Governance and Growth: Overview of Evidence, Alternative Research and Policy Responses Mushtaq H. Khan, Department of Economics, SOAS Governance for Growth Workshop, Russell Hotel July 2-3 2007

Governance, good governance and the state Governance as a reform priority emerged in the 1970s and 1980s when the economic failure of many undemocratic and corrupt regimes in developing countries could no longer be ignored Criticisms from developing country civil society were soon joined by the development community and mainstream economists The result was the good governance agenda: improving accountability, the control of corruption and rent seeking, the protection and stabilization of property rights, and improving the rule of law

Institutions, rules and governance Douglass North defined institutions as rules, but he also pointed out that the existence of a rule does not mean it can be enforced The debate on governance is sometimes about the particular rules that should be enforced, and sometimes about improving the governance capabilities that allow the enforcement of these rules The two issues are closely connected because if a particular set of rules cannot be enforced, their appropriateness as a policy priority can be questioned

Sources of support for good governance reforms Civil society in developing countries often supports the enforcement of these rules on the grounds that many are highly desirable goals in themselves Fiduciary responsibility of donor agencies has driven concerns about corruption and the diversion of resources: focus on PFM, anti-corruption strategies and accountability Our concern is with theory and evidence on the relationship between better enforcement of ‘good governance’ institutions and economic growth Even if good governance institutions are desirable, Is the reform agenda implementable to any significant extent? Are these institutions and governance capabilities the right priorities for growth?

Background theory: Institutional Economics and Transaction Costs Douglass North: Market transaction costs depend on how well-protected property rights are, and on the institutions protecting contracts (the rule of law) Reducing market transaction costs reduces market failures and accelerates investment and growth Efficient market economies therefore require reforms to improve the protection of property rights and establish an effective rule of law

Rent-seeking and state intervention State intervention (like the operation of markets) is not costless: Krueger, Bhagwati, Posner and others argued there were significant rent-seeking costs whenever states intervened The early recommendation was liberalization: if the state did not create rents there would be no rent seeking Today there is a recognition that many state services are critical: so the focus is on reducing rent-seeking costs in critical areas by fighting corruption and improving accountability

New political economy: the incentives of political actors Politics identified both as a platform for rent seeking and a competitive constraint on rent seekers Olson’s work on stationary bandits and democracy: Democracy limits rent seeking in developing countries (but not necessarily advanced ones!) Models of neo-patrimonialism in Africa argued that the absence of democracy allowed ‘big men’ to use clientelism to sustain their power at the expense of high levels of corruption and property right instability Emerging policy support for democracy and decentralization as conditions for efficient markets and low rent seeking

The New Policy Agenda

The Governance-Growth Debates The debate on theory and evidence focuses on 3 questions Are these institutions and their proper enforcement desirable goals or are they also necessary preconditions for development? Even if in theory effective enforcement of these institutions would enhance growth, to what extent are they achievable in the typical developing country? By focusing on these governance conditions, are we taking our eyes off other more important institutional rules and associated governance capabilities that are both achievable and important for growth?

Governance and Growth: the Evidence

Rule of Law and Growth

State Capabilities and Reform Priorities

‘Which’ governance capabilities to target and ‘how’ to measure progress How to measure governance has taken up a lot of time, particularly with critiques of the Kaufmann-Kray indicators and their responses More important question is are we focusing on achievable institutions and governance capabilities required for their enforcement The broader debate on the evidence is covered in Hazel Gray’s literature review

Theory reconsidered: Transaction Costs North’s analysis has implications that are often ignored: reducing transaction costs is costly and all economies (including the US) have high levels of aggregate expenditure on ‘transaction sectors’ When the productive sector is small, individual capitalists may want stable property rights but are rationally unwilling to pay high taxes because they know they will still have to separately protect their individual rights And if market transaction costs remain high, individual capitalists have to devise non-market arrangements to acquire the assets and resources they need The focus on property rights stability across the board is immediately unachievable and may be ignoring reforms that are likely to actually make a difference

Stable property rights may be unachievable in developing countries Evidence from the transformational states of East Asia and China shows a different set of de facto institutions: property right stability focused on growth-generating investors and governance capabilities for enforcing these At the same time formal and informal institutions for non-market transfers of assets were common and were usually growth enhancing Keefer points out that the same property right stability score could hide significantly different property right protection strategies Moore and Schmitz, Sayeed: Close relationships between business and political power brokers are common in developing countries, in some cases they result in growth, in others they result in the collusion Adam Smith warned of

Rents, rent seeking and corruption Early rent seeking theories also have serious shortcomings: they focus on the rent seeking cost and not on the types of rents Stiglitz and many others have shown that a vast range of rents are essential for the proper functioning of ‘market economies’ Many rents are damaging, other rents are second-best responses to market failures that would be even worse without the rents Some recent research has looked at the damaging incentives created by natural resource rents and aid (Moore, Keefer) Issues here are whether the best response is to try and reduce these rents or improve the institutional and governance capacities of the recipient to use these rents effectively (Dijohn, Khan)

Rents, rent seeking and corruption However, a much wider range of rents can evolve in developing countries and we need to build on the extensive analysis of rents Rents are typically created (and protected) through rent-seeking activities but many rents may have positive effects for growth in a context of pervasive market failure (Khan and Jomo) The compatibility or otherwise of the political and institutional structure and the requirements of second-best efficiency for particular rents define the success of otherwise of the ‘rent management system’ In this analysis, what matters is the compatibility of the institutional rules for second-best improvements and the governance capabilities for their enforcement

Political stabilization is a very different process in developing countries Political stabilization is expensive and in developing countries requires off-budget resource allocations (Khan) As a result, honest politicians find it difficult to get elected, making the link between democracy, accountability, anti-corruption and property right stability weak or non-existent The structure of patron-client networks (Khan) and political organizations (Keefer) rather than democracy and accountability can help to explain differences in rent creation strategies North, Wallis, Weingast and Webb are developing a model of the Limited Access Order: violence potential in developing countries requires the creation of rents to achieve stability: potential governance implications for developing countries

Links identified in new research

Policy Agenda Donor concern about the theft of their money should not be confused with the challenge of governance reforms to accelerate development If key parts of the good governance agenda are not easily implementable the agenda can damage the identification of other pragmatic capacity-building goals The ‘diagnostics’ of identifying market failures that are both important and can be addressed given political and institutional initial conditions involves judgements – we should not expect a consensus on these difficult issues (but research has identified a range of alternative ‘rules’ and ‘governance capabilities’ that deserve attention) Policy makers should not wait for an academic consensus: they should also respond to theory, facts and their own experiences in developing countries

Some discussion points The broad agenda of good governance does not necessarily have to be abandoned if we recognize the (very) long time scales required for its effective implementation Identifying the immediate governance priorities for growth involves making political judgements: A viable approach may be to encourage country stakeholders to identify the institutions and enforcement capacities that are required for the success of their growth strategies. Specific donor concerns could support narrow governance interests such as PFM and other ‘actionable indicators’. Some of these reforms could contribute to growth provided they are complementary with and not a substitute for a growth strategy for the country The debate about how to measure should not be confused with what to measure. The great contribution of WGI has been to keep governance at the centre of the policy debate