Three propositions to correct economic incentives in Nepal

Hom Pantto be presented at the workshop “Nepal: forging a new beginning”organised by the ANFS Canberra

On 5 October 2008 atThe ANU

The Four Questions

• What are the fundamental problems facing the country?

• What are their causes?

• What are their solutions, and

• Is there a time sequence of the solutions?

Searching for THE Fundamental Problem

Ancient philosophers have identified three sources of pain and sufferings

• Material: Cause and cure of the pain are material (produce more)

• Devine: cause unknown, cure material (example natural disaster, do more research/worship)

• Spiritual: Causes and cures of sufferings are in our own mind, in our own thinking (enlighten yourself – everything is impermanent! …)

Here we limit to the material problems only. What is our status on this front?

Stock take: where is Nepal?

per capita gni of Nepal, Australia and USA

0

10000

20000

30000

40000

50000

1975 1980 1985 1990 1995 2000 2005

curr

ent U

S$ Nepal

Australia

United States

Source: World Bank, WDIs

What caused this gap?

• Difference in average labor productivity!

For example, if each Nepali worker on an average produces 10 times more than is producing now, then an average Nepali becomes nearly 10 times richer!

And if this goes on for many years…

How can labor productivity be increased?

Skilled +LaborBetter machines

and toolsEnergy

Labor Productivity

Here machines and tools driven by energy do more work with fewer labor giving higher labor productivity. A truck driver and a truck can do the job of 1000 porters, for example. Energy use is thus an indicator of mechanization.

The higher the per capita energy use the higher the labor productivity

per capita energy use in Nepal, Australia and USA

0100020003000400050006000700080009000

1975 1980 1985 1990 1995 2000 2005

kg o

f o

il e

qu

ival

ent

Nepal

Australia

United States

Source: World Bank, WDIs

per capita energy use relative to Nepal (Nepal=1)

0

5

10

15

20

25

30

35

40

1975 1980 1985 1990 1995 2000 2005

Nepal

Australia

United States

Source: World Bank, WDIs

Sustainability issues?

• Use clean energy, such as hydro, solar and wind• Keep recycling/reusing• Choose appropriate technologies

Let us keep this issue aside.

Worried about unemployment?

• Mechanization, while increasing productivity, displaces labor by machines. Use of tractors will throw many farm workers out of job, etc.

• True. But those people can be employed elsewhere, say in road construction, with better tools/machines, who can produce even more. That is how the economy grows!

How can we get better machines and tools? More Investments!

Skilled LaborBetter machines

and toolsEnergy

Average Labor

Productivity

Investment in human capital

(training)

Investment in physical capital

Why investments were so low in Nepal?

• History and geography: Land-locked, small segmented markets needed small scale production (subsistence economy)

• External constraints: Who ventured to go for bigger markets got affected badly by recurring transit problems (part of the story)

• Weak law and order: corrupt officials were promoted and decorated and they were never pursued for their crimes (impunity) and– people who invested in the wrong type of business thrived and people

who invested in genuine businesses were battered by the institutionalized corruption and impunity

• Value system: society judged the success of a person by the wealth accumulated irrespective of how the wealth was acquired.

• Clever people chose easier, less riskier path to riches… the country became corrupt!

Corruption perception index (10 for the cleanliest)

0

2

4

6

8

10

2004 2005 2008

Nepal

Australia

USA

Denmark

:

Source: Transparency international

• To Sum up, corruption and impunity – increased the costs and risks of doing business – increased the uncertainty on the revenue flows– set out wrong examples of success/failures.

• It can be easily inferred that the underlying rewards and punishment system of Nepal so far has not been conducive to encourage sufficient investments in socially desirable sectors.

The fundamental problem

As many material problems facing the country can be attributed to poverty which in turn can be attributed to low investments -

I assert that wrong reward and punishment system (or wrongly aligned incentive system) is THE fundamental problem behind the persistent poverty and backwardness observed in Nepal.

Predictable and persistent incentives change human behavior. A corrupt official can become clean or a clean one can become corrupt provided incentives are structured appropriately.

Q2: Why the incentive system had been wrong? What are its causes?• Historically Nepal had accorded special privileges to its

rulers, they were above the constitution. They themselves had been the source of the constitution.

• Numerous concentric circles developed around the ruler which also got special exemptions either bestowed by the ruler or by practice or by their own influence. Effectively, the force of law applied was directly proportional to the perceived distance from the centre.

• Law enforcement became discretionary and this environment bred all sorts of corruption. There was a total violation of the principle of Natural Justice and the Human Rights.

• The country became heaven for both petty and organised criminals. It was difficult to make a distinction between criminals, politicians and government officials.

Economic incentives were distorted because this environment -

• added costs and created uncertainty on returns (IMF estimates this accounts for 1/3 impact of corruption)

• distorted the composition of public expenditure by diverting funds to high bribe potential projects rather than to high impact ones.

• created inefficiencies in the operation of markets. (prices reflected neither true social cost of supply nor social value to the user. Can’t do proper project analysis.)

• reduced the revenue of government, which in turn lowered the capacity of the government to invest, pay good salaries and maintain law and order.

In addition, corruption and impunity further distorted incentives because

• It weakened the law enforcing agencies (prevents or makes it more difficult for the government to implement laws and policies)

• It protected criminals and it reduced the risks of doing criminal businesses (insurance role) thereby promoted organised crimes. Socially unproductive and/or crime connected investments, however, flourished.

• Caused negative reputation effects: Politicians earned bad reputation so it encouraged wrong people to go into the mainstream politics for the wrong reasons who wanted to perpetuate corruption and impunity. If remained unchecked, this could be the biggest problem facing the Republic of Nepal. (‘regulatory’ capture by criminals!).

• Encouraged ethnocentric/parochial movements:People who were excluded (living in outer circles) have had to establish their connections to the centre in one way or the other. Movements for ethnicity/geography based federal structure, though not the optimal solution, is therefore the result of network based governance, rampant corruption and impunity.

This means that if all people believe that they will have access to the governance system equally when needed then such ethnocentric/parochial movements will fade away.

In summary

Special privileges, discretionary law enforcement and opaque bureaucracy were the prime causes for the growth of corruption and impunity in Nepal which together were the fundamental reasons behind the distorted incentive system of the kingdom of Nepal.

Removing these perversions is the greatest challenge to be faced by the FDR of Nepal.

What are the solutions?

To reduce corruption and impunity to a manageable level we need to eliminate the conditions that bred it

We suggest three propositions:

Proposition 1: Enforce Rule of Law

Have an inclusive constitution. Bring everyone, irrespective of their role in the society, under one law. Enforce it without exception upholding the principle of natural justice and the Human Rights.

Proposition 2: Maintain Transparency and accountability

Make all rules, regulations and decisions of the government completely transparent. Opaqueness breeds crime and corruption. Make all decision makers accountable for the decisions/indecisions they make. Guarantee FOI including freedom of press (i.e. free Thaahaa!).

Proposition 3: Establish Credible Political Will

To win public support and succeed it is necessary to establish that there is a credible political will to uproot corruption and impunity. Start cleaning the system from the top. All major political parties must flush out corrupt and/or criminal minded persons from their leadership positions at all levels. (attracts more right kind of people into the party and politics). Need to accept fair competition within and across the parties. Keep elections free and fair.

This will help establish credibility of the political will, make people sovereign and mobilize public (including party cadres) support against crime, corruption and violations of all kinds.

In summary, the propositions suggest institutional reforms that will

• Change judicial culture • Change bureaucratic culture and • Change political culture!

Clearly, there may be resistance from the criminal elements. The reforms are not easy.

How would they work?

• The first two reforms will expose the corrupt and criminal elements and increase the chance of their prosecution substantially.

• This will reduce the value of ill-gotten wealth and thus reduce the incentive to practice corruption.

• The third one brings right kind of people into politics for the right reason. In a democracy, if a major party genuinely starts cleaning itself, others should follow by the ‘policy convergence’ rule.

• Those who don’t, as the CA election results have indicated clearly, would be vanquished even in present day Nepal.

Sequencing of reforms?

• In my view, while the CA is drafting the constitution the major parties should adopt proposition 3 as a matter of priority. Government cannot force this change. It has to come from within.

• Of the other two propositions, it seems to me that transparency is a precondition for effective law enforcement. Proposition 2 should be adopted immediately. Media and civil society can then become effective.

Sequencing…

The reforms can be sequenced as follows1. Make the government rules, regulations and

decisions transparent and decision makers accountable for the decisions. Enforce FOI.

2. Develop all inclusive, fair and efficient legal system and continue law enforcement without exceptions

3. Require all political parties to be transparent as well. Mobilise people, NGOs and Civil Society against crime, corruption and all kind of nontransparencies.

Key Conclusion

• The fundamental problem: wrongly aligned incentive system

• Causes: concentric power circles, discretionary application of law and opaque governance that bred corruption, crime and impunity

• Solutions: Maintain transparency accountability and rule of one law without exception!

• Sequence: Transparency, accountability, law enforcement…

Thank you!