Second-best institutions

Want to know why "best practices" are an unhelpful way to think about institutional reform?  How to improve contract enforcement without doing more harm than good? Why the World Bank's Doing Business Surveys can lead you astray about reform priorities? Why outward orientation is often achieved better under selective export promotion than under  import liberalization? When central bank independence and inflation targeting can backfire?

For these and other outrageous ideas see here. 

Comments

[Alfred]

"Obviously, the legal system has (so far) not constrained the growth of Vietnam’s private sector."

Hhmm, how can you be sure about that? Vietnam is growing at 8% a year, but perhaps it would be growing at 10% or 12% a year if it had a sound legal system. Ok, it's just an untested hypothesis - but so is your statement that the legal system has not constrained Vietnam's growth.

"Imagine that some of the firms begin to think that they can rely on courts and therefore don’t care about the reputation of the suppliers that they work with. Since suppliers that cheat now have an improved outside option, the discipline that prevents opportunistic behavior in relational contracts is undermined (Dixit 2004, chap. 2)."

If courts work properly, contracts will be enforced and there will be less incentive to cheat (for cheating will be judicially punished).

"In fact, under free entry, the incentive to engage in cost discovery is eliminated totally"

Ok. But how can policy-makers know what industries deserve entry barriers? None of the industries already existing in a given country - I suppose -, since in these cases we already know they are profitable (or they wouldn't exist). But from the multitude of unexisting industries, how can the government know which ones would be profitable but are still unexplored because of positive externalities? And how could governments calculate the adequate level of restrictiveness for the entry barriers? And since we're on the subject of second-best practices, would you recommend such policy for a developing country whose bureaucrats lack technical skills and are likely to be captured by the private interests they deal with?

"The efficiency reason is that the Asian model of liberalization protects employment in the transition to the new long-run equilibrium."

Yes, as long as you define efficiency in terms of jobs (and not in terms of aggregate wealth). Indeed, when it comes to trade jobs can only be protected at the cost of efficiency.

"and it is telling that few of the central banks in Asia are independent."

Again: perhaps those Asian economies would be growing more if they had independent central banks (same point regarding the legal system).

[Peter Gallagher]

An interesting essay that makes a good argument that institutional reform needs careful design, isn't a panacea, and that sequencing matters.

But I agree with Alfred's criticisms. I think there's an 'excluded middle' in the logic of this essay and in September's 'Saving Globalization'. Because some economies have done well with second-best approaches is good grounds for recognizing the complexity (specificity) of policy choices. But it doesn't add-up to a recommendation for second-best.

Making 'policy space' makes room for rent-seeking that on balance is likely to sap efficiency measured as aggregate income, our only long-term guide to a better deal for most (or all). The argument for 'policy space' rather than liberalization is like the infant-industry argument in fancy dress. It is attractive as long as the 'infant' will grow up pretty quickly. But they usually don't.

If all governments were wise, incorruptible, long-lived and smart enough to identify, and act on, the 'binding constraint' reliably then we could probably promote 'second' best institutional reform to something like 'first'. But you'd have to be an especially sunny optimist to bet on it.

I think in the real world we're better-off saying to them: 'your job is to try to cut the excess costs identified in the Doing Business surveys'. We know that they'll get firms' support for the institutional adjustments. And it's the less harmful prescription.

[Per Kurowski]

Second-Best Institutions is a very interesting document and I will post many of my reactions to it piecemeal.

On page 6 in the chapter of entry regulations from Ricardo Hausmann and Rodrik (2003) it is concluded that “There need to be some rents in equilibrium, maintained through entry restrictions or other means, for entrepreneurship” since if the opportunity-discoverer investing his money finds something good his returns will be diluted by the copycats while if it is not that good he gets settled with all the costs.

Well from whatever angle you look at it this is the economic justification for handing out intellectual property rights… but how to do that and so that it does not result in a too ugly monopoly that is the challenge.

I have frequently toyed and written about the idea that there should be differences in taxation between enterprises that benefit from protection, IPR-entry barriers- and those that don’t. Sort of a legalized societal protection racket. In fact seeing how society is supposed to spend fortunes defending IPR rights for free when they frequently do not have the resources to defend their voters from the day to day dangers on the streets seems to be plain stupid.

[Per Kurowski]

Since “best practices” currently lie between a “Thou shall not discriminate between foreign and local investors” and “Foreign investors bring in more goodies” let me include below an extract from my “Noise and Voice” that touches upon this issue, especially because it also refers to local vs. foreign rent capture.

Foreign vs. local investors

Whether there are some differences between foreign and local investors that the Knowledge Bank should be aware of, while helping countries develop, is most probably a very sensitive issue.

Just like the saying that goes “Of course all men are created equal, but some are more equal than others” I cannot see why we should not be able to acknowledge and discuss differences between local and foreign investors.

Let us paint a mental picture of a big company with a sizable debt in a country where devaluation rumors abound. In that case I submit to you that if the owner of the company was a foreigner he would look to saddle the company with as much debt as possible, local or foreign, and try to get out his own capital investments as fast as possible, weakening, of course, the company in the process. If, on the contrary, the owner were a local citizen, he would do his utmost to come up with local finance to pay off as much foreign-denominated debt as possible. Is this true? I do not know it for sure … but why have I seen this over and over again, and what does it imply for a developing country?

Let us now take the case of that sort of easy and quite profitable business that in small local markets could tend to develop into a quasi-monopoly—like a brewery. My impression is that if the owners are local they would tend to reinvest much more of the easy earnings in their own country than if the owners are foreign and all surpluses have to be sent to a central treasury. Is this true? I do not know it for sure … but why have I seen this over and over again, and what does it imply for a developing country?

But then again, in some circumstances, I have also seen the local investors escaping the country much faster than foreigners … but perhaps then also doing the right thing!

By the way, when I say foreigners I do not mean foreign citizens who are residents in the country; they are sometimes the most resilient nationals of them all; no, I mean all those foreigners who are really foreign everywhere, except perhaps in business-class lounge at some airports.

[Per Kurowski]

And when in the document Danni Rodrik makes a reference to “import liberalization may result in workers in previously protected industries being displaced and transferred into even less productive activities such as informality or unemployment” this carried out in Venezuela in the early 1990s together with oil prices falling under ten dollars per barrel at the end of 1998…explains 99.9% of why there is a hugo chávez as president.

[Per Kurowski]

And don’t get me going on that best practice of banking regulations invented in Basel for countries that were already satisfied with the development they had achieved and therefore could accept minimum capital requirements for banks that were exclusively based on risk assessments; a system that was later gladly adopted by many developing countries as their bank regulators of central bankers did not want to be seen as any less risk adverse than their developed-country-peers.

The risk adverseness thereby introduced in developing countries, where risk is the oxygen of development, turned their commercial banking system from being not so very good but still financiers of development, into financiers of the public sector and consumers.

Poor World Bank…it cannot be easy to do development while being forced to harmonize with the IMF. Read their financial sector assessments…99% about avoiding the risk of a bank crisis… while the rest of the country is dying. If we allowed this to go on then the last job standing, at least in Latin America, will be as a more economically efficient substitute for an automated bank teller machine.

[paine]

dani
nice list

but isn't there an over arching distinction here
between what's good for an
industrializing nation
and whats good for a border hoping low wage wanting
trans nat production site arbitrageur

[paine]

just read the first few comments

shame on u
u logic chopping
sophistry spewing
trans nat corporate board rooom stooges

that's my maoism kicking in

read 'new democracy'
by the chairman
written in 40 or 41
(i believe)

where the comprador vs national entrepreneurs are
seperated like sweet cream from sour milk

[paine]

per-k
on the side of the angels
you lovely chap

but pour quoi
the concessions to the tilted casino rules ??

[Ali Sohail (Pakistan)]

great write up! it may have its loopholes, but a very open feel to the subject!

Mr rodrik, i ve to say- with all the good work u have done, this in terms of ideas and perspective, (humble yet provocative, simple yet controversial) is a great starting point towards bridging the mentality gap practiced, enforced and preached in our world today - or i say that maybe because i feel- it is very closer to home!

I have been wanting to read something of these lines for a while now- in a country such as pakistan- this is the reality we live in- its time we accept and go further in this prescribed ideology ' second best institution' - rather than moving towards the perfect well modelled text book world- which does not exist in our environment- we try ,and always fall short in replicating and further curse and plague our system, detest its existence- the time has come, to mentally accept and diverge into building economic and social models on these realities rather than fighting, striving and unsatisfyingly working for the soo-called first best models -(atleast today)our markets are not made for such, our politics do not exist for such, are not ready for such, are not willing to such- let us also not become such-
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