The global financial and economic crisis of 2008 has brought an urgency to focus on shorter-term policy issues related to managing bubbles, analyzing current development paradigms, and drawing out policy lessons for future action, particularly lessons learned during the past two years. At the same, longer-term development challenges also must be addressed to avoid the mistakes of 1970s and 1980s when managing stabilization issues dominated economic policy making and development economics was pushed aside for a while. For example, with the exception of East Asian countries and more recently India, why are African, Eastern European and Central Asian, and other South Asian countries unable to sustain high growth rates for more than five to seven years? What are the policy implications of demographic changes and climate change? There is a need for policy discussion on frontier topics such as rethinking globalization in trade, finance, and labor; new economic geography; green growth; and inclusive, balanced, and sustainable growth.
The 15th-century Florentine Niccolo Machiavelli is said to be the first to state, “Never waste the opportunities offered by a good crisis.” During a crisis, countries experiment with policies and learn a lot in a hurry. This overview shares this learning on early policy responses to the current economic crisis, focusing particularly on specific issues that are of interest to policy makers and practitioners in the developing countries. The overview is a compilation of notes that staff members of the World Bank Institute have used during global dialogues and international seminars and conferences since October 2008.
What brought the world to the edge of an abyss in September 2008? After quickly recovering from the Asian crisis of 1997-98, world economic growth accelerated during the period 2000-07. However, in hindsight, there was a ‘perfect storm’ in the making as US and European housing defaults began to pile up beginning in late 2006, oil prices doubled in a few months during late 2007 and early 2008, while rice, wheat, and corn prices jumped by 40-50% during the same period.
The bursting of the housing bubbles in the United States and Europe has led to a surge in defaults and foreclosures1, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt (US financial firms lost over $1 trillion by Dec 2008). This problem is especially severe because households, corporations, and government took on so much debt during the bubble years (that debt cumulated to over 400% of US GDP in U.S. and about 450% of UK GDP).
There were many other culprits. A long period of abundant liquidity, rising asset prices and low interest rates, in the context of international financial integration and innovation, led to the build-up of global macroeconomic imbalances as well as a global “search-for-yield” and general under-pricing of risk by investors. Complex, non-transparent instruments were mispriced and misunderstood. Regulators in some cases facilitated, and in other cases failed to respond to, the build-up in imbalances. Service providers, including credit rating agencies, loan originators and payment collectors, were also involved. Is it crisis in corporate governance or is it government failure, or is it both?
What has been the immediate impact of the crisis? World output declined by an unprecedented by 2.25% (annualized) in the last quarter of 2008. Global trade and industrial activity have fallen abruptly between October 2008 and January 2009. All the major industrial economies entered a period of deep recession, and several emerging markets were sputtering in late 2008. Emerging and developing economies’ growth has decelerated abruptly to 3.25%, mostly because of external pressures—lower foreign demand, reversal of capital inflows (including FDI, portfolio flows and remittances) and plunging commodity prices. But, the reforms of past decades and accumulation of large foreign exchange reserves made emerging markets more resilient than in previous crises and were faring relatively better. Anemic global growth has reversed the commodity price boom and lowered inflation. These price declines (except for gold) have dampened growth prospects for a number of commodity-exporting economies. About 64 million people may have been pushed below the poverty line during the first few months of crisis. If the Asian crisis is any indication, poverty is likely to be much higher in several affected countries long after the global economy recovers.
Why the need to upgrade the foundations of economics and policy? As Krugman and others have pointed out, economists have been divided into two groups – those believing in primacy of free markets and those advocating a greater role for government in regulating the markets and protecting the consumers from the excesses of the private sector. So a false dichotomy was being set up and discussed. There is a need for paradigm shift as both market and government are complementary and both are required, and economics is pluralistic. The basis of economic behavior itself is questionable --- we are rational more often than not, but animal spirits take over in many instances, such as when we are investing. Herd behavior is common as witnessed not only in the financial crisis, but in our penchant to acquire houses that we cannot afford just because everyone else is buying houses, in trading stocks, in ensuring adequate food supplies before a cyclone, or when buying things which are on sale shoppers rushing into a store even trampling people during that rush. It is said that greed and fear drive Wall Street, but as T.D. Wilson in his book “Strangers to Ourselves” points out human beings operate both unconsciously as if on an autopilot and consciously. Decision making by the unconscious mind as well as conscious mind can both be disastrous. For example, when we are trying to hire someone for a job, within a split second we may decide if we like or dislike a candidate (unconscious decision), but we take a long time before deciding if we should invite someone for dinner (conscious decision). Behavior economists find a ton of inconsistent behavior in our day to day life. Behavioral economics and neuroeconomics suggest that rational behavior by economic agents at all times could be questioned. The mind has its own highs and lows depending on what we are doing, as if we are all on ‘drugs’.
Pricing mechanism works well in a market for oranges and apples, but it may not work well in a few other markets. There are deterministic and stochastic economic processes. The Economic world is a pluralistic world, a world of multiple equilibria and nonlinearity with threshold effects. Moreover, production, trade, distribution and marketing are now in the hands of large firms and multinational corporations. At best, big business is now ‘oligopolistic’ in its market structure, colluding with political power to protect its economic interests, and resorts to monopolistic pricing to the detriment of its consumers. Just because there are a few market failures does not mean that we need to return to the commanding heights of the state and abandon markets. Why have the well-established political, financial and regulatory institutions of the US and UK failed then during the run up to the crisis, and why the much ‘underdeveloped’ institutions of BRICs and other emerging markets managed to work well in managing the crisis? Under these circumstances, why would Basel II or III financial architecture work better?
Changing Paradigm. This sentiment of combining the market mechanisms with an important role for government, depending upon a country’s stage of economic development is called new structural economics. A lower income country may require the government to provide a lot of public goods, such as education, subsidizing technology development and adaption, and so on, while an advanced economy may require a regulatory role by the government and clearly a less prominent role of the government. This is the new structural Economics framework that requires government to reinforce the comparative advantage of its country (and not in comparative advantage defying strategy). But how can one explain growth in India since 1991, which is despite government, while in China it is because of government since early 1980s? How can one explain the diverse economic and political performance of India, Pakistan and Bangladesh, who were all part of British India until 1947 and who inherited the same initial conditions, behavior and institutions from their colonial master?
The essential open-economy model could now include newer dimensions, such as animal spirits in some markets of finance and investment but rational expectations in product and labor markets, the role of financial intermediaries in the overall economy, monopolistic firms and pricing in most markets, assets in consumption, investment, and Central Bank objective function (expanded Taylor rule) and international finance accelerator to capture the massive global financial flows (which are multiple times the value of world real GDP). When models are upgraded to bring in ‘realism’ the fiscal and trade multipliers are likely to be much smaller than hitherto estimated.
The need for fiscal activism to shore up aggregate demand during a recession or depression as espoused by Keynes has returned to vogue. However, early indications in the score of countries that resorted to fiscal stimulus packages is that pump priming is not working that well in a globalized world where additional spending leaks out in the form of higher imports and higher household savings in US and the world. The magnitude of fiscal multipliers may be just around 1, moreover, the tax refunds that US resorted to in mid-2008 did not prevent the recession of late 2008. Keynes never discussed the ‘law of unintended consequences’ and governments may have created newer bubbles by resorting to fiscal stimulus packages. Fiscal stimulus may stimulate demand for a short period of time, but prevent quick adjustment of the real economy and job creation, and relegate the economy to ‘mediocrity’ for quite some time. If the choice is for an economy to ‘muddle through’ or ‘painful adjustment’, politicians –given their penchant to seek re-election and obfuscate policies and programs– will invariably choose the muddle-through option. Hence, the popularity of fiscal stimulus packages, bailouts without conditionality, and liquidity provision at zero interest rates. The poor face less delivery of services and higher unemployment (e.g. over 20% unemployment rates in poorer neighborhoods in the US in early 2010 despite massive fiscal stimulus package) and the tax-payers invariably pay for these expansionary policies that re-distributed wealth from the poor and the middle class to the financial sector. The stimulus financed programs are supposed to be timely, temporary, and targeted, but in reality they end up being protracted, permanent and un-targeted. Government interventions can worsen and prolong the crisis by creating ‘new bubbles.’ Of course, one can argue the counterfactual – things would have been even worse if it were not for the stimulus packages. There is an argument to be made that fiscal stimulus could take the form of financing ‘greener growth’ through subsidies and tax cuts for promoting lower carbon emissions whether it be in household appliances, production practices, or car manufacturing.
Modern macroeconomics does not incorporate the role of financial intermediaries in their models. The structure of banks and financial intermediaries does not matter in current economic models. Banks used deposits (which are protected by deposit insurance) as a base to generate loans and provide credit. Monetary policy also affects the economy through the quantity of bank reserves and thereby bank credit. We know that financial firms create financial instruments, particularly during a boom, that provide credit to finance the boom. Minsky (1982) outlines that at the beginning of the credit cycle, the duration of the loans is longer but gets shorter and shorter during later stages of this credit cycle as new loans are basically given to service the interest on previous loans (the so-called greening of loans). In such a way, the Minsky-Kindleberger theories emphasized irrational myopia and herd-like behavior causing endogenous cycles as greed and fear dominate banking and investment behavior rather than rational, long-term projection of fundamentals. While greed leads to under-pricing of risk, fear leads to over-pricing of risk. While the U.S. mortgage crisis can be partly explained by greed and fear, it does not explain the timing of the crisis, the duration of credit cycle in US and why it is of different durations in different countries, and how long will a financial collapse last.
Monetary policy is challenged by how best it can manage credit growth and asset bubbles. The “Great Moderation” speech of 2005 by Fed Chairman turned to be ‘a chimera.’ Too much emphasis on inflation, targeting it as close to zero as possible, may have had huge costs in terms of real output. Monetary rules are needed to manage aggregate credit growth that considers output growth and sectoral allocation of credit (e.g. how much to housing or financial sector). Most central banks in developed and emerging economies use the Taylor-rule for monetary policy and this rule needs to be augmented with newer set of variables, such as assets, in order to prevent asset bubbles and rapid credit growth.
To minimize credit bubbles in the future, policy makers should: (i) develop an international system to monitor leveraging by banks and financial institutions, particularly the large ones, including leveraging among the various sectors in different geographic areas. Developing such a “heat map” is necessary because central banks are usually unable to identify credit bubbles but can monitor leverage ratios at micro- and macro levels; (ii) Encourage banks to develop risk models that include leverage ratios and internal risk-adjusted weights in each of the real sectors. Can private sector risk managers do it by themselves? Not really; the private sector has invested heavily in risk management tools and progressed quite a bit in its use of quantitative and qualitative tools, but private sector risk managers would need the help of global institutions, which have an advantage in comparing and contrasting across countries, sectors, and firms. Stress testing by the private sector has failed. The behavior of financial firms and their counterparts has been disappointing during this crisis because the best risk management would have been for the credit agencies to insist that mortgage originators have a stake in the debt instruments at all times; (iii) Regulate pockets of leverage (for example, trade brokers in certain institutions), including by ensuring more capital for such highly leveraged firms, by increasing margin requirements, or by imposing restrictions such as loan-to-value ratios for housing loans. Capital requirements are necessary but not sufficient; (iv) Phase out the distortions arising from bias in terms of directed credit and tax exemptions for the real estate.
After the Asian crisis of 1997, emerging markets appeared to move towards a bi-polar exchange rate regimes (fixed or flexible) but since the collapse of Argentina one to one peg to US dollar in 2001, and because of fear of full float of local currency, central banks have stuck to ‘intermediate regime’ of flexibility. It is now shown that this flexible and intermediate regime, yields benefits in terms of higher output growth and lower inflation. Moreover, capital controls are now being used to manage outflow of capital in emerging markets.
Exchange rate regimes. At the time of the crisis, most large developing countries had established more flexible exchange rate regimes. Local currencies depreciated sharply during August to October of 2008, but on average the depreciation was in the range of 8 to 10%. But the currencies of Brazil, Chile, Colombia, Hungary, Mexico, Poland, Turkey, and South Africa experienced much larger depreciation in the initial months of the crisis. Some central banks intervened heavily to slow down this depreciation and lost large reserves in doing so. The apparent immediate response by developing countries during those three months was to target policy more to address domestic conditions rather than to defend exchange rate levels. Interest rates were increased during the early months of crisis of 2008, but when compared with other emerging market crises of previous decades, the interest rate increases were very mild.
Since the early months of the crisis, expansionary fiscal policies and monetary easing in more than 40 countries have been put in place to avert a serious economic downturn. These measures will put additional pressure on specific currencies to depreciate against U.S. dollar and other major currencies.
For almost a decade, international economic observers have advised governments that the world needs a major adjustment. Sustained global growth requires that the United States cut back on its domestic demand and let the dollar depreciate to increase net exports, which will enable the United States to improve its current account balances. Conversely, China and other Asian countries should stimulate domestic demand and let their exchange rates appreciate. These steps would rebalance aggregate demand from the United States and toward China, which would help sustain a global recovery.
Export-led strategy and Industrial Policies. Export-led strategy is about exploiting comparative advantage and trading for mutual gain of all countries involved. Trade brings in its train increased competition among firms, access to new technologies and new practices that enhance productivity. Global trade means advantage of economies of scale (large markets). Countries that are succeeding in export diversification have large pool of skills from production to marketing. But, trade is now in the hands of large conglomerates, and multi-national corporations, and production is now scattered in different countries. Therefore, new comers in most activities and sectors have a difficult time to compete in an ‘oligopolistic’ market structure. In theory, a firm (or country) has a comparative advantage in labor-intensive traditional sectors, but the firm (or country) with government support embarks on a somewhat risky, skill-intensive activity. In general, as the skill level crosses a certain line, the marginal cost declines steeply, but as the skill level grows further, the productivity ceases to grow at the same pace, and the wages in the primary sector outpace it. This trend happens because skill level does enhance productivity, but it does so to different degrees during the product’s life. Thus, productivity takes the form of a U-shaped curve. In the beginning, the wage rate, as well as the skill level, is low, and the country is forced to import. Gradual familiarity leads to more productivity. Despite a concomitant rise in wages, such productivity gains lead to increased exports. A further increase in the wage depletes the comparative advantage in a particular product. Thus, the nation is forced to produce another good that uses labor less intensively, and higher-skilled workers can be used more effectively. This story explains a country’s gradual upgrading of exports, from textiles to chemicals to iron and steel to automobiles and, finally, to electronics. The Republic of Korea and Finland are two examples of countries that have used this approach.
As one nation grows in skill and its products are upgraded from labor-intensive to capital-intensive goods, another nation grows and takes over the market in labor-intensive products. This phenomenon happened in East Asia. A skill ladder began with Japan as the most skilled country, followed by other Asian Tigers. Kojima (2000) extended the flying geese model to incorporate the transport of one industry to another country, where the wage is lower, even though the productivity of the workers in the second country is not as high as in the parent country. This gradual shift of comparative advantage causes a high growth rate in a particular economy at a particular time. For example, Taiwan, China, supplanted Japan in the production of certain goods when Japan lost comparative advantage in that industry.
The further the government moves away from comparative advantage, the more the costs of subsidization and support increase and, over time, become fiscally burdensome. Moreover, once government support is withdrawn, the industry may become uncompetitive, may generate fewer surpluses and resources to reinvest, and may have to close down. When such support is stopped, the industry’s profits evaporate, whereas in the private sector they do not. Opponents still believe that East Asian countries would have grown even faster had they not used industrial policies.
The new industrial policy group argues that state intervention is needed in R&D and innovation policy to encourage low-carbon, high-growth industries. The group argues that the private sector does not internalize the carbon emissions, and state intervention will deal with this negative externality. Why did information technology (IT) industries take off in India and Ireland without state intervention? Is the success of East Asian countries attributable to their trade openness strategy rather than to state intervention? Or do both state intervention and openness together make up a successful recipe for rapid development? Is there an export-diversified strategy for developing countries that works most of the time? Is the new industrial policy more appropriate for the 21st century?
The financial system, measured by assets, profits, contribution to GDP, stock market capitalization, employment etc, has expanded rapidly since 1990. For example, global financial assets were about 50 trillion in 1989 and increased to about 200 trillion by 2007, during the same period financial depth increased from 200% of world GDP to 400% in 2007. The financial crisis has raised a plethora of issues, many of which are inter-twined. There have been failures on all fronts – market failures in the form of financial firms innovating new instruments while neglecting risk management practices, credit rating agencies failing in rating assets without much thought to risk, private auditors not checking Lehman Brothers’ assets and liabilities, government failures in the form of central bank keeping interest rates low in the run up to the crisis, and government entities such as Fannie and Freddie involved in mortgage lending and making enormous losses, and failure by regulators for not checking the books of financial firms such as Lehman Brothers that were moving toxic assets of the balance sheets, and last but least the financial economists who failed to foresee to crisis. There is plenty of blame to go around but one thing is clear: State ownership of financial firms is back. After decades of rising foreign ownership of banks (shrinking state ownership) in almost all regions, except Middle East and South Asia, the trend could be reversed especially in the developed countries.
The crisis has shifted focus from foreign private ownership to some state ownership, from micro to macro prudential regulations, to re-assessment of deposit insurance, lender of last resort, and implicit guarantees, to consumer protection and taxpayer protection, from mark to market accounting to mark to funding, to revamping of credit rating agencies, to crisis in corporate governance and questioning of remuneration in financial firms, and to strengthening of supervision. These and a number of related issues of interest to policy makers are discussed below.
Given the large set of issues arising from the crisis, the major challenges facing countries are essentially two: (i) Government entities which are subsidizing directed credit (e.g. Frannie and Freddie in USA; similar type of ‘chaebol’ lending to industrial firms triggered the Asian crisis of 1997; and (ii) universality of too big to fail entities, where systemic important firms, often politically powerful conglomerates that are controlled by elites, have to be bailed out, which in turn leads to the moral hazard problem, where the large entity is considered worthy saving at all costs, including use of lender of last resort facilities from the Central Bank and tax payers money from the Treasury. The too big to fail entities also then knowingly max-out on leveraged lending (40 to one in case of USA) and ‘gamble’ on financially innovative instruments (e.g. mortgage-backed securities and credit default swaps in case of USA). The large entities also have the political clout to suppress regulations and/or evade regulations. Successful regulation requires that the regulator should have information on exposure to systemic risks. Too big to fail institutions were exposed to CD swaps (e.g. AIG in USA) and we knew little about its exposure. The reason is that there is data on a firm by firm but there is no agency that can put it all together. But policy makers and politicians are reluctant to address these two problems head on. Instead the focus on a large set of problems, as detailed below, and obfuscate the issues.
Until the crisis, capital ratios of individual banks are assumed to be adequate for the stability of the entire financial system. But in an inter-connected and leveraged financial world, selling of an asset because it is deemed risky by one financial firm may be good for that firm but if all firms sold the ‘toxic asset’ around the same time, the price of this asset will plummet and lead to wide-spread liquidity problems, losses, and heighten the uncertainty in the system. A macro-prudential approach is needed to look at risky assets taking into consideration the existence of liquidity risks, market risks, credit risks, insolvency risks, and other forms of risks. The recent crisis has shown that market discipline is not a defense against macro-risks. During booms, securitization appears to help improve the safety of financial firms, and most financial firms show good assets and strong balance sheets but when crises follow the booms these very firms have bad assets and bad balance sheets. For example, in March 2010 it was revealed that short-sellers in September 2008 were worried about the Lehman Brothers book-keeping, who were parking their bad assets with mutual funds while showing good assets on their books. In this case, market players knew more than regulators, but neither the market players nor the regulators were able to assess the macro risks. Therefore, differentiation of good versus bad banks and good versus bad assets is very poor.
The G-20 meetings of March 2009 recommended that during booms capital buffers be built so that during busts these buffers can be drawn down. For example, financial stability committees that exist in a number of countries could recommend that capital requirement ratios be kept relatively low during bad economic times but increased to twice as much during periods of a boom. Similarly, mismatches between maturity of assets and liabilities can be regulated through capital requirements. The Geneva report of 2009 recommends that a two-year asset that cannot be posted with the Central Bank should be matched with a two-year liability. Any mismatch should be prone to increase in capital ratios, over and above the boom-bust capital requirements. It is hoped that stacking of capital requirements would prevent systemic failures.
Financial Policy should be mandated first to deal with credit booms. Given the limitations of monetary policy, such as interest rate increases in dealing with booms, prudential and administrative measures may be better targeted and less-costly. For example, minimum regulatory capital requirements should be increased during booms and lowered during downturns. Similarly, limits on sectoral loan concentration, tighter eligibility and collateral requirements for booming sectors, limits on foreign exposure etc could have been deployed to contain risks associated with credit booms and busts.
Booms and busts are inherent to the financial world, and the aim is to moderate the risks during the cycles using micro and macro prudential regulations, as well as other measures such as strengthening supervision. Supervisors need to focus on both micro and macro analysis and oversight, work more closely with Central Bank regulators, and be more proactive in restricting specific firms that are lending too much against housing or properties or other risky assets.
Another regulation that is being discussed is the introduction of mark to funding accounting to complement the current mark to market or fair value accounting. In a liquidity crisis, the market price of assets fall more precipitously below the present value and this triggers the need for capital requirement. Under mark to funding approach, a weighted average of market price and present value of asset could be used, with funding institutions proposing the value of the weights. This may moderate the risks to the financial system.
Furthermore, the interaction between macroeconomic policy and financial sector should be improved. In every country, macroeconomic and financial stability is generally separated. While macroeconomic policy is focused on low inflation and high growth, financial sector is focused on bank-by-bank supervision of formal sector banks. Past crises and the current one again show that shadow financial and non-financial sector (e.g. investment banks, hedge funds, housing societies, government-secured enterprises etc) carry large risks connected with credit growth, leveraging and asset prices. Several prudential measures are needed to deal with these set of issues. In addition, the macroeconomic policy is concerned with corporate sector and how it finances the investment spending, including the public private infrastructure. Monetary theory and policy is concerned primarily with credit channel as the transmission mechanism. Such an approach is based on past thinking of credit rationing and crowding out among competing demands of public and private sectors. Meanwhile, the financial system has become too innovative and revolutionized investment financing mechanisms. For example, the private investors are interested in maximizing their profits but this is not taken into account in defining the objective function of the Central Bank.
Do Institutions matter? We were told that in the presence of social conflict between various groups, between haves and have-nots, political power precedes political institutions, economic institutions and economic policies. But, political power could be de jure (due to constitution, fair elections and smooth transition to political power) or de facto such as dictatorships and authoritarian leaders usurping power by coups and violence. Sixteenth century colonialism established ‘settler’ and ‘exploitative’ institutions depending on the then existing ‘climate’ in the colonized countries. For example, if the climate was unbearable and malaria-stricken, the colonial masters established an exploitative relationship of shipping out natural resources. If the climate was hospitable, they settled in with family in these countries and started administration and other institutions.
More recently good institutions were supposed to emerge when only de jure political power is in place. Also, a political and legal system that places constraints on elites is often conducive for better institutions. Following this logic, institutional economists have reasoned that advanced economies that de jure democratic political institutions have smooth transition, predictability and place constraints on elites and abuse of political power and have strong institutions that ensure a system of checks on the executive, law and order, property rights etc. The theory of institutions is that bad policy outcomes is the result of bad institutions and these are common in developing countries, where the distribution of political power needs to be reformed and deeper causes need to be strengthened. Others have argued that market-oriented institutions are important for economic policy management. By this categorization, the advanced economies had better institutions that led to sound economic performance and consistently higher economic outcomes.
How can we now explain the ‘mass delusion’ that occurred in the Wall Street during 2007-08 aided and abetted by government, political institutions (Congress) and economic institutions (Central bank, major financial institutions, regulatory agencies, credit rating agencies, and so on)? How is it possible that the better institutions in advanced countries had mismanaged risk so badly? How could ‘relatively bad institutions’ of BRICs manage to stave off a global crisis and manage their own ‘financial rogues’ better?
Olson (1965) argued that interests of the elites are narrowly defined as they prefer local and regional public goods rather than national public goods that are beneficial to all segments of population. They prefer government spending on social sectors for their benefit, bailouts and subsidies and transfers that are supposed to benefit the poor and vulnerable groups, but which they can capture, while at the same time they want to pay lower taxes. Crisis in corporate governance in the form of excessive-risk taking by the CEOs of financial firms, and not being held accountable or checked in time by stakeholders and boards, are symptoms of this broader societal problem of ‘privatizing gains and socializing losses.’
More recently, there is a growing body of work on the influence of politics on economic inputs (e.g. government policies and programs) and economic outcomes. Douglass North’s insight is that politically determined structures (of property rights, government spending allocations, etc) do not necessarily maximize the efficiency or growth potential of the economy. Rather the politically-determined structures try to maximize the returns to the political leaders/rulers/strong groups (“elites”). If we follow this logic, then both developed and developing countries distort allocation of resources and retard growth and development. Others have argued that patron-client relationship is rampant in policy making in both developing and developed countries. Bates (1981) argues that collusion between urban-based interest groups and political elites resulted in punitive taxation of agriculture. Adam and Connell (1999) note that in countries where restraining-institutions are absent, the government is likely to be captured by a small group and trade-off growth for redistribution that is beneficial to the favored group. More recent work by Acemoglu (2005), Easterly and Levine (1997 and 2003), and Alesina and Ferrara (2005) is along similar lines of state-capture by elites, whether it is along urban-rural divide, economic sector interests (agriculture versus manufacturing) or ethnic diversity or due to ethno-linguistic fractionalization.
However, we now know from 60 years of development experience that South East Asian countries (authoritarian regimes with few constraints on executive) have generated successful economic outcomes, while African countries (mostly with strong rulers) have had relatively less success. To explain this contrast, political scientists and economists use the concept of “weak and strong economic states.” Weak economic states lack/have limited capacity to tax, regulate and play a developmental role (e.g. African states which cannot extract revenues from the rest of the society and fail to invest in public goods). In addition to weak capacity, we also know that self-interested elites will only invest if future private rewards are attractive. When the state is weak, the elites are uncertain about the future and are likely to appropriate fewer rewards, if any, in the future (Acemoglu, 2005).
State capture could be defined as the efforts of affluent individuals or groups, private firms, or oligarchs, to shape the laws, public policies, rules and regulations of the state to their own advantage. This ‘shaping’ may be done not only by the private firms or richer elites (top 20% on the income distribution scale) but in some countries by ethnic groups or powerful economic groups. As such, to fully understand the dynamics of state capture, the analysis must be based on winners and losers not only in terms of income groups but also in terms of powerful groups and vested interests, including bureaucracy. In other words, state capture and re-distributive conflicts are part of the same spectrum of good-to-bad governance.
Countries that are ‘highly captured’ may exhibit capture of all or most institutions by ‘big business’ and powerful groups. As such parliament, political parties, the executives including ministries and public enterprises, judicial courts, and bureaucrats, may all be captured. The capture may take place jointly or separately depending upon the economic interests of the powerful groups or elites. So a highly-captured country, in the absence of effective institutions, is likely to suffer from low tax revenues, lower private and public investment, higher redistribution, and therefore slower output expansion, and lower level and quality of public provision of services to the poor.
So bottom line is that state capture (of institutions, regulations and economic policy) is happening in almost all countries and this should be avoided; otherwise economic outcomes will be bad, or would they? How does one avoid state capture? There is a need to continuously promote competition but this is not automatic just because there is freedom to compete. Powerful, vested interest groups, usually large oligopolistic firms, capture the institutions and the benefits of market-oriented reforms (e.g. in the transition countries, the oligarchs benefited from privatization and de-regulation of prices and investment). In advanced, transition and developing countries, domestic and international cartels and anti-competitive business practices have taken hold in product, trade and financial markets. In fact, the OPEC cartel in crude oil, and food additives, steel, large transformers and pharmaceutical products, and trade in a number of areas (from bananas to arms sales) is dominated by firms from the richer countries.
There is a need for breaking up the too big to fail institutions and curbing the monopolistic firms, and to encourage civil society groups to organize and advocate, for consumer protection agencies, for community-driven development, for encouraging small and medium enterprises, for fiscal and political decentralization though decentralized units are shown to be as ‘captured’ as centralized units, for term limits on elected or nominated officials in executive, legislative and judicial bodies, curbing the revolving door of patron-clients, and above all for more punitive punishment for ‘white collar crime’ of financial fraud and pension-raiding, and of course ‘enlightened leadership.’
Geography of Urbanization has become an important issue. Governments can to a degree manage the growth of existing urban centers and the in situ expansion of small towns into cities through investment in transport and other infrastructure, through regulations and land use rules that strictly control whether a piece of land is developed and for what purpose it is developed. For example, the urbanization of high risk flood-plains, coastal areas, steeply- sloped areas, earthquake prone areas, and regions where water will be increasingly scarce could be tightly regulated and existing habitation gradually scaled back through tax policies and other actions that fully reflect the costs of insuring against risks. Such actions will undoubtedly face intense opposition2. Awareness raising programs coupled with a gradually tightening of implementation is probably the only way forward. This is not a knowledge gap problem: it is one arising from the unwillingness to write off sunk costs, the continuing attractions of coastal regions and long settled urban areas, legacy transport infrastructures, and in developing countries, the combined pressures exerted by population growth and urban migration. The great challenge will be in winning sufficient political support from a majority of the stakeholders and implementing a partial deconstruction and rebuilding of cities. This is a project for the long term, something politicians are rarely inclined to tackle, leaving it to future generations to worry over.
Land use planning and zoning laws, real estate taxes, floor area ratios, and the urban transport infrastructure are among the instruments governments can use more effectively to build low carbon, sustainable cities that grow vertically. But few are doing so and awareness of the need for raising urbanization to a new level so as to avoid future crises is spreading slowly. It goes without saying that starting the process of constructing “smarter cities” now while there is time has many advantages with regard to planning and execution. Whether the threat of climate change and resource constraints will triumph over scientific illiteracy, denial and procrastination to strengthen implementation, remains to be seen.
Reinforcing urban design with measures to reduce carbon emissions can conserve water and minimize heat island effects. This is a necessity not an option. Large gains are possible from better harnessing of tested and cost effective technologies which remain underutilized because of inertia, ignorance, and the desire to avoid initial costs even when they can be rapidly recouped. Pricing policies [especially for energy and water], codes and standards for buildings and appliances, incentives for new technology adoption and research, road pricing and other measures can achieve dramatic results. ICT now permits the building of integrated electricity and water utilization systems that can monitor use, differentiate prices by time period and user, and reward frugality. However, the experience of even advanced countries in phasing in codes, standards and road pricing for example, can be a salutary reminder of how stoutly a raising of standards and monitoring is opposed and the slow acting, slippage prone nature of localized enforcement especially under decentralized conditions.
Economic sustainability is key. Urban location and macro and social stability are among the preconditions to be met. Other well rehearsed requirements subject to policy control include adequate infrastructure (now including IT infrastructure), a skilled workforce, serviced land,3 affordable housing, connectedness to other cities, acceptable levels of congestion and pollution, decent public services, and business friendly environment, etc. This is a long and familiar checklist. The reason why so many cities are falling short of their desired benchmarks is because leadership, governance capacity, and resources are all too frequently lacking. Again, there are no easy answers to the above.
This also is well traveled ground with few innovations to report. The local tax and pricing tools, the center-local fiscal arrangements, and the avenues for raising capital from financial markets, are all familiar. So also are budgeting, accounting, and auditing procedures for efficiently allocating funds and minimizing leakages. Adequate municipal financing [which derives from a buoyant broad-based economy] and fiscal discipline, nationally imposed and municipally reinforced, are inseparable from long run urban sustainability.
The competitiveness of manufacturing or in rare cases tradable services e.g. IT enabled services, business services and software, is a function of factor costs, the quality of the workforce, and of connectedness. Municipalities can influence these through the setting of rental rates and charges for power, water, sewage, and other services. Incentives – and locally sponsored technical and consulting entities – can enhance the supply of skills. But lower-middle and middle income urban centers must look beyond the low cost model of competitiveness and derive more of their edge from technological prowess and innovation. Building innovation capability is widely viewed as the quickest route to prosperity because the intense competition squeezes much of the profit out of standardized commodities. Only through ceaseless differentiation of products and innovation will suppliers earn the quasi rents which can fuel rapid growth. Innovative urban economies are also better able to cope with fluctuations in demand and to recover from shocks by evolving their product mix and attracting new activities.
Technological change seems to be influenced by five sets of policies and institutions:
- Policies affecting the composition of industry and of acquired technological capability and the contribution of FDI to this capability.
- Education and research policies that determine the foundation-building strengths of primary and secondary schooling, the quality of tertiary education, and the volume and productivity of R&D in universities, firms and specialized institutes.4
- Sociopolitical institutions that assign status and recognition to learning and encourage intellectual achievement, safeguard intellectual property, and promote openness to ideas and to the circulation of knowledge workers.
- Institutions that stimulate competition among producers of ideas, of goods, and of services that regulate performance and set standards.
- Policies affecting the productivity and innovativeness of urban centers.
Policy makers are working on all these registers; however, tangible evidence of innovativeness is materializing slowly as experienced researchers, intermediaries, and venture capitalists aggregate into critical masses and an innovation culture gels within rapidly evolving urban environments. Typically, a strong desire exists to hurry the process along. Countries need first to build their knowledge base and to move closer to the frontiers of technology in selected fields. When countries reach this state, greater scope exists for sustained innovation. Acquiring this technological capability is no simple matter, however; the process of adoption and adaptation remains uncodified. After countries have acquired substantial technological depth and are near the frontiers of knowledge, what might push the system they have created to deliver high and persisting levels of innovation or any significant innovation is difficult to determine. Spending on R&D can help; the innovation strategies of major firms can make a contribution, especially if they spin off innovative firms; new entrants can serve as bearers of technology; and the excellence of the research universities can feed the pool of skills, ideas, and entrepreneurship. Beyond this, there is little concrete to say. Whether research can fulfill the demands of national policy makers and chief executive officers who would like to make innovation routine remains an open question.
1. It is estimated that in the United States there were almost 7 million housing loans ‘under water’ and close to default, each loan averaging about $300,000; this totals to $2.1 trillion. In addition, potential defaults on credit card payments, student and car loan payments are estimated to be in the range of about $10-12 trillion. The government could have directly taken over these bad housing loans and loans held potential defaulters but moral hazard (rewarding bad behavior will incentivize even non-defaulters to default on loan payments) can exacerbate the problem.
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