States and markets: complements or substitutes?

Richer countries have larger governments– why?

The chart shows the relationship between (the logarithm of) per-capita GDP and the share of government consumption in GDP in 2003, for all countries for which data exist in the World Development Indicators of the World Bank. The estimated slope coefficient is 1.5, and is statistically significant at more than

99%.

Changing conceptions of market capitalism: capitalism 1.0

• Insight: the market is the most creative and dynamic economic engine known to man

• Textbook renditions (still common) presume it requires a minimal state– National defense, protection of property rights, and the

administration of justice– Not necessarily Adam Smith’s own view

• Corresponds to the 19th century “liberal” view and today’s libertarian vision

• Insight: markets are not self-creating, self-regulating, self-stabilizing, or self-legitimizing

• Therefore they need to be embedded in a wide range of institutions– Regulatory institutions, redistributive institutions, monetary and

fiscal institutions, institutions of conflict management, …

• In practice: Keynes + the welfare state • A national system of capitalism, not a global one

– Bretton Woods made the system work by throwing lots of “sand in the wheels” of international commerce and finance

• Capital controls plus a highly permissive GATT

Changing conceptions of market capitalism: capitalism 2.0

Why markets need states

• The institutional prerequisites of markets• A typology of institutions• Sources of institutional divergence• Implications for globalization

Institutions: definitions

• Institutions are “the rules of the game in a society” (Douglass North)

• Institutions are "a set of humanly devised behavioral rules that govern and shape the interactions of human beings, in part by helping them to form expectations of what other people will do." Lin and Nugent (1995, 2306-2307).

• Can be formal (laws, regulations) or informal (patterns of behavior, conventions, moral codes)

Markets are about gainful exchange. Why would they not exist or perform poorly? Consider potential seller S who has something (a commodity, labor services, money to lend, an idea …) that is of greater value to potential buyer B. What is required for the exchange to actually take place?

1. excludability (good is private, not public) 2. ownership (property rights) 3. compliance (enforcement of contracts) 4. information (observability of all relevant attributes of the good/service) 5. stable and reliable medium of exchange (unless there is “double coincidence of wants”) 6. peace and security 7. transport/communication to bring parties together

There is potential for opportunistic behavior (“cheating”) in the absence of these conditions. Opportunistic behavior creates “transaction costs.” Good institutions are those that minimize these “transaction costs” at reasonable cost. Some types of goods/services more prone to such transaction costs:

markets for credit, insurance, ideas, differentiated goods

Institutional prerequisites for markets

Special circumstances of public goods Public goods: neither feasible, nor desirable to exclude non-payers

(knowledge, irrigation control, environment, monetary and financial stability) Challenge with public goods is not to create markets in them, but to ensure that they are provided (at efficient levels). Same types of opportunistic behavior (“non-cooperation”) and transaction costs plague provision of public goods. Here too, good institutions are those that minimize transaction costs at reasonable costs. Markets versus organizations Transaction costs can determine the boundaries between markets and “hierarchies” or organizations. When market exchange is subject to high transaction costs, tendency to internalize the transaction within firms or organizations. Theory of the firm. Coase Theorem With zero transaction costs, institutional arrangements (e.g., who has property rights over what) do not matter, and markets automatically generate the efficient outcomes (Ronald Coase). Goods and services end up where they are valued the most. Any and all gains from exchange are realized.

Consider S and B again, and describe payoffs S honest cheat

honest G, G -L, G+ B cheat G+, -L 0, 0

G, L, > 0. Three interpretations:

(a) Market exchange (b) Provision of public goods: “contribute” or “do not contribute” (c) Relationship between government and investors/producers: “expropriate/not” and “invest/not”

Game theoretic interpretation of institutional prerequisites (I)

Game theoretic interpretation of institutional prerequisite (II)

Standard PD: Cheating is dominant strategy for both players, and (C,C) constitutes sole stable equilibrium, even though both would be better off under (H,H). No exchange, no gains. What prevents a binding contract to adhere to (H,H)?

Lack of enforcement mechanism

The roles of commitment, pre-commitment, and credibility. In practice, firms and households respond to these problems by undertaking (productivity-reducing) activities that reduce their exposure to opportunism: personal inspection, lack of credit, lack of delegation, restricting transactions to “trustworthy” individuals Solutions:

1. Third-party enforcement (legal institutions, regulatory institutions, the state) 2. Self-enforcement (in repeated interactions) through reputation

This distinction maps, crudely, into formal and informal institutions (with some notable exceptions, e.g., the Sicilian mafia).

a. Market-creating institutions i. Property rights

incl. corporate governance ii. Contract enforcement

b. Market-regulating institutions

i. Regulatory institutions Anti-trust, prudential regulation, environmental and safety regulations, etc

ii. Labor market institutions iii. Correction of market and coordination failures

“Industrial policies”

c. Market-stabilizing institutions (macroeconomic management) i. Monetary, fiscal and currency arrangements

d. Market-legitimizing institutions

i. Redistribution ii. Social insurance

iii. Political democracy

A typology of formal institutions

The example of social insurance (I)

The example of social insurance (II)

More recent evidence

“ … we have documented that the association between openness and socialspending is positive but has become shallower over time. Extending the specification toindicators of financial development, private financial markets appear to substitute forpublic redistribution along both cross-country and time series dimensions.In cross-section, not only public redistribution but also private financial markettransactions tend to increase with international economic openness, addressing the needfor consumption smoothing in the presence of international sources of income instability.Systematically different combinations of public schemes and private contracts areobserved in countries characterized by different legal and social traditions. Whencountry-specific intercepts control for such permanent differences, we find evidence of atendency for globalization to be associated with declining generosity of social spendingwithin each country. The tendency is more pronounced in countries where welldeveloped financial markets absorb a larger proportion of demand for consumptionsmoothing. As financial markets have become more uniformly well-developed in theOECD, this explains why, in cross-section, public social expenditure has become lesspositively associated with openness.”

-- Bertola and Lo Prete (2008)

Institutional heterogeneity: example of labor market institutions

Variety of institutional arrangements:

• Degree of centralization or coordination of wage setting• Degree of employment protection• Importance of minimum wages• Generosity of unemployment benefits• Extent of “active” labor market policies?• Unionization rates• Labor representation/participation in company boards

These refer to differences only among advanced nations!

Sources of institutional diversity and divergence

• Universal institutional functions do not map into unique institutional designs

– Security of property rights, market-based incentives, outward orientation, macroeconomic stability … can all be achieved in diverse institutional settings

• Institutional diversity is grounded in:– Differences in social preferences (over equity versus

opportunity, for example)– Hysteresis and path dependence due to institutional

clusters and complementarities (US versus Japan versus various European models)

– Context specificity of desirable institutional arrangements to promote economic development

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

What type of property rights? Private, public, cooperative?

What type of legal regime? Common law? Civil law? Adopt or innovate?

What is the right balance between decentralized market competition and public intervention?

Which types of financial institutions/corporate governance are most appropriate for mobilizing domestic savings?

Is there a role for “industrial policy” to stimulate investment in non-traditional areas?

UNIVERSAL PRINCIPLES

Property rights: Ensure potential and current investors can retain the returns to their investments

Incentives: Align producer incentives with social costs and benefits.

Rule of law: Provide a transparent, stable and predictable set of rules.

OBJECTIVE

Productive efficiency (static and dynamic)

Multiplicity of desirable institutional arrangements

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

How independent should the central bank be?

What is the appropriate exchange-rate regime? (dollarization, currency board, adjustable peg, controlled float, pure float)

Should fiscal policy be rule-bound, and if so what are the appropriate rules?

Size of the public economy.

What is the appropriate regulatory apparatus for the financial system?

What is the appropriate regulatory treatment of capital account transactions?

UNIVERSAL PRINCIPLES

Sound money: Do not generate liquidity beyond the increase in nominal money demand at reasonable inflation.

Fiscal sustainability: Ensure public debt remains “reasonable” and stable in relation to national aggregates.

Prudential regulation: Prevent financial system from taking excessive risk.

OBJECTIVE

Macroeconomic and Financial Stability

PLAUSIBLE DIVERSITY IN INSTITUTIONAL ARRANGEMENTS

How progressive should the tax system be?

Should pension systems be public or private?

Should grant schemes be conditional?

What are the appropriate points of intervention: educational system? access to health? access to credit? labor markets? tax system?

What is the role of “social funds”?

Redistribution of endowments? (land reform, endowments-at-birth)

Organization of labor markets: decentralized or institutionalized?

Modes of service delivery: NGOs, participatory arrangements., etc.

UNIVERSAL PRINCIPLES

Targeting: Redistributive programs should be targeted as closely as possible to the intended beneficiaries.

Incentive compatibility: Redistributive programs should minimize incentive distortions.

OBJECTIVE

Distributive justice and poverty alleviation

East Asian institutional “anomalies”Institutional domain Standard ideal “East Asian” pattern

Property rights Private, enforced by the rule of law Private, but govt authority occasionally overrides the law (esp. in Korea).  

Corporate governance Shareholder (“outsider”) control, protection of shareholder rights  

Insider control

Business-government relations Arms’ length, rule based Close interactions 

Industrial organization 

Decentralized, competitive markets, with tough anti-trust enforcement 

Horizontal and vertical integration in production (chaebol); government-mandated “cartels”

Financial system Deregulated, securities based, with free entry. Prudential supervision through regulatory oversight.

Bank based, restricted entry, heavily controlled by government, directed lending, weak formal regulation. 

Labor markets Decentralized, de-institutionalized, “flexible” labor markets

Lifetime employment in core enterprises (Japan) 

International capital flows “prudently” free Restricted (until the 1990s)  

Public ownership None in productive sectors Plenty in upstream industries. 

Institutional “heterodoxy” is a common feature of successful economies

Where do institutions come from?

• Demand-side explanations: institutions are created by those who stand to benefit from them– Colonial origins (Acemoglu, Johnson, Robinson 2001)

• Glaeser et al. (2004) critique– Initial factor endowments

• Type of agriculture: small-holding versus plantation (Engerman and Sokoloff 2002)

• Size of educated middle class (Rajan and Zingales 2006) – Expanding international economic integration

• Benign theories– Trade and capital flows increase demand for “good” institutions

• Malign theories– Increased trade strengthens “regressive” elites (Latin America, U.S. South)

• Supply-side explanations– Imposition by foreign powers

• East Germany, North Korea, Japan(?),..– Adoption of imported legal norms and rules

• “law and development” school– Institutional innovation and experimentation

• Chinese example• Institutional hysteresis, lock-in

a. Market-creating institutions i. Property rights

incl. corporate governance ii. Contract enforcement

b. Market-regulating institutions

i. Regulatory institutions Anti-trust, prudential regulation, environmental and safety regulations, etc

ii. Labor market institutions iii. Correction of market and coordination failures

“Industrial policies”

c. Market-stabilizing institutions (macroeconomic management) i. Monetary, fiscal and currency arrangements

d. Market-legitimizing institutions

i. Redistribution ii. Social insurance

iii. Political democracy

Back to our typology of institutions

Which one of these exist at the global level? What are the consequences of their non-existence?

Implications for global economic governance:Institutional diversity/incompleteness across

national settings is a source of transaction costs blocking deep integration…

• Despite disappearance of formal border barriers, border effects remain strong– “Missing” trade– Small net capital flows

• Trade: the role of regulatory & jurisdictional discontinuities – Borders are estimated to raise costs by around 40%

• Capital flows: problems of sovereign risk, moral hazard, and absence of ILLR– Do not exist (or greatly alleviated) within nations– Result in financial instability internationally

Therefore, deep economic integration and economic convergence are not possible without institutional

harmonization…

• EU versus NAFTA models • One is hard because it entails legal, political integration

– Acquis communautaire (>80,000 pages)– European Court of Justice– Significant inter-regional transfers– Growing pains of a quasi-federal political system

• The other is comparatively easy• But only the first model has the potential to achieve full economic

integration