"don't just enable-somehow we've got to gettogether and both become something new." Exactly Imagine a matrix. There are many kinds of devel-what this means, the adherent admits, is unclear, opment problems, in which different kinds ofbut it is deeply felt: this text tends to combine indigenous institutions may under different kindsexhortation and frustrating vagueness. of sociocultural conditions play differentially

useful roles-while for other kinds of problems inThe reader will recognize that these four texts other sociocultural settings the same institutionsgo well beyond issues of indigenous institutions and may have little or no useful role. We need todevelopment. Indeed, I suspect that one's choice unpack this matrix of problem, sociocultural context,among these prototypical texts is influenced by such and institutions.things as one's academic discipline, "personalitytype," and "culture," perhaps as much as by the Here are some ideas for doing so:evidence on the specific subject under discussion,such as indigenous institutions and development. Market Failures

But the point here is not the origins of these "texts" Take credit markets as an example. They exhibitor even their validity, rather that we need a re- predictable problems of information, economies ofsponse that is akin to literary criticism. It is worth- scale, and enforcement. Indigenous institutionswhile to recognize that multiple texts exist, to may help overcome these problems. For instance,analyze them and deconstruct them-especially our they may have better information on the riskinessown texts. We must be ready to hear these differing of specific potential clients and more efficientresponses and to double check our own reactions to screening techniques. They may provide a low-costmake sure they are not simply texts.10 How might and credible way of pooling transaction costs andwe push such discussions beyond texts? risks, taking advantage of economies of scale. They

may possess both techniques of enforcement and (ifOne goal of development is to replace inefficient carefully designed) appropriate incentives formethods of production (technologies in the amplest applying them.sense) with more efficient ones. Since productivityis often higher in other parts of the world than in This is only one example. The general headingmany underdeveloped regions, it would seem easy for project designers and policy makers is this:to "develop" simply by borrowing better produc- What are the market failures we see? How mighttion technologies. But we have learned that borrow- indigenous institutions provide the information,ing is often not successful because (among other economies of scale, enforcement, incentives, andthings): so on, that could help mollify those failures? What

new problems would using such institutions entail* Resources are insufficient (capital, human (for example, their managerial inefficiency andcapital). their own implicit market power) and how might

these be ameliorated (for example, management* Incentives are skewed (public sector, private training, accounting systems, oversight, and so on)?sector).

Bureaucratic Failures* Property rights are weak.

Typically it is difficult to measure outputs in public* Monopoly power is seized for private ends and agencies and therefore difficult to create appropri-not public purposes, in part because countervailing ate incentives within the bureaucracy. Controls,institutions are weak or absent. discipline, professionalism, and exhortation

attempt to substitute for links between pay andResponding to these problems, development performance. But they are imperfect substitutes,strategies have moved from the simple increase of and monopoly plus discretion minus accountabilityphysical and human capital to the adjustment of is also a recipe for corruption. In many countries,economic policies to governance to institutional bureaucracies underperform and even becomeadjustment. Now we raise a further issue, "Might predatory, perhaps especially in countries with low

].1

levels of human resources, weak countervailing councils from local to regional to national levels:institutions, and legacies of colonialism and dirigiste councils of indigenous institutions. The possibilitieseconomics. and the pitfalls of such initiatives, in terms of

inefficiencies and possible monopoly power, mustHow might indigenous institutions play a role in be anticipated. The idea once again would be toovercoming these failures? The policy analytical create a kind of checklist or framework for policytask is to examine the sources of the failure one-by- analysis, which would then be applied to specificone. Might indigenous institutions be utilized to situations.provide better information on the outputs ofgovernment agencies? How? Might they provide These headings are I hope suggestive but they areincentives to government agents? Might they be certainly not exhaustive. They try to exemplifyefficient mechanisms for the delivery of public three points.services, perhaps because they "internalize" someof the costs of predatory behavior and therefore First, to understand where indigenous institutionshave better incentives to deliver the goods? Might might have a role to play we need to analyze thethey be used to provide "competition" in service specific sector or problem at hand, its market anddelivery? Working through such questions might nonmarket failures. Second, we need a framework orgenerate a host of ideas that otherwise would not model for analyzing these market or nonmarkethave occurred to us. failures. The one I have been using is economic;

there may well be other useful approaches. Third,Once again, we must also anticipate the problems in this analytical effort it will of course be essentialthat using such institutions might entail-co- to have local knowledge and involve local experts inoptation, inefficiency, the creation of market power, indigenous institutions. Through this process oneand others-and consider ways to ameliorate or would analyze the benefits and costs of variousprevent these problems in advance. ways of taking indigenous institutions into account.

The Rule of Law Adjusting to local institutions would likely havemany forms, depending on the problem, the

The administration of justice is often an obstacle to institutions, and the sociocultural setting. Some-economic as well as political development. How times indigenous institutions would be importantmight traditional institutions help remedy some of and sometimes unimportant. Sometimes the resultthe failures of the current system? As in the previ- might be to avoid indigenous institutions alto-ous headings, we would analyze various dimen- gether. The point is that by working systematicallysions of information and incentives. We would add in project and policy design through frameworksfurther headings. Can traditional means of dispute like these, we might be able to go beyond "texts"resolution be exploited to replace or supplement and generate practical ideas for taking indigenousmore formal mechanisms? institutions into account-ideas that through our

customary modes of policy analysis might other-Again, the costs and risks of using indigenous wise never surface.institutions would be analyzed as well. What sortsof training and accountability might render these Notes"informal" mechanisms more efficient and lesssubject to monopoly-creation and arbitrariness? 1. Robert Putnam, with R. Leonardi and R.Y. Nanetti, MakingWould these "improvements" themselves threaten Democracy Work: Civic Traditions in Modern Italythe indigenous institution in any way? (Princeton, NJ: Princeton University Press, 1993).

Governance 2. Among many papers, see Steven Cornell and Joseph Kalt,"Reloading the Dice: Improving the Chances for Economic

How might indigenous institutions help improve Development on American Indian Reservations" (Cambridge,How mlht mdgenou mshttons elp Iprove MA: Kennedy School of Government, March 1992).representation, openness, transparency, andlegitimacy? Consider a Bolivian initiative-the use 3. For example, the many studies described in Africa Technicalof local organizations not only to define needs and Department, Indigenous Management Practices: Lessons forin some cases deliver local public services but also Africa's Management in the '90s, Work Program and Method-(in concert with this) to create a new, parallel set of ology (Washington, D.C.: The World Bank, May 1993);

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Mamadou Dia, "Indigenous Management Practices: Lessons tional behavior." I lament the confusion but have notfor Africa's Management in the '90s," in Culture and Develop- discovered an antidote.ment in Africa, Vol. 1, ed. I. Serageldin and J. Taboroff(Washington, D.C.: The World Bank, 1994). 7. Richard A. Posner, "A Theory of Primitive Society, with

Special Reference to Law," Journal of Law and Economics,4. For a World Bank reference among many examples, see Vol. 23, No. 1 (1980).Jacob Yaron, "What Makes Rural Financial InstitutionsSuccessful?" The World Bank Research Observer, Vol. 9, No. 8. Robert Klitgaard, "Taking Culture into Account: FromI (January 1994), who explains that "One key to success 'Let's' to 'How"' in Culture and Development in Africa, Vol.appears to be the introduction of a social mechanism that 1, ed. Ismail Serageldin and June Taboroff(Washington,lowers transaction costs, while supplying effective peer D.C.: The World Bank, 1994).pressure for screening loan applicants and collecting loans"(p. 68). 9. Mamadou Dia, Africa 's Management in the 1990s and

Beyond: From Institutional "Transplant" to Institutional5. S. Romanoff, S. Carter, and J. Lynam, "Cassava Production Reconciliation (Washington, D.C.: The World Bank,and Processing in a Cross-Cultural Sample" (New Haven, CT: forthcoming).Human Relations Area Files, December 1991).

10. Robert Klitgaard, "Poisonous Texts," Negotiation Journal,6. Many authors have noted that "institutions" means both Vol. 8, No. 3 (July 1992)."organizations" and "norms, beliefs, even patterns of conven-

5. Institutional Adjustment andAdjusting to Institutions

Institutional adjustment means improving the izing public services. There we worried aboutinstitutions that facilitate the achievement of our economic competition. Now we worry aboutaims; adjusting to institutions means taking existing administrative and political competition.institutions into account without changing them.Which should we do, under what circumstances? There are, however, important differences that(Let us take "we" in the most generous possible affect the process of designing adjustment strate-sense to include especially people themselves as gies in the two domains. I will exaggerate to makethey decide to resist or accelerate various brands of a point."development.")

Devising a structural adjustment program centersLong ago Albert 0. Hirschman warned that no on a few crucial decisions at the top: devaluation,matter which choice we undertake we will be setting prices free, lowering tariffs and removingcriticized for it. If we are what he calls "trait quantitative restrictions, deregulating, and cuttingtakers" we decide to work with the institutions we spending. A few people can make and dictatefind. We will later be criticized for perpetuating these decisions in a relatively short time. Ininefficient, hierarchical, sexist, urban-biased Turkey, for example, fewer than ten technocratsinstitutions-even if our efforts succeed. If we are under Turgut Ozal knew the content of reforms"trait makers," trying to alter underlying institu- before they were announced.2 If the politicaltions, we will be criticized as naive, imperialistic, leadership wants it done, it is done. (Aside toculturally biased social engineers-even if our readers who are political leaders: I did say I wasgoals are met.' exaggerating.)

And this is one reason why dealing with institu- In contrast, institutional adjustment requirestions-adjusting them, or adjusting to them-is extensive tailoring to specific circumstances, and itprecarious. It is compounded by the fact that we will require ownership not only by top leaders butseem to know relatively little about how to do by the rank-and-file officials who will implementeither. institutional reforms. Thus, in most cases institu-

tional adjustment will require extensive consulta-True, when thinking about institutional adjust- tion, participation, and joint learning. Process isment, there are appealing analogies to structural crucial.adjustment. In the case of structural adjustment,we worried about "getting prices right" for private This difference implies, I believe, a greater empha-sector agents. Now we worry about "getting sis on experimentation. The word experiment mayincentives right" for public sector agents. There we carry unwanted connotations, but it captures antried to create open and transparent markets. Now important element of successful institutionalwe try to create open and transparent govern- adjustment. A lesson from many past efforts atments. There we worried about property rights administrative reform is that attempts to craftand privatization in order to decentralize economic once-and-for-all, systemwide changes fail. For onedecision-making efficiently. Now we worry about thing, the very complexity and finality of suchempowering stakeholders and optimally decentral- reforms offer too many chances for vested interests

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to resist. Experiments limited in time and extent, in lessons of more general applicability to institutionalwhich the vested interests can help design the ways adjustment and hints for a catalytic role for outsid-to measure success, give reforms a chance. ers. Sensitive subjects like corruption, and more

broadly institutional adjustment, may require aMost institutional reforms will need to learn as they therapeutic approachi. First the subject of corruptiongo. Blueprints are simply too difficult. Framing is demystified through the analysis by participantsadjustment efforts as "experiments" emphasizes of case studies from other countries-and casethe learning. It also suggests measurement after a studies of successful campaigns to reduce corrup-specified period of time, which is also welcome. tion. Then analytical frameworks are supplied that

help participants realize that corruption is not (justThere are exceptions to these generalizations. or primarily) a problem of evil people, but one ofSometimes, in order to be credible and effective, sick institutions. A heuristic formula is: corruptionchange must be systemwide and sudden, without equals monopoly plus discretion minus account-the announced prospect of changing again after an ability. To members of corrupt organizations thisexperimental period. insight often proves therapeutic.

But with regard to institutional adjustment, my As in good therapy, the participants then move toexperience is that it is wise to begin in carefully self-diagnosis and self-prescription, looking atdefined sectors with efforts that may be criticized corruption in their own ministry or country, itsfor being "too simple," but from which lessons can causes, and its possible remedies. The facilitatorsoon be drawn and improvements made. Doing assists in several ways: by asking questions,too many sectors with too complicated a system is helping combine seemingly different phenomena ortheoretically preferable but practically perilous. separate seemingly similar ones, by pushing when

the group avoids work or escapes into relativism orBut aren't these institutional issues too sensitive cynicism. Out of such an experience emerge both aand too contextual for the World Bank to consider? deeper understanding of general phenomena andDo the Bank's comparative advantages include specific manifestations of corruption, and a plan ofsuch things as local knowledge, politics and history action to begin to fight them.and culture, and projects with large requirementsfor participation and partnership in the sense I This plan may require assistance, and this is wherehave been describing? external actors can help. Beyond money and ideas,

outsiders can help in surprising ways by "impos-These questions raise serious issues. But in some ing" conditions and deadlines that fortify localcases I believe the World Bank's entrance into decisionmaking and self-discipline. An aura ofinstitutional adjustment can be catalytic. Some- international respectability-"part of a worldwidetimes outside assistance can help legitimate sensi- program to fight the universal plague of corruption,tive issues, help leaders make credible not just here in [country x]"-may help nervouscommitments. Incidentally, with regard to institu- actors coalesce around reform.tional adjustment the dividing line between "will-ing" and "unwilling" leaders is not as clear as As part of a strategy of institutional development,journalistic accounts may make it appear. For the World Bank and other agencies may be able toexample, in my experience many leaders are, so to "lever" such workshops. A project that followsspeak, schizophrenic about corruption. They may such an event-or several such events at differentsincerely loathe it and wish to eradicate it, while at levels of the public and private sectors-may usethe same time participating in it or allowing it to the workshop's recommendations, co-opt key actorsoccur. It is also true that in my workshops on as managers and monitors, and via carrots andcorruption, after some time people are remarkably sticks improve the chances that the adjustmentfrank about the corruption that exists, how it process will succeed.works, and how it might be prevented-even whenthese analyses belie an incriminatingly intimate Healing the Aid Relationshipknowledge.

The therapeutic metaphor may be carried one stepI do not have time to describe these several-day- further-the need to adjust the institution oflong workshops here, but I do want to cite certain international aid itself. The relationship between

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donor and recipient, between lender and borrower, requires learning together, new processes ofhas its own rules of the game. They, too, may together analyzing and experimenting with ourbenefit from economic analysis. Some of the incentive structures.failures of aid to foster institutional developmentcan be analyzed using institutional economics. Let us go even further. I mentioned above thatConsider three incentive problems in the aid sensitive subjects like institutional adjustment mayrelationship. require a tiherapeutic approach. At the end of

Chiildhood and Society, Erik Erikson concludes thatFirst, technical assistance personnel are usually not the therapist has to become a partner and tran-paid for training successors or developing capacity, scend certain historical roles. Listen and see if hisbut for completing a certain technical job (or simply words do not also ring true for the aid giver, thefor being in situ for a contractually specified length foreign adviser, the expatriate activist.of time).

"In a more enlightened world," Erikson wrote inSecond, staff members of donor institutions often 1950, comparing the situation to that in Freud'slack appropriate incentives. Their compensation time, "and under much more complicated histori-and promotion depends hardly at all on the cal conditions the analyst must face once more theeventual success of "their" projects, but instead on whole problem of judicious partnership whichshorter run measures of "craft" quality and even expresses the spirit of analytic work more cre-the amounts of money or number of projects atively than does apathetic tolerance or autocraticmoved through the donor bureaucracy. If officials guidance. The various identities which at first lentare forced to operate through narrow-gauged themselves to a fusion with the new identity of theprojects, it can inhibit their ability to tackle cross- analyst-identities based on talmudic argument,cutting institutional issues such as information and on messianic zeal, on punitive orthodoxy, onincentives.3 faddist sensationalism, on professional and social

ambition-all these identities and their culturalThird, lending agencies do not optimally share the origins must now become part of the analyst'srisks that their conditional aid entails. In principle, analysis, so that he may be able to discard archaicthe amount they are repaid should depend in part rituals of control and learn to identify with theon the success of their conditionality, given that the lasting value of his job of enlightenment. Onlyrecipient follows it. Currently, the risks are dispro- thus can he set free in himself and in his patientportionately borne by recipients. that remnant of judicious indignation without

which a cure is but a straw in the changeable windThese three incentive problems help explain some of history."5

of the chronic problems of the aid relationship. Allthree will be difficult to remedy. Like some of the Notesproblems analyzed above, their amelioration mayrequire an experimental attitude, the participation l. Albert 0. Hirschman, Development Projects Observedof staff and clients in pilot efforts, and an openness (Washington: The Brookings Institution, 1962).

to learn with other donors and with recipients. 2. Anne 0. Krueger, Political Economy of Policy Reform in

Developing Countries (Cambridge: MIT Press, 1993), p.So, the economic perspective suggests that aid 131.resembles a transaction involving risk-sharing andappropriate incentives. But aid is more than a 3. Samuel Paul, Institutional Development in World Banktransaction: it is a relationship, a partnership (as Projects: A Cross-Sectoral Review. WPS 392. (Washington,the Bank's Katherine Marshall among others has D.C.: World Bank, Country Economics Department, 1990),emphasized). The aid relationship is itself an esp. p. 45.institution in need of adjustment. Beyond econom-ics, might other metaphors lead us to the right 4. Thomas Bucaille, "Metamorphoses du probleme africain:ics, might other metaphors lead us to the right L'economie africaine et la cooperation frantais depuis 1945,"kinds of institutional reforms in this domain? E VThomas Bucaille has usefully noted that aid is, or Etudes, Vol. 373, Nos. 1-2 (1990).should be, a pedagogical relationship in the best 5. Erik H. Erikson, Childhood and Society, 2nd ed., revisedsense of that dangerous word.4 Understanding our and enlarged (New York: W.W. Norton, 1963 [1950]), p.individually and mutually inappropriate incentives 424, emphasis added.

Appendix 1: Some Economics of IncentiveSchemes

This appendix tries to convey the essence of an industry demand y. You might take y into accounteconomic approach to the incentive problem, to enable a more precise estimate of my effort.using a variation of the principal-agent model. Acentral idea is that since the agent's performance The wage you pay me can be analyzed as havingis only imperfectly measured, paying a wage two parts, one fixed and one dependent on yourbased on what the principal can observe creates a assessment of my effort:risk for the agent. Because of risk-aversion, theagent would prefer a fixed wage that does not w = cc + 1 (e + x + yy)depend on performance. But the principaldislikes fixed wages, because then the agent has D is a measure of the incerntive intensiht of our wageno economic incentive for higher performance. contract. When it is zero, you pay me a fixed wageThe optimal wage agreement strikes a balance a. The parameter y measures how much weightbetween risk-sharing and incentives. Usually this you give to y in relation to z.combines a fixed payment that does not dependon a measure of performance with a variable What contract would be socially optimal (for thepayment that does. two of us?) Assume expected values of x and y are

normed to zero (for convenience), and assume noThe appendix then tries to derive, schematically, wealth effects. My certain equivalent is equal tosome policy implications of this approach. expected income-cost of effort-a risk premium

for the income risk I bear because (x + yy) is aThe Model random variable. Milgrom and Roberts (1992: 247)

show that the risk premium turns out to be ap-Suppose you are the principal and I am your proximated by 1/2r 32 Var (x + yy). Your certainagent. Your profits are a function of my efforts: equivalent as a risk-neutral employer is the ex-Profit = P(e). But my efforts are costly to me: Cost pected profit-expected wage.= C(e). Ideally, you would pay me a wage equalto the value of my marginal product. But you Both of our certain equivalents depend on the fourdon't know my effort e, at least not perfectly. You variables oa, e, 13, and y. By the assumption of "nocan observe an indicator of my effort, which is wealth effects," an efficient contract will maximize

the sum of the certain equivalents. But there is alsoz = e + x, an incentive constraint, which says that I as your

agent will set my effort level such that the marginalwhere x is a random variable representing the benefit = marginal cost. So an employment con-measurement error. tract is efficient if and only if the choices ca, e, 1,

and y maximize the total certain equivalent amongYou can also observe a variable y, which is not all "incentive compatible" contracts where 13 - C'(e)correlated to e but is correlated to x. For example, = 0. The solution generally has some fixed pay andsuppose z is sales of the product for this month. It some variable pay that is a function of the twois some function of my effort but also depends on measures z and y.

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TABLE Al: CoNDroNs FAVORING AND NoT FAVORING PAY-PERFORMANCE LINKs

Aspect of Incentive Favorable to Intense Unfavorable to IntentseIntensity Principle Incentives Ince ltives

P'(e)= marginal social Additional efforts by Because of other constraints,benefits of more effort public servants lead to additional efforts by publicby agent big gains in effectiveness servants yield no gains in effectiveness

r = agent's risk-aversion Employees are almost risk- Employees are very risk-averse,neutral, perhaps because perhaps because poorplentiful opportunities existand they are already well-off

Var (x+yy) = how Effort and results are easy Effort and results are almostaccurately agent's effort to measure impossible to measure

C"(e) = responsiveness Effort is very responsive to Effort is not responsive toof agent's effort to incentives incentives (for example, high incentives (for example, fixed-

discretion) pace activity)

From this model we can derive the incentive insufficient funds available foi evaluation inintensity principle. The strength of incentives many poor countries.should be an increasing function of the marginalreturns to the task, the accuracy with which The incentive intensity principle suggests thatperformance is measured, the responsiveness of under some unfavorable conditions, intensethe agent's effort to incentives, and the agent's incentives will not yield efficient bureaucracies.risk-tolerance. Under those conditions, trying to raise 13 would

have meager and indeed perhaps negativeD = P'(e)/ {1 + r[Var(x +yy)]C"(e)} effects.

where C"(e) is the slope of the marginal effort But there is a third point. The four parameters ofcurve. This formula is computed by maximizing the incentive intensity principle are not necessar-the total certain equivalent of principal and agent ily immutable. In particular, notice that when thewith respect to e.1 measurement of performance improves, a wage

package can be constructed that both enhancesThe incentive intensity principle suggests that incentives and reduces risk.3 This is why betterunder some conditions it is optimal to have information is at the heart of institutional reform."highly intense" incentives, but under otherconditions a flat wage is the right choice. Table Al Coping with Problems with Incentive Reformsshows some of the extreme conditions favoringand not favoring performance-based pay. Box Al summarizes some of the difficulties

facing performance-based incentives. Beyond theIn many public bureaucracies, especially in categories suggested by the incentive intensitydeveloping countries, the conditions seem to principle, it adds considerations of incentiveresemble those in the right-hand column of Table dynamics, political economy, and layers ofAl. Of particular importance is the difficulty of hierarchy.measuring performance-in the model, reducingVar(x +yy). In part this is due to the nature of the In particular, agents and principals may takegoods being produced in the public sector.2 In dynamic steps that undermine incentives andpart it is due to the primitive technologies and information. Consider agents first:

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* Agents distort activities toward those things appraisal. The appraisals are often limited toeasily measured at the cost of those things not employee inputs, qualifications, or endowments,easily measured. rather than to the much more difficult idea of

contribution to value-added.* Agents engage in influence activities: distortinginformation, influencing evaluators of information, * In performance ratings, intermediate layers ofnot revealing useful private information. the hierarchy collude with or extract rents from

lower levels, undermining the system (and in* If relative rankings of agents are used, agents extreme models leaving underlings no better offmay avoid useful teamwork or even sabotage than before).others.

Such issues have been analyzed in the literature,* Agents may avoid job transfers or the learning and the complexities of reality soon overwhelmof new skills, for fear of losing bonuses attached to available economic models. In particular, whenexisting arrangements and competencies. dynamics are included, the incentive intensity

principal no longer can be assured to hold.4* Agents may act collectively to transmogrify Without a host of special assumptions, we cannotperformance bonuses into higher base pay. pretend to "compute" the optimal incentive

intensity any longer, even in theory.Principals may also take steps that undermine thesystem: Nonetheless, the very categories suggested by

theory as undermining performance incentives* Ratchet effects: after learning more about the provide a framework for considering how inproduction function, principals move the goal practice these problems might be mitigated. Boxposts, leaving agents worse off than before. Al contains some examples. And, building on the

incentive intensity principle, the framework for* Intermediate layers of the bureaucracy may policy analysis in Box A2 suggests ways to makesimply lack incentives to undertake performance incentive reforms more likely to succeed.

Box Al: SU,MMARY OF SOME CONDITIONs AFFECrnNG THE DESIRABILITY OF PERFORMANCE-BASED INCENTIVES

P'(e) = Marginal social benefits of more effort by agentr = Agent's risk-aversionVar(x +yy) How accurately agent's effort can be measuredC"(e) = Responsiveness of agent's effort to incentives

Additional complications:

1. How to afford incentive schemes (use non-monetary incentives as well; use samples; borrowmeasurement techniques when possible; involve agents and clients in performance appraisal; use partialfees-for-service; watch out for bonuses that become standard).

2. Extraneous factors determine P'(e) (control for them statistically; use tournaments, contests, relativerankings, but these create side-effects).

3. Teamwork (may need group incentives, but then free-rider problems; collusion).

4. Dynamics and political economy (skewing agents toward the measurable to the detriment of the lessmeasurable; "influence activities," including dissimulation, gaming, sabotage, and corruption; ratcheteffect; creating disincentives for transfers, learning new skills, and so on; answers include a richerinformational environment and processes that build transparency and credibility).

5. Layers of bureaucracy (evaluators may not have correct incentives).

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Box A2: A (PARTIAL) FRAMEWORK FOR POLICY ANALYSIS

1. Strengthen the link between employee effort ways to evaluate the experiment's results in aand the agency's value-added. relatively short time.

m Make credible commitments about the evolution* Make sure everyone understands what the of pay-performance formulas over time, to avoid thevalue-added is and how it is being sought. What "ratchet effect." Again, a process is often important.are the "key tasks" of the organization? What For example, if employees, management, and clientsdoes it take to perform them better? help appraise progress and set new incentive* Incentive reforms require the participation of schemes, along with a guarantee to return to statusemployees themselves in the specification of each quo ante under agreed-upon conditions, this mayagency's objectives, performance measures, and engender the confidence to enable an experimentincentives. This helps educate everyone on the with incentive pay to begin.links between effort and value-added. * Avoid incentive master plans for all agencieso Help employees improve the quality of their and all time. Learn by doing. Make sure affectedefforts (training, feedback on achievements). parties take part in the evaluation of the incentivea Sometimes p'(e) is dose to zero for any experiments.individual but is large for groups of employees. a Facilitate employee self-selection. IntroducingIn such cases team incentives are more feasible performance-based pay can be expected to leadand desirable than individual incentives. (Free- workers with lower risk-aversion to prefer publicrider problems may then emerge, which demand sector jobs.another iteration of solutions.)

3. Reduce the variance of measures of performance.2. Reduce the risk-aversion of employees.

* Include information from clients.• Raise the level of the pay. a Empower clients. Seek analogies to market* Help remove employees' uncertainties about power or joint management. Experiment with userpay-for-performance by running transparent charges and analogies to them such as in-kindexperirnents where employees (and clients) help to contributions, sharing them with employees.design quantitative and qualitative measures of u Quantitative and qualitative outcome measuresperformance, appropriate incentive schedules, and can be used. So can peer ratings, as long as ratings

The problems raised by dynamic considerations performance and high levels of corruption will beand the political economy of incentive reforms do chronic because, our models say, they are "ratio-not yield ready solutions. Probably, however, part nal" responses to a miserable organizationalof the answer concerns the processes through which environment. For organizations to work better, this(1) performance measures are designed and (2) environment must change.incentives are constructed and tested and reas-sessed. These changes in process can be under- The last point opens new horizons for thinkingstood, I believe, as a rational response to the about institutional development. From the per-possible dynamic and political economy problems spective of a given manager or minister in a givenwith performance-based incentives. system, reforming incentives may be impossible.

Not only do civil service rules not permit it, but theImplications manager may not have the authority or the re-

sources to generate the measures of performanceWe have seen that the desirability and design of on which an effective incentive system depends.pay-for-performance schemes depend in predict- What is needed is analogous to structural adjust-able ways on aspects of the task environment. ment: a change in the rules of the game, a newGiven the task environments found in many public enabling environment. A key feature of the neededbureaucracies in developing countries, perfor- reform is better information about what govern-mance pay will fail, and consequently low levels of ment agencies do and what results they achieve.

21

(Box A2 continued)

are forced to be "on a curve" (that is, not * Incentives include money but also othereveryone can be rated "excellent"). things, which may be less expensive:* Extraneous variables can be taken into promotions, training, travel, special assignments,account in the design of incentive schemes (the y transfers, awards, favorable recognition, andin the incentive intensity principle could try to simple praise. Even information about how wellmeasure such extraneous variables, which are one is doing turns out to function as an incentive.given weight g). Examples are controlling for * Remember the principle of the sample:students' social backgrounds in estimates of incentives can be based on samples ofschool contributions to learning and in the performance. Especially in an experiment, therePhilippines Bureau of Internal Revenue is no need for the comprehensive measurementcontrolling for the tax base of a local district in of each and every outcome of each and everyestimating the efficiency of the district office in action.raising revenues. Also, an incentive scheme may * Cultivate political support, particularly fromemploy measures of relative performance, unions and foreign donors. The idea of ananalogous to tournaments, which help "control experiment reduces their worries and involvesfor" the extraneous variables that affect them in design and evaluation.everyone's performnance up or down. o Challenge technical assistance (TA) by

foreigners. For example, learn by doing rather4. Reduce the costs to employees of additional than attempting comprehensive studies that ofteneffort. end up being inconclusive or unsatisfactory. For

example, use TA funds to finance experiments* Begin with the easiest cases. In particular, try where local experts and even governnentreforms in areas where performance is relatively officials carry out the required "studies" based oneasy to measure objectively and where the the participatory diagnosis of what is alreadyrevenues raised or costs saved can make the known about problems and possible solutions.experiment self-financing. * Privatize creatively. This can mean* Through training and better equipment, shift experimenting with hybrids of public and privatethe cost-of-effort curve. sectors working together to provide services.

Information about performance may incidentally5. Reduce the costs of providing incentives. be enhanced.

The task is daunting, precisely because public effective management is almost impossible" [p. 175].) Asagencies take on the provision of the kinds of prospects for performance pay, the two other comers of thegoods that private markets will not optimally table are in-between.supply. But it is not impossible, as is testified by Can meatuineffiin Cannotmeaue effofan exciting array of efforts around the world. ( a______._re efJort (onno u__ a__rc c_fli7r

Can measure Production (e.g., internal Craft (enforcement agencies,

Notes oaucomes revenue, social security, corps of engineers, forestpost office, FBI) rangers)

1. Paul Milgrom and John Roberts, Economics, Organization Cannot measure Procedural (e.g., armed Coping (foreign service,and Management (Englewood Cliffs, NJ: Prentice-Hall, outconies forces in peacetime) some schools, some police1992), p. 247. activities)

Source: Based on James Q, Wilson, Bureaucracy (New York: Basic Books,2. James Q. Wilson distinguishes four types of public 1989), Chap. 9organizations, depending on the measurability of what mightbe called their efforts and their outputs. In "production" 3. Milgrom and Roberts show that there is an associatedorganizations, both efforts and outputs can be measured; here, monitoring intensity principle. More resources should bethe prospects for performance-based incentives are strong. At spent on monitoring when it is desirable to give strongthe other extreme, "coping" organizations, in which neither incentives. Measuring performance carefully and providingefforts nor outputs can be gauged, are weak candidates for intense incentives are complements. It is also possible thatincentive pay. (Indeed, Wilson says, "In coping organizations policy changes exogenous to any particular manager improve

22

the ability to gather, process, and interpret information about 4. Laffont and Tirole note that optimal linear incentiveperformnance. If so, incentive intensity will increase, and so schemes "were no longer so once dynamics, politicalwill the welfare of agents and the performance of the economy, or multi-principal conditions were thrown in"organization. (p. 663).

Appendix 2: Summary Advice onIncentive Reforms

The following points represent what might be called * Avoid incentive master plans for all agencieshints or lessons from the incentive reforms I have and all time. Learn by doing. Make surestudied. affected parties take part in the evaluation of the

incentive experiments.* Incentive reforms require the participation ofemployees themselves in the specification of each * Begin with the easiest cases. In particular, tryagency's objectives, performance measures, and reforms in areas where performance is relativelyincentives. easy to measure objectively and where the

revenues raised or costs saved can make the* In designing performance measures, it is helpful experiment self-financing.to define "key tasks"-in other words, to analyzethe organization's "production function" carefully. * Remember the principle of the sample:

incentives can be based on samples of* Quantitative and qualitative outcome measures performance. Especially in an experiment, therecan be used. So can peer ratings, as long as ratings is no need for the comprehensive measurementare forced to be "on a curve" (that is, not everyone of each and every outcome of each and everycan be rated "excellent"). action.

* Include information from clients. * Cultivate political support, particularly fromunions and foreign donors. The idea of an

* Empower clients. Seek analogies to market experiment reduces their worries and involvespower or joint management. In pursuing such them in design and evaluation.reforms, continually think "information andincentives." * Challenge technical assistance by foreigners.

For example, learn by doing rather than* Experiment with user charges and analogies to attempting comprehensive studies that often endthem such as in-kind contributions, sharing them up being inconclusive or unsatisfactory. Forwith employees. example, use TA funds to finance experiments

where local experts and even government* Team incentives are often more feasible and officials carry out the required "studies" baseddesirable than individual incentives. on the participatory diagnosis of what is already

known about problems and possible solutions.* Incentives include money but also other things:promotions, training, travel, special assignments, * Privatize creatively. This can meantransfers, awards, favorable recognition, and simple experimenting with hybrids of public andpraise. Even information about how well one is private sectors working together to providedoing turns out to function as an incentive. services.

23

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