Wednesday, December 10, 2014

The samurai and globalization: does culture matter for development?

Augusto Lopez-Claros & Valeria Perotti

The transformation of Japan into a modern economy at the end of the 19th century is a tale of culture and cultural change. The centuries-long transmission of values like honor, loyalty, duty, obedience and discipline in the bushido (the code of conduct of the samurai) contributed in fundamental ways to shape Japan’s human capital. However, a change in mindset – triggered by the personal influence of key political figures – needed to happen in order for the country to devote its efforts to economic development.

Japan’s 250-year old feudal shogunate collapsed in 1867-68 and power returned to the emperor in Kyoto. The Home Minister appointed in 1873, Okubo Toshimichi, was relentless in the recruitment of talent for his Ministry, believing that promotions should be based on merit rather than family or military connections, and that those trained abroad were particularly well-suited to assist him in his efforts to launch Japan in a sustained process of modernization. But perhaps Okubo’s most important attribute was his willingness to examine the economic and scientific achievements in the developed world and to inspire others at home with a vision of the meaning of a modern Japan.

Okubo embarked on a program of reforms, such as export promotion, the development of a merchant marine, the establishment of model factories, and government loans to small-scale industry. By 1878, when a group of former samurai assassinated Okubo as a consequence of the deep grievances generated by the collapse of the shogunate in key segments of Japanese society, the mindset had changed and Okubo’s associates had no problems moving his program forward. Within a hundred years, Japan had emerged as the world’s second largest economy and one of its foremost technological innovators.

It is difficult to argue against the extent to which a particular work ethic and system of personal values and attitudes—part of what we normally understand as culture—played a central role in Japan’s emergence as a world economic power. But for a variety of reasons, economists have avoided getting too closely involved with the concept of culture and its relationship to economic development. There is a general acceptance that culture must have a role in guiding a population along a particular path, but, as Landes (2000) points out, a discomfort with what can be construed as implied criticism of a particular culture has discouraged broader public discourse.

The role of culture in economic development is not an easy subject to get a handle on. To start with, one faces issues of definition. The more all-encompassing the definition, the less helpful it tends to be in explaining patterns of development. Economists tend to narrowly define culture as “customary beliefs and values that ethnic, religious, and social groups transmit fairly unchanged from generation to generation” (Guiso, Sapienza and Zingales, 2006). This approach is largely dictated by the aim to identify causal relationships, by focusing on aspects of culture that are constant over time. Not surprisingly, some of the most insightful writing on the subject has been done by anthropologists. Murdock (1965) argues that a culture consists of habits that are shared by members of a society. It is the product of learning, not of heredity. Woolcock (2014) highlights how the sociologic scholarship has evolved to consider culture as “shaping a repertoire or ‘tool kit’ of habits, skills, and styles from which people construct ‘strategies of action’” (Swidler, 1986, p.273).

A second complication is that even with a sensible definition, one would have to confront the fact that cultural identity is not fixed. Cultural change—anthropologists tell us—begins with processes of innovation, of which cultural borrowing or diffusion is by far the most common.  But it can also be precipitated by social acceptance, by selective elimination and by integration.

From a policy perspective, malleable aspects of culture are more interesting as they open up the possibility for intervention. The World Bank’s 2015 World Development Report cites a number of examples of interventions that have determined a cultural change to trigger improvements in welfare: one example is political affirmative action for women in West Bengal.

There are other complications, however, in attempting to use cultural explanations for economic development.Huntington (2000) remarks how in the early 1960s Ghana and Korea were broadly comparable in terms of income per capita, structure of production, and foreign aid. Thirty years later the contrast could not be more pronounced. According to Huntington, culture had a major role in explaining it: “South Koreans valued thrift, investment, hard work, education, organization, and discipline. Ghanaians had different values. In short, cultures count.”[1] The problem with this formulation is that it does not provide a very auspicious basis to start a dialogue with Ghana as to how they could catch up with Korea. Not surprisingly, international financial organizations and bilateral donors have shied away from framing the debate in terms of cultural norms. 

Beyond issues of presentation, it is possible that “culture”, in fact, disguises other forces at work, more amenable to change. How much of the Ghana’s stunted development is simply the result of bad policies? In many developing countries investors are unwilling to plan for the long-term because of the risks associated with political instability. What may appear to be cultural traits may, in fact, be behaviors shaped by economic incentives and thus amenable to change through changes in the underlying incentives. So, to take an example, the absence of a work ethic in the Soviet Union was not a reflection of some ingrained cultural trait, but rather was a natural response to an environment in which wage differentials were extremely narrow, promotion was not linked to performance, and life-time employment was more or less guaranteed. People’s behaviour at work was totally consistent with this particular set of dis-incentives.

Sachs (2000) identifies a number of factors which have fundamentally affected development in various parts of the world and can be detached from conceptions of culture. He notes, for instance, the (dis)advantages of geography, such as access to natural resources, being landlocked or part of a poor, volatile neighborhood. Easterly (2006) discusses the heavy burden on Africa associated with the historically arbitrary demarcation of international borders. Poverty may have more to do with geography and climate, with natural resource management, and with the toxic interactions between ethnic diversity and artificial borders, than with purely cultural factors.

As a result of globalization, because “citizens are more exposed to successful behaviors elsewhere” (Porter, 1990 p. 26), geography, climate, and natural resources are gradually giving way to knowledge, education, and access to new technologies as the key drivers of productivity and economic growth. We are witnessing the gradual emergence of a universal, global culture based on such values as adherence to civil and human rights, gender equality, respect for property rights, the rule of law, acceptance of market forces as a mechanism for resource allocation.

In saying that education and the acquisition of knowledge and skills are desirable development objectives we are making a statement that holds true across different regions of the world, that applies to all contemporary civilizations. Of course, societies will differ in the ways and the extent to which they have internalized some of these values in their policies, their traditions and their institutions. Acceptance of the desirability of gender equality, for instance, does not mean that inequalities and injustices based on gender—deeply entrenched in all our cultures, to a greater or lesser extent—will suddenly disappear. But few would disagree with the thesis that gender disparities are out of step with modernity and that their presence retards human progress. Development is not only about reducing poverty and expanding opportunities against the background of rising incomes. It is also in a very fundamental way about adopting a set of values that are compatible with humanity’s moral development.

Easterly, William. 2006. The white man's burden: why the West's efforts to aid the rest have done so much ill and so little good. New York: Penguin Press.
Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2006. “Does Culture Affect Economic Outcomes?”, Journal of Economic Perspectives 20: 23-48.
Harrison, Lawrence E., Samuel P Huntington. 2000. Culture Matters. New York: Basic Books.
Landes, David. 1998. The Wealth and Poverty of Nations. London: Little, Brown and Company.
Murdock, George Peter. 1965. Culture and Society. Pittsburg: University of Pittsburg Press.
Sachs, Jeffrey. 2000. Notes on a new sociology of economic development. In: Harrison, L.E., S.P. Huntington. 2000. Culture Matters. New York: Basic Books, 29-43.
Swidler, Ann. 1986. “Culture in action: symbols and strategies”, American Sociological Review 51: 273-286.
Woolcock, Michael. 2014. “Culture, Politics, and Development”. Policy Research Working Paper 6939. Washington: The World Bank.

[1] Huntington, p. xiii.

Monday, November 24, 2014

The Moral Dimensions of Corruption

2010 International Corruption Hunters Alliance Conference In our earlier blogs on corruption we have looked at the causes and consequences of corruption within the process of economic development. In our last blog, Six Strategies to Fight Corruption, we addressed the question of what can be done about it, and discussed the role of economic policies in developing the right sorts of incentives and institutions to reduce its incidence. This blog will provide some thoughts on the moral dimensions of corruption.

In his erudite and all-encompassing study of bribery through the ages, Noonan (1984, p. 700) observes that “the common good of any society consists not only in its material possessions but in its shared ideals. When these ideals are betrayed, as they are betrayed when bribery is practiced, the common good, intangible though it be, suffers injury.” Bribery and corruption—however much the experts may wish to disguise them in the language of costs and benefits and economic choices—have a moral dimension. We ignore it at our own risk and at considerable cost to society in terms of the effectiveness of measures taken to limit or ameliorate their corrosive effects. Noonan gives several reasons to support the thesis that bribery has a strong moral dimension. By now, it has been criminalized in virtually every country in the planet, although enforcement of the laws condemning it may be weak. As we have seen, corruption itself may have weakened the state and its capacity to punish violations of the law, but there is little ambiguity that bribery is regarded everywhere as a perversion, hence the need for secrecy, for deception, and the use of euphemisms (gifts, contributions) by the guilty when it explodes into the open.

Bribery interacts with power. He who is willing to pay the most will be granted the exemption, will shut out the competitor, will gain the advantage. A plutocracy, a world in which wealth and money rule, is not a system likely to capture the popular imagination. Bribers understand this, and for that very reason they do not advertise their actions and are condemned to act behind the scenes, on the margins of legality and morality. Of course, bribery and corruption are betrayals of trust. Noonan (p. 704) puts it elegantly when he says: “the social injury inflicted by breaches of trust goes beyond any material measurement. When government officials act to enrich themselves they act against the fabric on which they depend, for what else does government rest upon except the expectation that those chosen to act for the public welfare will serve that welfare?” Equally important, bribery and corruption are deeply at odds with the moral basis of most of the world’s great religions, which have often provided the moral underpinnings of the modern state, as is clear, for instance, by reading the U.S. Constitution and other such founding documents.

In many of the measures discussed in previous blogs aimed at combating corruption, the underlying philosophy is one of eliminating the opportunity for corruption by changing incentives, by closing off loopholes and eliminating misconceived rules that encourage corrupt behavior. If, for instance, the budget is formulated, approved and executed in an environment of clear rules and transparent procedures, it is far less likely to be a mechanism for abuse and personal enrichment. But an approach that focuses solely on changing the rules and the incentives, accompanied by appropriately harsh punishment for violation of the rules, is likely to be far more effective if it is also supported by efforts to buttress the moral and ethical foundation of human behavior. A strategy in the struggle against corruption that is based solely on the design of better rules and harsher punishment for offenders is likely to be expensive and inefficient: expensive because of the need to build an infrastructure of enforcement that is credible and which catches and deals with offenders, but inefficient because it immediately pits the regulators/enforcers against the offenders in a cat-and-mouse game. And we have seen that the mice are often well-equipped to win, because the stakes are so high and the cat (regulator) is underpaid, overstretched, and outsmarted. The 2008-2009 global financial crisis revealed huge gaps in the regulation of the “shadow” banking system (hedge funds, investment banks, other off-balance sheet vehicles), but also showed that poorly-paid regulators are no match for the creativity of bankers willing to stretch the rules in an effort to disguise reality and boost short-term profits.

This means that in the long-term perspective, anticorruption strategies have to be supported by moral education and the strengthening of the ethical principles underpinning society. Appropriate policies and the right sorts of incentives may, in the end, go some way in addressing the problem of corruption but may in many places not be enough. This may mean reinforcing the civic responsibility component of secular education. It may require religious leaders—who bear such heavy responsibility for the decline of religion as a force for social cohesion—to set aside narrow doctrinal differences and return to the spiritual roots of their respective faiths to revitalize their ability to lead individuals and societies to a stronger identification with the spiritual rather than the material dimension of human nature. In particular, it will involve partnerships with all the organizations and social forces that have a strong ethical foundation. In a society with stronger ethical standards, the struggle against corruption will gain a new source of strength that will complement the progress made in recent years in improving the legal framework designed to combat bribery and corruption.

Tuesday, September 23, 2014

Austerity vs. Fiscal Stimulus: A False Dilemma?

The 2008-2009 global financial crisis led to a number of large–scale government interventions across the world. These included massive provisions of liquidity, the takeover of weak financial institutions, the extension of deposit insurance schemes, purchases by the government of troubled assets, bank recapitalization and, of course, packages of fiscal stimulus, sometimes of a scale not seen since World War II. Even the IMF, the world’s traditional guardian of sound public finance, came out strongly in favor of fiscal loosening, arguing through its managing director that “if there has ever been a time in modern economic history when fiscal policy and a fiscal stimulus should be used, it's now” and that it should take place “everywhere where it's possible. Everywhere where you have some room concerning debt sustainability. Everywhere where inflation is low enough not to risk having some kind of return of inflation, this effort has to be made.

One can argue whether the responses to the crisis were well-designed in particular countries, but there seems to be broad consensus that rapid international action on a number of fronts was necessary to prevent a 1930s-like depression with unforeseen global economic consequences. In the years that followed, public-debt levels rose rapidly, particularly among the advanced economies. Spain, for instance, saw its debt levels rise from under 37% of GDP in 2007 (well within the Maastricht criteria) to about 100% of GDP in 2014, according to IMF estimates.

Indeed, in many countries public indebtedness today stands at levels last seen at the end of World War II. These fiscal developments, however, have not prevented the emergence of an intense debate, particularly in Europe but also in the United States and other OECD countries, about the desirability of continued fiscal loosening, to mitigate the effects of weak economic growth and high levels of unemployment. These debates—largely academic at first—have intensified recently and have had political spillovers in some countries, with resigning ministers arguing against the constraints of “austerity,” as happened recently in France.

I would like to argue that this debate is largely a false one, in the sense that many countries, in fact, do not have the luxury of entering into a prolonged period of fiscal expansion, in the hopes of revitalizing anemic growth rates. Some form of fiscal consolidation, supported by other structural and institutional reforms, may be the only viable path in coming years. Here are three arguments in support of this claim.
  1. Reduced fiscal space. Many countries currently “suffering” the rigors of austerity face a sobering fiscal arithmetic over the next several years. To take an example: in 2013 Spain had a total financing need in excess of 20 percent of GDP. About two thirds of this consisted of maturing public debt and the rest was explained by a persistent budget deficit. The fiscal authorities, therefore, needed to access the bond markets on an annual basis to the tune of close to $300 billion (the financing figures for this year are broadly similar). This level of funding can be manageable in the context of a growing global economy with bullish investors and confident consumers. It becomes a huge risk if investors decide that the debt burden is unsustainable. In that scenario, interest rates will rise (sometimes with amazing speed) and the ability of the government to fund itself at reasonable cost will suddenly evaporate. With high debt levels, the room for fiscal maneuver is constrained by the mood of the international bond markets. To argue against austerity is fine, provided the authorities are certain that they will not lose the confidence of the markets in the process. With debt levels hovering around 100% of GDP that certainty is simply not there.  Not only are governments constrained in a fiscal stimulus, but with rising debt levels a growing share of spending will have to go to debt service, limiting expenditures on education, infrastructure and health and other areas that will improve competitiveness. Furthermore, not being a captive of the markets, means policymakers can be proactive about reforms, rather than reactive to a changing external environment.
  2. Medium-term pressures. One line of thinking argues that we should not worry excessively about debt levels now. In the United Kingdom and the United States, for instance, debt levels at the end of World War II were well in excess of 100% of GDP (in the UK substantially so). A combination of relatively good fiscal management, some inflation, and economic growth brought these levels down significantly by the mid-1970s. The problem with this argument is that the decades following the war had very favorable demographics, with substantial increases in the working age populations. Today we have the opposite problem: ageing populations. The cost of pensions, healthcare, and other social benefits is projected to rise rapidly over the next several decades. In the United States, for instance, 78 million people were born between 1946 and 1964 (the “baby boomers”) and this cohort started retiring in 2011. And this is not a problem only in rich industrial countries. China, Russia, Poland, Indonesia, Turkey, Mexico, to name a few, have an ageing population of their own. So, in coming years and decades, there will be fiscal pressures that were not present in the late 1940s and 1950s and that will significantly add to budgetary burdens and erode the ability of governments to simply “grow out of debt.”
  3. Unstable financial markets. There are credible economists (Nobel laureates even) who argue that the global financial system is inherently unstable, that there is no guarantee that it will not crash in the future as a result of abuse, misbehavior or other factors unrelated to those which caused the last crisis. Robert Shiller (2009), a leading observer of financial markets and one who issued repeated warnings about the real estate bubble in the United States, thinks that “capitalist economies, left to their own devices, without the balancing of governments, are essentially unstable.” There is no certainty, thus, that we could not yet again face what we saw in 2008 following the collapse of Lehman, or some variant thereof. What makes this a nightmare scenario is that the ability of governments to prevent an economic depression through a variety of interventions, such as those deployed in 2008-2009, will be very much a function of the health of their own finances. Absent this, what is left is the Latin American scenario of the 1980s: debt default and potentially very high inflation, except that this time around the impact would be global and highly destabilizing. The point here is that another financial crisis could put exactly the same kinds of pressures on budgets that we saw after 2008, but now the starting point, in terms of debt levels, is much worse.
It is misguided to think that if we could only relax budget rules and allow bigger deficits and correspondingly higher levels of debt, this will eliminate the need for the painful and long delayed reforms that highly indebted countries so desperately need. France, a member of the G7 and one of the world’s larger economies, has been running budget deficits without interruption for the past 40 consecutive years. In good times and bad times. Under conservative governments, and left-leaning ones. Along the way, public debt has more than quadrupled from under 21% of GDP in 1980 to close to 97% of GDP in 2014. To argue that, now, with weak economic growth, the solution is to be found in yet another episode of fiscal loosening is to profoundly misdiagnose the cause for the sluggish growth. Sustainable economic recovery—essential to successfully address the debt problem—will only come when governments implement reforms that will help remove supply-side barriers that have long undermined competitiveness and reduced potential growth. If anything, the global financial crisis has shown the high costs associated with delayed reforms.

Thursday, May 15, 2014

Six Strategies to Fight Corruption

Having looked at some of the ways in which corruption damages the social and institutional fabric of a country, we now turn to reform options open to governments to reduce corruption and mitigate its effects. Rose-Ackerman (1998) recommends a two-pronged strategy aimed at increasing the benefits of being honest and the costs of being corrupt, a sensible combination of reward and punishment as the driving force of reforms. This is a vast subject. We discuss below six complementary approaches.

1. Paying civil servants well
Whether civil servants are appropriately compensated or grossly underpaid will clearly affect motivation and incentives. If public sector wages are too low, employees may find themselves under pressure to supplement their incomes in “unofficial” ways. Van Rijckeghem and Weder (2001) did some empirical work showing that in a sample of less developed countries, there is an inverse relationship between the level of public sector wages and the incidence of corruption.

2. Creating transparency and openness in government spending
Subsidies, tax exemptions, public procurement of goods and services, soft credits, extra-budgetary funds under the control of politicians—all are elements of the various ways in which governments manage public resources. Governments collect taxes, tap the capital markets to raise money, receive foreign aid and develop mechanisms to allocate these resources to satisfy a multiplicity of needs. Some countries do this in ways that are relatively transparent and make efforts to ensure that resources will be used in the public interest. The more open and transparent the process, the less opportunity it will provide for malfeasance and abuse. Collier (2007) provides persuasive evidence on the negative impact of ineffective systems of budget control. Countries where citizens are able to scrutinize government activities and debate the merits of various public policies also makes a difference. In this respect, press freedoms and levels of literacy will, likewise, shape in important ways the context for reforms. Whether the country has an active civil society, with a culture of participation could be an important ingredient supporting various strategies aimed at reducing corruption.

New Zealand, which is consistently one of the top performers in Transparency International’s Corruption Perceptions Index, is a pioneer in creating transparent budget processes, having approved in 1994 the Fiscal Responsibility Act, providing a legal framework for transparent management of public resources.

3. Cutting red tape
The high correlation between the incidence of corruption and the extent of bureaucratic red tape as captured, for instance, by the Doing Business indicators suggests the desirability of eliminating as many needless regulations while safeguarding the essential regulatory functions of the state. The sorts of regulations that are on the books of many countries—to open up a new business, to register property, to engage in international trade, and a plethora of other certifications and licenses—are sometimes not only extremely burdensome but governments have often not paused to examine whether the purpose for which they were introduced is at all relevant to the needs of the present. Rose-Ackerman (1998) suggests that “the most obvious approach is simply to eliminate laws and programs that breed corruption.”

4. Replacing regressive and distorting subsidies with targeted cash transfers
Subsidies are another example of how government policy can distort incentives and create opportunities for corruption. According to an IMF study (2013), consumer subsidies for energy products amount to some $1.9 trillion per year, equivalent to about 2.5 percent of global GDP or 8 percent of government revenues. These subsidies are very regressively distributed, with over 60 percent of total benefits accruing to the richest 20 percent of households, in the case of gasoline. Removing them could result in a significant reduction in CO2 emissions and generate other positive spillover effects. Subsidies often lead to smuggling, to shortages, and to the emergence of black markets. Putting aside the issue of the opportunity costs (how many schools could be built with the cost of one year’s energy subsidy?), and the environmental implications associated with artificially low prices, subsidies can often put the government at the center of corruption-generating schemes. Much better to replace expensive, regressive subsidies with targeted cash transfers.

5. Establishing international conventions
Because in a globalized economy corruption increasingly has a cross-border dimension, the international legal framework for corruption control is a key element among the options open to governments. This framework has improved significantly over the past decade. In addition to the OECD’s Anti-Bribery Convention, in 2005 the UN Convention Against Corruption (UNCAC) entered into force, and by late 2013 had been ratified by the vast majority of its 140 signatories. The UNCAC is a promising instrument because it creates a global framework involving developed and developing nations and covers a broad range of subjects, including domestic and foreign corruption, extortion, preventive measures, anti-money laundering provisions, conflict of interest laws, means to recover illicit funds deposited by officials in offshore banks, among others. Since the UN has no enforcement powers, the effectiveness of the Convention as a tool to deter corruption will very much depend on the establishment of adequate national monitoring mechanisms to assess government compliance.

Others (Heinemann and Heimann (2006)) have argued that a more workable approach in the fight against corruption may consist of more robust implementation of the anticorruption laws in the 40 states that have signed the OECD’s AntiBribery Convention. Governments will need to be more pro-active in cracking down on OECD companies that continue to bribe foreign officials. In their efforts to protect the commercial interests of national companies, governments have at times been tempted to shield companies from the need to comply with anticorruption laws, in a misguided attempt not to undermine their position vis-à-vis competitors in other countries. Trade promotion should not be seen to trump corruption control. Governments continue to be afflicted by double standards, criminalizing bribery at home but often looking the other way when bribery involves foreign officials in non-OECD countries.

6. Deploying smart technology
Just as government-induced distortions provide many opportunities for corruption, it is also the case that frequent, direct contact between government officials and citizens can open the way for illicit transactions. One way to address this problem is to use readily available technologies to encourage more of an arms-length relationship between officials and civil society; in this respect the Internet has been proved to be an effective tool to reduce corruption (Andersen et al., 2011). In some countries the use of online platforms to facilitate the government’s interactions with civil society and the business community has been particularly successful in the areas of tax collection, public procurement, and red tape. Perhaps one of the most fertile sources of corruption in the world is associated with the purchasing activities of the state. Purchases of goods and services by the state can be sizable, in most countries somewhere between 5-10 percent of GDP. Because the awarding of contracts can involve a measure of bureaucratic discretion, and because most countries have long histories of graft, kickbacks, and collusion in public procurement, more and more countries have opted for procedures that guarantee adequate levels of openness, competition, a level playing field for suppliers, fairly clear bidding procedures, and so on.

Chile is one country that has used the latest technologies to create one of the world’s most transparent public procurement systems in the world. ChileCompra was launched in 2003, and is a public electronic system for purchasing and hiring, based on an Internet platform. It has earned a worldwide reputation for excellence, transparency and efficiency. It serves companies, public organizations as well as individual citizens, and is by far the largest business-to-business site in the country, involving 850 purchasing organizations. In 2012 users completed 2.1 million purchases issuing invoices totaling US$9.1 billion. It has also been a catalyst for the use of the Internet throughout the country.

In many of the measures discussed above aimed at combating corruption, the underlying philosophy is one of eliminating the opportunity for corruption by changing incentives, by closing off loopholes and eliminating misconceived rules that encourage corrupt behavior. But an approach that focuses solely on changing the rules and the incentives, accompanied by appropriately harsh punishment for violation of the rules, is likely to be far more effective if it is also supported by efforts to buttress the moral and ethical foundation of human behavior. We will turn our attention to this in a future blog.

Monday, March 31, 2014

Nine Reasons why Corruption is a Destroyer of Human Prosperity

Anti-Corruption billboard In an earlier blog post, we commented on the sources of corruption, the factors that have turned it into a powerful obstacle to sustainable economic development. We noted that the presence of dysfunctional and onerous regulations and poorly formulated policies, often created incentives for individuals and businesses to short-circuit them through the paying of bribes. We now turn to the consequences of corruption, to better understand why it is a destroyer of human prosperity.

First, corruption undermines government revenue and, therefore, limits the ability of the government to invest in productivity-enhancing areas. Where corruption is endemic, individuals will view paying taxes as a questionable business proposition. There is a delicate tension between the government in its role as tax collector and the business community and individuals as tax payers. The system works reasonably well when those who pay taxes feel that there is a good chance that they will see a future payoff, such as improvements in the country’s infrastructure, better schools and a better-trained and healthier workforce. Corruption sabotages this implicit contract. When corruption is allowed to flourish taxpayers will feel justified in finding creative ways to avoid paying taxes or, worse, become bribers themselves.

To the extent that corruption undermines revenue, it adversely affects government efforts to reduce poverty. Money that leaks out of the budget because of corruption will not be available to lighten the burden of the poor. Of course, corruption also undermines the case of those who argue that foreign aid can be an important element of the fight against global poverty—why should taxpayers in the richer countries be asked to support the lavish lifestyles of the kleptocrats in corrupt states?

Second, corruption distorts the decision-making connected with public investment projects (Tanzi and Davoodi, 1997). Large capital projects provide tempting opportunities for corruption. Governments will often undertake projects of a larger scope or complexity than warranted by the needs of the country. Public investment will thus be higher—the world is littered with the skeletons of white elephants, often built with external credits, and representing a heavy burden on meager budgets. In the context of scarce resources, governments will find it necessary to cut spending elsewhere, sometimes in socially vital areas, or in operations and maintenance. Tanzi (1998) plausibly argues that corruption will also reduce expenditure on health and education because these are areas where it may be more difficult to collect bribes, though some have argued that provider absenteeism, a serious problem in the educational and health sectors of many countries, is itself a form of “quiet/silent corruption.”

Third, there is solid empirical evidence that the higher the level of corruption in a country, the larger the share of its economic activity that will go underground, beyond the reach of the tax authorities.  Not surprisingly, studies have shown that corruption also undermines foreign direct investment since it acts in ways that are indistinguishable from a tax; other things being equal, investors will always prefer to establish themselves in less corrupt countries. Wei (2000) reviewed FDI data from 14 source countries to 45 host countries, and concluded that: “an increase in the corruption level from that of Singapore to that of Mexico is equivalent to raising the tax rate by 21-24 percentage points.”

Fourth, corruption discourages private-sector development and innovation and encourages inefficiency. Budding entrepreneurs with bright ideas will be intimidated by the bureaucratic obstacles, financial costs and psychological burdens of starting new business ventures and will either opt for taking their ideas to some other less corrupt country or, more likely, desist altogether. In either case, economic growth is adversely affected. The high incidence of corruption will mean an additional financial burden on businesses, undermining their international competitiveness. Unlike a tax, which is known and predictable and can be built into the cost structure of the enterprise in an orderly fashion, bribes are unpredictable and will complicate cost control, reduce profits and undermine the efficiency of those who must pay them to stay in business. Mauro (1995) used some indices of corruption and institutional efficiency to show that corruption lowers investment and, hence, economic growth.

Fifth, corruption contributes to a misallocation of human resources. To sustain a system of corruption, officials and those who pay them will have to invest time and effort in the development of certain skills, nurture certain relationships, and build up a range of supporting institutions and opaque systems, such as off-the-books transactions, secret bank accounts, and the like. Surveys have shown that the greater the incidence of corruption in the country, the greater the share of time that management has to allocate to dealing with ensuring compliance with regulations, avoiding penalties, and dealing with the bribery system that underpins them, activities that draw attention and resources away from production, strategic planning, and so on.

Sixth, corruption has disturbing distributional implications. Empirical work shows that corruption actually contributes to worsening income distribution. Gupta, Davoodi and Alonso-Terme (1998) have shown that corruption, by lowering economic growth, perceptibly pushes up income inequality. It also distorts the tax system because the wealthy and powerful are able to use their connections to make sure that the tax system works in their favor. It leads to inefficient targeting of social programs, many of which will acquire regressive features, with benefits disproportionately allocated to the higher income brackets; e.g., gasoline subsidies to the car-owning middle classes in India.

Seventh, corruption creates uncertainty. There are no enforceable property rights emanating from a transaction involving bribery. The firm that obtains a concession from a bureaucrat as a result of bribery cannot know with certainty how long the benefit will last. The terms of the “contract” may have to be constantly renegotiated to extend the life of the benefit or to prevent its collapse. Indeed, the briber, having flouted the law, may fall prey to extortion from which it may prove difficult to extricate himself. In an uncertain environment with insecure property rights, the firm will be less willing to invest and to plan for the longer-term.  A short-term focus to maximize short-term profits will be the optimal strategy, even if this leads to deforestation, say, or the rapid exhaustion of non-renewable resources.

This uncertainty is partly responsible for a perversion in the sorts of incentives that prompt individuals to want to seek public office. Where corruption is rife, politicians will want to remain in office as long as possible, not because they are even remotely serving the public good, but merely because they will not want to yield to others the pecuniary benefits of high office. Where long stays in office are no longer an option, then the new government will want to steal as much as possible as quickly as possible, given a relatively short window of opportunity.

Eighth, because corruption is a betrayal of trust, it diminishes the legitimacy of the state and moral stature of the bureaucracy in the eyes of the population. While efforts will be made to shroud such corrupt transactions in secrecy, particularly when the opportunities for bribery are linked to some government-inspired initiative, the relevant details will leak out and will tarnish the reputation of the government, thereby damaging its credibility and limiting its ability to become a constructive agent of change. Corrupt governments will have a tougher time being credible enforcers of contracts and protectors of property rights.

Ninth, bribery and corruption lead to other forms of crime. Because corruption breeds corruption, it tends soon enough to lead to the creation of mafias and organized criminal groups who use their financial power to infiltrate legal businesses, to intimidate, to create protection rackets and a climate of fear and uncertainty. In states with weak institutions, the police may be overwhelmed, reducing the probability that criminals will be caught. This, in turn, encourages more people to become corrupt, further impairing the efficiency of law enforcement, a vicious cycle that will affect the investment climate in noxious ways, further undermining economic growth. In many countries, as corruption gives rise to mafias and organized crime, the police and other organs of the state may themselves become criminalized. By then, businesses will not only have to deal with corruption-ridden bureaucracies, but they will also be vulnerable to attacks from competitors who will pay the police or tax inspectors to harass and intimidate.

There is really no limit to the extent to which corruption, once it is unleashed, can undermine the stability of the state and organized society. Tax inspectors will extort businesses; the police will kidnap innocents and demand ransom; the prime minister will demand payoffs to make himself available for meetings; aid money will disappear into the private offshore bank accounts of senior officials; the head of state will demand that particular taxes be credited directly to his personal account. Investment will come to a standstill, or, worse, capital flight will lead to disinvestment. In countries where corruption becomes intertwined with domestic politics, separate centers of power will emerge to rival the power of the state. At that point, the chances that the government will actually be able to do anything to control corruption will disappear and the state will mutate into a kleptocracy, the eighth circle of hell in Dante’s Divine Comedy.

Alternatively, the state, to preserve its power, may opt for warfare, engulfing the country in a cycle of violence. In any case, corrupt failed, or failing, states become a security threat for the whole international community, “because they are incubators of terrorism, the narcotics trade, money laundering, human trafficking, and other global crime—raising issues far beyond corruption itself” (Heineman and Heimann 2006).

Monday, February 10, 2014

What are the Sources of Corruption?

In a previous blog we discussed the factors that have pushed issues of corruption to the centre of policy debates about sound economic management. A related question deals with the sources of corruption: where does it come from, what are the factors that have nourished it and turned it into such a powerful impediment to sustainable economic development? Economists seem to agree that an important source of corruption stems from the distributional attributes of the state. For better or for worse, the role of the state in the economy has expanded in a major way over the past century. In 1913 the 13 largest economies in the world, accounting for the bulk of global economic output, had an average expenditure ratio in relation to GDP of around 12%. This ratio had risen to 43% by 1990, with many countries’ ratios well in excess of 50%.  This rise was associated with the proliferation of benefits under state control and also in the various ways in which the state imposes costs on society. While a larger state need not necessarily be associated with higher levels of corruption—the Nordic countries illustrate this—it is the case that the larger the number of interactions between officials and private citizens, the larger the number of opportunities in which the latter may wish to illegally pay for benefits to which they are not entitled, or avoid responsibilities or costs for which they bear an obligation.

Governing often translates into the issuing of licenses and permits. From the cradle to the grave, the average citizen has to enter into transactions with some government office or bureaucrat to obtain a birth certificate, to get a passport, to pay taxes, to open up a new business, to drive a car, to register property, to engage in foreign trade, to sell a good or service to the government, to hire an employee, to be allowed to build a house, among countless others. The World Bank’s Doing Business Report has become a useful annual compendium of the burdens of business regulation in 189 countries. The picture that emerges from the report for a large number of countries is a sobering one. Go to the report’s website and see why in so many parts of the world businesses endure numbing levels of bureaucracy and red tape. In fact, the data in the report eloquently highlights the extent to which many governments discourage the development of entrepreneurship in their own private sectors. Not surprisingly, the prevalence of corruption is highly correlated with the incidence of red tape and excessive regulation. The figure below shows the country rankings for Transparency International’s latest Corruption Perceptions Index and the rankings for DB 2014 for a total of 175 countries. The figure speaks for itself: the greater the extent of bureaucracy and red tape, the greater the incidence of corruption—the correlation coefficient is close to 0.80.

A number of surveys have shown that businesses allocate considerable time and resources to dealing with red tape. Often, they may feel that the paying of bribes is a way to save time and enhance efficiency and, in many countries, possibly the only way to get business done without undermining the firm’s competitive position vis-à-vis those who pay bribes routinely. Obviously, the more dysfunctional the economic and legal system and the more onerous the regulations, the greater the incentives for individuals and businesses to short-circuit it through the paying of bribes.  The literature is full of examples: the absurdities of central planning in the Soviet Union induced “corruption” on the part of the factory managers, to add a degree of flexibility to a system that made a mockery of efficiency in resource allocation. The more insane the rules, the more likely will participants in the system find themselves breaking them.

Leff, a Harvard researcher argued in an insightful analysis in 1964 that those who viewed corruption as an unremittingly bad thing were implicitly assuming that governments were well-motivated and committed to the implementation of policies that advanced the cause of economic development. In reality, Leff thought that in many countries policies were largely geared to advancing the interests of the ruling elite. Leff and Nye (a Harvard colleague) both suggested that corruption was partly a response to market distortions, to red tape, excessive and unreasonable regulation and bad policies but these, in turn, were also themselves affected by the levels of corruption prevailing in the country, in a symbiotic two-way form of causality that turned corruption into an intractable social and economic problem. While it is clear that bribes and corruption may in some cases be responses to the existence of distortions in the economy, we will see in a future blog that far from enhancing efficiency, corruption imposes heavy costs on society, across a broad range of fronts.

The tax system itself is often a source of corruption, particularly in those cases where the underlying legislation is unclear or otherwise difficult to understand, presumably giving tax inspectors and auditors considerable leeway in interpretation. Unclear tax laws will give rise to unwholesome “compromises” between tax inspectors and taxpayers. More generally, there are numerous ways in which various features of government organization and policy create incentives for the emergence of corrupt behavior. As noted above, the imposing presence of the state in the economy and, in particular, the provision of goods and services at below market prices create fertile ground for corruption. Invariably, they give rise to the creation of some form of rationing mechanism to manage excess demand, requiring the exercise of discretion on the part of some government official(s). I remember a meeting at the Central Bank of Russia in May of 1992 in which we were shown an annex running into several pages with the exchange rates that applied for the importation of various items, from luxury cars, to medications to baby carriages. Some bureaucrats had managed to come up with some mysterious criteria establishing dozens upon dozens of prices for foreign exchange, depending on the item to be imported. Needless to say, the list allowed considerable latitude for discretion.

A similar regime existed for export quotas, allowing those who obtained an export license to benefit from the huge gap between the domestic price and the international price. Another legacy of the Soviet Union was a system of directed credits, essentially highly subsidized loans to agriculture and industry. At rates of interest that were absurdly negative in real terms, the demand for them was unusually strong and, of course, the criteria for allocation opaque in the extreme.

While it is easy to see the incentives for bribes provided by such examples, the resulting losses in economic efficiency are likewise evident. Directed credits in Russia did not generally end up with farmers. Rather they ended up with the highest bidder who then used the proceeds to buy foreign exchange and finance capital flight (the credits themselves were never paid back or were paid in deeply depreciated rubles). Export quotas resulted in massive losses for the Russian budget, at a time when the country was going through a severe economic contraction and when, therefore, there were enormous pressures for increased social spending. Susan Rose-Ackerman, one of the leading experts on corruption, calls the above kind of bribery, bribes that clear the market or that equate supply and demand.

Some bribes are offered as incentive payments for bureaucrats. These can take a variety of forms, such as “speed money,” ubiquitous in many parts of the world, and typically used to “facilitate” some transaction, to jump the queue, and so on. Some economists have argued that this could improve efficiency since incentives are provided to work more quickly and those who value their time highly can move faster. Gunnar Myrdal (1968), however, has pointed out that, over time, incentives could work the other way: bureaucrats will deliberately slow things down or, worse, will find imaginary obstacles or themselves create new obstacles, in order to attract facilitation fees. So, in the end, “speed money” is not paid to speed things up but rather to avoid delays artificially created by corrupt bureaucrats. Indeed, some of the regulations enforced in many parts of the world are so devoid of rationality that one can only infer that they were introduced to create opportunities for bribery. Far from being a way to enhance efficiency, paying bribes preserves and strengthens the bribery machinery. This is a vast subject. The reader can find many more examples here. In our next blog we will turn our attention to the issue of the various consequences or effects of corruption.

Friday, January 24, 2014

Why is Corruption Today Less of a Taboo than a Quarter Century Ago?

For those of us who have had an interest in corruption for much of our careers, there is little doubt that sometime in the late 1980s and early 1990s there was a shift in thinking within the development community about the role of corruption in the development process. The shift was tentative at first; continued reluctance to touch upon a subject that was seen to have a large political dimension coexisted for a while with increasing references to the importance of “good governance” in encouraging successful development. What were the factors that contributed to this shift? One that quickly comes to mind is linked to the falling of the Berlin Wall and the associated collapse of central planning as a supposedly viable alternative to the free market. It was obvious that it was not inappropriate monetary policies that led to the collapse of central planning but rather widespread institutional failings, including a lethal mix of authoritarianism (i.e., lack of accountability) and corruption.

The collapse of central planning in the late 1980s and the need for the international community to assist these countries in making a successful transition to democratic forms of governance and economies based on market principles made it glaringly clear that it would take far more to do so than “getting inflation right” or reducing the budget deficit. Literally overnight, the economics profession was forced to confront a much broader set of issues beyond conventional macroeconomic policy. Related to the demise of central planning, the end of the Cold War had clear cut implications for the willingness of the international community to turn a blind eye to glaring instances of corruption in places where ideological loyalties had led to episodes of collective blindness. By the late 1980s, for instance, Mobutu was cut off by the donor community, no longer willing to quietly reward him for his persistent loyalty to the West during the Cold War.

A second factor was growing frustration with the plight of people in Africa and other parts of the developing world. Gains in the global fight against poverty had begun to bear some fruit but these were largely concentrated in China, with Africa actually seeing further increases in the number of poor. I was an economist in the IMF during the late 1980s and early 1990s and distinctly remember efforts by the IMF staff—particularly in Africa—to look beyond macroeconomic stabilization to issues of structural and institutional reforms and corruption could no longer be ignored.

A third factor had to do with developments in the academic community. In particular, research on the importance of property rights, education and training, and institutions, including some empirical work which began to suggest that differences in institutions appeared to explain an important share of the growth differential between countries, and therefore have an influence upon countries’ growth performance. (For a nice survey see, for instance, Acemoglu et. al., “Institutions as the Fundamental Cause of Long-Run Growth”, in Handbook of Economic Growth, Elsevier, 2004).  For a growing number of economists corruption began to be seen as an economic issue and this led to a better understanding of the economic effects of corruption, a topic to which we will turn in a future blog.

Also playing an important role was the intensification, beginning in the 1980s, of the pace of globalization. Globalization and its supporting technologies have clearly led to a remarkable increase in transparency and to people’s demand for openness and greater scrutiny. The multilateral organizations were not immune to these influences. How could one ignore or fail to see the stashing away of billions of dollars of ill-gotten wealth in secret bank accounts by the world’s worst autocrats, many of them long-standing clients of these organizations?

In parallel to these developments and further raising international public awareness of corruption, the 1990s witnessed a large number of scandals involving major political figures in some form of bribery or corruption. In India and Pakistan the prime ministers were defeated largely because they were dogged by corruption charges. In South Korea two presidents were jailed following disclosures of bribery, while in Brazil and Venezuela bribery charges resulted in the presidents being impeached and removed from office. In Italy, Italian magistrates sent to jail a not insignificant number of the political class, who had ruled the country in the post-war period, and exposed the vast web of bribery that had bound together political parties and members of the business community. There was less progress in Africa but, without question, corruption became harder to hide and the new technologies of communication proved a useful ally of increasing openness and transparency.

A related development pertains to changes in the global economy, which significantly boosted the perceived importance of productivity as a primary engine of prosperity. Globalization highlighted the importance of efficiency. Countries could not hope to maintain their presence in the global economy and compete in an increasingly complex marketplace, unless they used scarce resources effectively. And the prevalence of corruption definitely detracted from this. Furthermore, business leaders began to speak more forcefully about the need for a level-playing field and the costs associated with doing business in corruption-ridden environments.

In the 1990s the United States government made efforts to keep the issue of corruption alive in its discussion with OECD partners, further raising international awareness. The Foreign Corrupt Practices Act of 1977 had forbidden American businessmen and corporations from bribing foreign government officials, imposing stiff penalties, including prison terms, on those engaged in the paying of illegal bribes. Because other OECD countries were not subject to such restrictions—in fact, the payment of bribes continued to be tax deductible in most other OECD countries, as a cost of doing business abroad—American companies began to complain that they were losing business to OECD competitors. Academics sifting through the data showed that following passage of the Act, U.S. business activities abroad declined substantially, as the Act had actually helped to undermine the competitive position of American firms. These developments gave considerable impetus to U.S. government efforts to persuade other OECD members to ban bribery practices and in 1997 the OECD adopted the Anti-Bribery Convention, an important legal achievement.

Also contributing to this shift in attitude was the work of Transparency International (TI) and the publication, beginning in 1993, of its now well-known Corruption Perceptions Index (CPI). That corruption existed everywhere was a well-known fact. What TI showed was that some countries had been more successful than others in curtailing it. The work of TI helped greatly to focus public attention on the issue of corruption and contributed to legitimizing public discourse on issues of corruption and thus eased the transition by the multilateral organizations into doing the same.

Transparency International was soon assisted in its efforts by the international organizations themselves. At the IMF/World Bank meeting in 1996 the Bank president, James Wolfensohn, gave a speech in which he did not mince words, saying that there was a collective responsibility to deal with “the cancer of corruption.” More important, Mr. Wolfensohn gave strong backing to Bank staff efforts to develop a broad range of governance indicators, including those specifically capturing the extent of corruption. This was an extremely important development because it made it possible for the Bank, through the use of quantified indicators and data, to focus attention on issues of governance and corruption while at the same time not appearing to interfere in the political affairs of its members.

While the above goes some way to explain what contributed to shift the thinking about the importance of corruption, in our next blogs we will examine three additional issues: what are the sources of corruption, what is the economic impact of corruption and what can be done about it?